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Jamal Munshi, Sonoma State Univesity, 1992 | ||
Questions we would like to answer
The answer to all of these questions is
A simple theory goes as follows. The interest rate paid by any debt contract consists of three multiplicative components. These are the liquidity premium, the inflation premium, and the risk premium. It is useful to realize at the outset that these components refer to the FUTURE not the past. That means that we project the future inflation rate, the future risk, and the future liquidity premium and determine today's interest rate. Please keep this in mind during this lecture. The theory is that the interest rate may be represented as:
It is thought that we use these criteria to determine our "REQUIRED" rate of return; that is, we will not invest unless the debt contract yields at least the value of R that reflects our projections of LP, IP, and RP. We also believe that if markets are efficient then markets react quickly to information. Prices and therefore yields reflect all available information about the future. In efficient markets prices will adjust to the aggregate projections of future components of the interest rate so that the market rate, or the "YIELD" on any debt instrument will equal the required rate. This condition is called "equilibrium". The required rate and the yield are actually two different concepts. We equate them only when we can assume that the market is at equilibrium. The liquidity premium of the interest rate is a product of our propensity to consume or our demand for liquidity whichever way you want to see this. It is a statement about human behavior. It says that ceteres paribus we would rather consume today than consume tomorrow but for a financial reward we could be made to wait. This means that even if we expected no inflation and the debt instrument carried no risk whatsoever, we would still demand a return of LP% because by investing we forego consumption. The inflation component represents the additional returns we demand just to break even on purchasing power. For a given numeraire wealth today, we want to be able to consume in the future at least what we could consume today. This would not be possible if the numeraire wealth remains the same and prices of consumables rise. But this would be possible if the numeraire wealth increases at least at the same rate as prices of consumpables. Changing expectation of inflation is thought to be the primary cause of interest rate volatility in time. It also explains why rates vary across countries. But inflation does not explain why in the same country and at the same point in time the yield varies across securities of the same maturity. This is explained by the risk premium theory that is at the root of modern finance. The risk premium represents the additional reward we demand because we are not sure that we will acutally receive the promised future cash flow stream that we are paying for now. Holders of debt instruments are thought to bear two kinds of risk - default risk and interest rate risk. Recall that a debt instrument is a contract that pays an annuity of $PMT for n years then a lump sum of $FACE at maturity. And this contract has a present value of $PV at any point in time depending on the time to maturity and the yield. If the writer of this contract becomes bankrupt in the meantime, the holder of the contract may not receive the remainder of the promised cash flow stream and this risk is called default risk. The default risk of bond issues is assessed as a bond "rating" and published by bond rating companies such as S&P, Moody's, and Fitch. In addition, as prevailing interest rates change, $PV will also change and this fluctuation in the PV is referred to as interest rate risk. Here in this model we are dealing with default risk and the higher the perceived risk of default the greater the returns demanded from the debt contract. Try this simple problem to see whether you can use the equation presented in this lecture. Compute the interest rate when LP=3% and we are expecting future inflation rate to be 2.5%. The debt contract is issued by NCR Corporation and we believe it has a certain likelyhood of default so we will not invest unless we receive at least a 6% risk premium. Also be able to use this equation backwards. Given the interest rate and two of the parameters, compute the third parameter.
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