Determinants of Market Interest Rates Case Study

Introduction

Determinants of market interest rates is a term used to explain various factors affecting the interest rate. These factors range from the real cost of money to inflation risk. Furthermore, factors dictate the pace of market interests as shown in the formula.

Market Interest Rate (K) = K*+ IP + DRP + LRP + MRP

Where,

K*= Real Risk-Free Rate of Interest

IP=Interest Premium

DRP= Default Risk Premium

LRP=Liquidity Risk Premium

MRP= Market Risk Premium

1. Real Risk-Free Rate of Interest (K*)

( Redux et al. 2011) The defined real risk-free rate of interest c as interest rates that tends to exist on riskless security or in a situation where there is expected to be zero or no inflation. Moreover it the rate of interest from government securities which bears no risk in the absence of inflation. It implies that the market interest rate determinant exists to compensate a particular investor for temporarily tying up their capital while at most occasions bearing no risk (Blinder & Alan 2012). However, the real risk-free rate of interest impact at most times has little or no impact on the economy. A common example is the U.S. Treasury security. Differences in the real risk-free rate of interest are relative to the type of bond issued. Thus a higher-risk bond is accounted for larger yield spread notably amongst smaller and less established companies compared to established blue chips companies with comparatively lower yield spread.

2. Nominal Risk-Free Rate

The nominal rate of interest can be described as the actual rate of interest charged by the giver of funds and paid by the demander of the funds. Furthermore, it may also be defined as the interest rate before taking inflation into account. To further understand our definition a formula constituting of a real risk-free rate of interest and premium of inflation is used as shown below.

OK 1=K*+ IP1/1

OK 2= K* + (IP1+IP2)/2

OK 3= K* + (1P1+1P2+1P3)/3

From the formula, a premium of inflation and the risk-free rate of interest compose nominal risk-free rate. Being a dependent variable, changes in the premium of inflation provides a drive that has a differential impact on the nominal risk-free rate of interest (Blinder & Alan 2012). Thus during inflationary times, central banks tend to set nominal rates high. In myriad cases, the government tends to overestimate the inflation level, and consequently, nominal rates are too high. These at all costs are not advisable as it inflicts serious repercussions on the economy as it inhibits spending.

Also, Central Banks offer set short-term nominal interest rates which acts as a basis for interest rates charged by banks and other financial institutions. After a period of recession nominal interest rates are usually held at low levels with the overall purpose of stimulating economic activities through low-interest rates which foster consumers to take loans and spend. However, for such a stimulus measure, inflation should not be a present or a near-term threat.

3. Default Risk Premium

Default risk premium is the additional amount paid by the borrower to compensate the lender for an assumption of default risk (Blinder&Allan 2012). In the most occasion, default premium is usually paid indirectly by the rate borrowers must repay their obligation. Thus the higher the default risk, the higher the interest rates and vice versa. To enhance our understanding, default risk premium impact on market interest rates is explained by the formula:

K= K*+IP+ DRP

Where, IP= Interest Premium, DRP= Default Risk Payment

Notably in government purposed security default risk payment is usually 0 since there is little on or no risk.

Risk on investment acts as a drive to levels of default risk payment. From an investor's perspective, issuing bonds to a company depends on the degree of default risk. Defaulting to companies is considered failure to meet bond obligations in the scheduled period, and thus the more likely a company is to default the riskier an investment is considered to be. Thus investors under such circumstances will be more than willing to demand a higher rate of return to build default risk premium into the price of bonds. This proves beyond doubt how default risk payment has an impact on market interest rates.

4. Liquidity Risk Premium

Liquidity risk premium can be termed as additional return on bonds that cannot be actively traded (Norris, 2018). Bonds which are illiquid are not easily bought and in many cases are sold at fair market value. Thus to compensate investors for this lack of liquidity, illiquid bonds pay a premium.

The difference in the liquidity nature of bonds acts as a drive in a variation of liquidity risk premium charged. In recent research conducted shows that, corporate bonds of investment -grade US companies have an average liquidity risk premium of 0.6 percent per annum which is comparatively low to speculative-grade bonds from small, less-known companies with an average liquidity premium of 1.5 percent per annum (Leaf Group 2018). Thus the more likely a bond can be traded the lesser the premium charged. For comprehensive understanding market interest rate through liquidity risk premium can be best explained using the formula

K=K*+IP+DRP+ LRP

5. Maturity Risk Premium

Maturity interest rate is the premium charged by the investor for capital losses due to changes in the market interest rates. It can also be defined as the risk premium that compensates investors for holding securities over time. With longer maturities comes more uncertainty about the economy and payback ability of the bond hence higher maturity risk premium. Variations of interest rates as a result of the long-term maturity of bond affects stocks in the same capacity hence need of compensation to the investors. Thus maturity risk premium determines market lending rates using the following formula.

K=K*+ IP+DRP+MRP

The United States Treasury Yield Curve

The United States Treasury yield curve represents the return on investment in percentage on the United States government tax obligations (Norris 2018). In other words, it's a presentation of the interest rates the US government pays to finance debt over a certain duration of time. The government offers a much higher yield of return with the increase in the time of maturity as shown in the graph. Besides higher yield rates are in consideration of inflation rates present or to occur in future. This is with an effort to ensure that investor's purchasing power is not eroded. From the graph yield percentages as at 12 April, 2017 is comparatively low to April 2018 the following year. Besides yield charges and rates are also affected by demand. Thus when the demand is low treasury yield is usually high to compensate for low demand as investors purchases bonds at discounts and are willing to pay an amount below par value. However, the government usually repays the face value of the coupon issued upon maturity, and high demand may result to lower yield percentage.

Types of Yield Curves

Normal Yield Curve

Period of economic expansion usually has an impact on longer-term bonds causing them to rise. Normal yield curve represents such trends. Prospects of longer-maturity bonds to come even higher in future encourage investors to forfeit short-term securities in hopes of purchasing long-term bonds for higher yields. However, it turns out risky to have investment tied up for a long period as their values are yet to decline with higher yield with time.

Inverted Yield Curve

During periods of economic recession, longer-term bonds may continuously fall. An inverted yield curve provides a presentation of the trend and suggests that expectation of longer maturity bonds to be come even lower by investors causes such trends. Thus many investors are willing to lock in yields before they decrease further.

Flat Yield Curve

A flat yield curve may arise from normal or inverted yield curve, depending on changing economic conditions. During the economic transition from expansion to slower development and even recession, yields on longer-maturity fall and yields on short-term maturity rise, inverting a normal yield curve to a flat yield curve (Redux et al., 2011).

Types of debt securities

The following is a list of the main type of debt security explained in detail.

1. Bond, notes and medium-term notes

Bond and notes can be issued on a standalone, once off basis or on a repeat programmebasis. The bonds issued under a programme are known as medium-term notes or MTNs, this allows an issuer to make multiple on the back of one principal set of documents.

2. Commercial Paper (CP)

CP is short-term debt securities which have a term less than 365 days in the UK context. Different rules apply in different places example the US.

3. Interest-bearing Securities

Most debt securities provide for interest payments to be made at regular intervals. At most occasion interest on debt can exist as fixed floating or variable rates basis.

4. Zero Coupon Securities

This is a debt security that bears no interest but is issued on discount of the face value. Upon redeeming of the debt the issuer pays the full face value of the security. Thus return to the investor is the difference between the discounted price of debt and the face value of the security.

5. Equity Linked Security

Equity-linked securities give the investor certain rights in respect of shares and therefore share some of the features of equity securities if those are exercised. The main types of equity-linked securities are.1 Convertible securities which allow investors to convert its debt securities into shares. 2. Exchangeable securities which allow investors to convert its debt securities into shares in a third company at a specified duration of time and price.

6. Asset-Backed Securities

Asset-backed securities are limited resource debt securities issued by a special purpose vehicle backed by income-producing financial assets.

7. Sovereign bonds

Sovereign bonds are debt securities issued by governments, either in their own domestic securities markets or in the international securities market. Types of debt security sovereign bonds issued include 1.Sukuk- debt offered under Islamic Law, 2. Project bonds- debt securities issued to fund all of the cost of a particular project and 3. Retail bonds-small denomination debt securities marketed to retail investors.

Valuation Model for a Corporate Bond

Per value at maturity of $1000, a maturity of 20 years, a coupon interest of 7% and yield to maturity of 4%. Coupons assumed to be paid semi annually

Present Value of time T= Expected cash flows in period T/ (1+I)

Expected Cash flow= $1000x 7%= 70

Present Value= 70/ (1+0.4/2) ^nX2

Present Value

Year 2 = 70/ (1+0.4/2) ^4= $64.67

Year 4= 70/ (1+0.4/2) ^8= $ 59.74

Year 6= 70/ (1+0.4/2) ^12= $ 55.19

Year 8= 70/ (1+0.4/2) ^16= $ 50.99

Year 10= 70/ (1+0.4/2) ^20= $ 47.10

Year 12= 70/ (1+0.4/2) ^24= $ 43.12

Year 14= 70/ (1+0.4/2) ^28= $ 40.20

Year 16= 70/ (1+0.4/2) ^32= $ 37.14

Year 18= 70/ (1+0.4/2) ^36= $ 34.31

Year 20= 1070/ (1+0.4/2) ^40= $ 484.50

Total Value of Bond = 917.36

The bond price significantly falls with time and drastically rises on the period of maturity. The movement of the bond price is critical to the investor as he or she can asses' profitability of the bond issued with time. According to the graph, the investor would opt to settle for short-term bond as it is comparatively less costly than a long-term investment of the bond. Price of the matured bored is lower than the par value or invested bond reflecting a bad investment. According to (Norris, 2010) such instances are as a result of a comparatively high discount rate than the coupon rate. Investors should, therefore, be on the lookout before they make any investment decisions....