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Corporate Finance ­FIN 622
VU
Lesson 06
TERM STRUCTURE OF INTEREST RATES
The relationship between long tem & short-term rates is known as Term Structure.
Interest rates in short & long terms are different. Term structure tells us nominal interest rate on default
free securities. When long-term rate is greater than short term then the term structure will be upward
sloping and when short-term rate is greater than the long term, the term structure will be downward
sloping.
The term structure of interest rates, also known as the yield curve, is a very common bond valuation
method.
There are three main patterns created by the term structure of interest rates:
1) Normal Yield Curve:
As its name indicates, this is the yield curve shape that forms during normal market conditions, wherein
investors generally believe that there will be no significant changes in the economy, such as in inflation
rates, and that the economy will continue to grow at a normal rate. During such conditions, investors expect
higher yields for fixed income instruments with long-term maturities that occur farther into the future. In
other words, the market expects long-term fixed income securities to offer higher yields than short-term
fixed income securities. This is a normal expectation of the market because short-term instruments generally
hold less risk than long-term instruments; the farther into the future the bond's maturity, the more time and,
therefore, uncertainty the bondholder faces before being paid back the principal. To invest in one
instrument for a longer period of time, an investor needs to be compensated for undertaking the additional
risk.
Remember that as general current interest rates increase, the price of a bond will decrease and its yield will
increase.
2) Flat Yield Curve:
These curves indicate that the market environment is sending mixed signals to investors, who are interpreting
interest rate movements in various ways. During such an environment, it is difficult for the market to determine
whether interest rates will move significantly in either direction farther into the future. A flat yield curve usually
occurs when the market is making a transition that emits different but simultaneous indications of what interest
rates will do. In other words, there may be some signals that short-term interest rates will raise and other signals
that long-term interest rates will fall. This condition will create a curve that is flatter than its normal positive
slope. When the yield curve is flat, investors can maximize their risk/return tradeoff by choosing fixed-income
securities with the least risk, or highest credit quality. In the rare instances wherein long-term interest rates
decline, a flat curve can sometimes lead to an inverted curve.
3) Inverted Yield Curve:
These yield curves are rare, and they form during extraordinary market conditions wherein the expectations
of investors are completely the inverse of those demonstrated by the normal yield curve. In such abnormal
market environments, bonds with maturity dates further into the future are expected to offer lower yields
than bonds with shorter maturities. The inverted yield curve indicates that the market currently expects
interest rates to decline as time moves farther into the future, which in turn means the market expects yields
of long-term bonds to decline. Remember, also, that as interest rates decrease, bond prices increase and
yields decline.
You may be wondering why investors would choose to purchase long-term fixed-income investments when
there is an inverted yield curve, which indicates that investors expect to receive less compensation for taking
on more risk. Some investors, however, interpret an inverted curve as an indication that the economy will
soon experience a slowdown, which causes future interest rates to give even lower yields. Before a
slowdown, it is better to lock money into long-term investments at present prevailing yields, because future
yields will be even lower.
REAL VS NOMINAL INTEREST RATES:
The nominal interest rate is the amount, in money terms, of interest payable.
For example, suppose household deposits $100 with a bank for 1 year and they receive interest of $10.
At the end of the year their balance is $110. In this case, the nominal interest rate is 10% per annum.
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Corporate Finance ­FIN 622
VU
The real interest rate, which measures the purchasing power of interest receipts, is calculated by
adjusting the nominal rate charged to take inflation into account.
If inflation in the economy has been 10% in the year, then the $110 in the account at the end of the
year buys the same amount as the $100 did a year ago. The real interest rate, in this case, is zero.
After the fact, the 'realized' real interest rate, which has actually occurred, is:
ir = in -- p
where p = the actual inflation rate over the year.
The expected real returns on an investment, before it is made, are:
ir = in -- pe
where:
in = nominal interest rate
ir = real interest rate
pe = expected or projected inflation over the year.
Market interest rates
There is a market for investments which ultimately includes the money market, bond market, stock
market and currency market as well as retail financial institutions like banks.
Exactly how these markets function is a complex question. However, economists generally agree that
the interest rates yielded by any investment take into account:
The risk-free cost of capital
Inflationary expectations
The level of risk in the investment
The costs of the transaction
Risk-free cost of capital
The risk-free cost of capital is the real interest on a risk-free loan. While no loan is ever entirely risk-
free, bills issued by major nations are generally regarded as risk-free benchmarks.
This rate incorporates the deferred consumption and alternative investments elements of interest.
Inflationary expectations
According to the theory of rational expectations, people form an expectation of what will happen to
inflation in the future. They then ensure that they offer or ask a nominal interest rate that means they
have the appropriate real interest rate on their investment.
This is given by the formula:
in = ir + pe
Where:
in = offered nominal interest rate
ir = desired real interest rate
pe = inflationary expectations
Risk
The level of risk in investments is taken into consideration. This is why very volatile investments like
shares and junk bonds have higher returns than safer ones like government bonds.
The extra interest charged on a risky investment is the risk premium. The required risk premium is
dependent on the risk preferences of the lender.
If an investment is 50% likely to go bankrupt, a risk-neutral lender will require their returns to double.
So for an investment normally returning $100 they would require $200 back. A risk-averse lender would
require more than $200 back and a risk-loving lender less than $200. Evidence suggests that most
lenders are in fact risk-averse.
Generally speaking a longer-term investment carries a maturity risk premium, because long-term loans
are exposed to more risk of default during their duration.
Liquidity preference
Most investors prefer their money to be in cash than in less fungible investments. Cash is on hand to be
spent immediately if the need arises, but some investments require time or effort to transfer into spend able
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Corporate Finance ­FIN 622
VU
form. This is known as liquidity preference. A 10-year loan, for instance, is very illiquid compared to a 1-
year loan. A 10-year US Treasury bond, however, is liquid because it can easily be sold on the market.
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Table of Contents:
  1. INTRODUCTION TO SUBJECT
  2. COMPARISON OF FINANCIAL STATEMENTS
  3. TIME VALUE OF MONEY
  4. Discounted Cash Flow, Effective Annual Interest Bond Valuation - introduction
  5. Features of Bond, Coupon Interest, Face value, Coupon rate, Duration or maturity date
  6. TERM STRUCTURE OF INTEREST RATES
  7. COMMON STOCK VALUATION
  8. Capital Budgeting Definition and Process
  9. METHODS OF PROJECT EVALUATIONS, Net present value, Weighted Average Cost of Capital
  10. METHODS OF PROJECT EVALUATIONS 2
  11. METHODS OF PROJECT EVALUATIONS 3
  12. ADVANCE EVALUATION METHODS: Sensitivity analysis, Profitability analysis, Break even accounting, Break even - economic
  13. Economic Break Even, Operating Leverage, Capital Rationing, Hard & Soft Rationing, Single & Multi Period Rationing
  14. Single period, Multi-period capital rationing, Linear programming
  15. Risk and Uncertainty, Measuring risk, Variability of return–Historical Return, Variance of return, Standard Deviation
  16. Portfolio and Diversification, Portfolio and Variance, Risk–Systematic & Unsystematic, Beta – Measure of systematic risk, Aggressive & defensive stocks
  17. Security Market Line, Capital Asset Pricing Model – CAPM Calculating Over, Under valued stocks
  18. Cost of Capital & Capital Structure, Components of Capital, Cost of Equity, Estimating g or growth rate, Dividend growth model, Cost of Debt, Bonds, Cost of Preferred Stocks
  19. Venture Capital, Cost of Debt & Bond, Weighted average cost of debt, Tax and cost of debt, Cost of Loans & Leases, Overall cost of capital – WACC, WACC & Capital Budgeting
  20. When to use WACC, Pure Play, Capital Structure and Financial Leverage
  21. Home made leverage, Modigliani & Miller Model, How WACC remains constant, Business & Financial Risk, M & M model with taxes
  22. Problems associated with high gearing, Bankruptcy costs, Optimal capital structure, Dividend policy
  23. Dividend and value of firm, Dividend relevance, Residual dividend policy, Financial planning process and control
  24. Budgeting process, Purpose, functions of budgets, Cash budgets–Preparation & interpretation
  25. Cash flow statement Direct method Indirect method, Working capital management, Cash and operating cycle
  26. Working capital management, Risk, Profitability and Liquidity - Working capital policies, Conservative, Aggressive, Moderate
  27. Classification of working capital, Current Assets Financing – Hedging approach, Short term Vs long term financing
  28. Overtrading – Indications & remedies, Cash management, Motives for Cash holding, Cash flow problems and remedies, Investing surplus cash
  29. Miller-Orr Model of cash management, Inventory management, Inventory costs, Economic order quantity, Reorder level, Discounts and EOQ
  30. Inventory cost – Stock out cost, Economic Order Point, Just in time (JIT), Debtors Management, Credit Control Policy
  31. Cash discounts, Cost of discount, Shortening average collection period, Credit instrument, Analyzing credit policy, Revenue effect, Cost effect, Cost of debt o Probability of default
  32. Effects of discounts–Not effecting volume, Extension of credit, Factoring, Management of creditors, Mergers & Acquisitions
  33. Synergies, Types of mergers, Why mergers fail, Merger process, Acquisition consideration
  34. Acquisition Consideration, Valuation of shares
  35. Assets Based Share Valuations, Hybrid Valuation methods, Procedure for public, private takeover
  36. Corporate Restructuring, Divestment, Purpose of divestment, Buyouts, Types of buyouts, Financial distress
  37. Sources of financial distress, Effects of financial distress, Reorganization
  38. Currency Risks, Transaction exposure, Translation exposure, Economic exposure
  39. Future payment situation – hedging, Currency futures – features, CF – future payment in FCY
  40. CF–future receipt in FCY, Forward contract vs. currency futures, Interest rate risk, Hedging against interest rate, Forward rate agreements, Decision rule
  41. Interest rate future, Prices in futures, Hedging–short term interest rate (STIR), Scenario–Borrowing in ST and risk of rising interest, Scenario–deposit and risk of lowering interest rates on deposits, Options and Swaps, Features of opti
  42. FOREIGN EXCHANGE MARKET’S OPTIONS
  43. Calculating financial benefit–Interest rate Option, Interest rate caps and floor, Swaps, Interest rate swaps, Currency swaps
  44. Exchange rate determination, Purchasing power parity theory, PPP model, International fisher effect, Exchange rate system, Fixed, Floating
  45. FOREIGN INVESTMENT: Motives, International operations, Export, Branch, Subsidiary, Joint venture, Licensing agreements, Political risk