Question 1: The Possible Determinants of Market Interest Rates
The following are the possible determinants of market interest rates:
The government. Interest rates are determined by the mandated government body. In the US, the Federal Reserve dictates the policies which consequently impact the interest rates (Heakar, 2019). The interest rates charged by banks on the lent-out loans are affected by the federal funds rate, a specific rate regulating the issuance of short term loans between banks and firms. The rate is set by the federal government using open market transactions and prior US securities. When the government buys the securities, banks have excess cash to lend. Consequently, they decrease their interest rates in order to attract lenders. On the other hand, banks are compelled to increase interest rates when the federal government sells the securities (Heakal, 2019). This is because the banks have lesser money for lending out.
Inflation. The market interest rates are impacted by inflation rates. Whenever the inflation rates are high, the interest rates are also high. Similarly, low inflation rates are met with low interest rates. Lenders increase the interest rates when the inflation rates are high in order to take care of reduced credit availability (Heakal, 2019). The lenders are keen to recoup their money and reduce the risks of the money lent out.
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Supply and demand. The supply and demand for money to be lent out by banks influence the interest rates. Whenever there is increased credit need, the interest rates are bound to increase. The availability of lots of money to be lent out will result in the reduction of interest rates (Heakal, 2019). Such an eventuality may occur when the banks receive huge cash deposits. The lending out of the money causes an increase of the money in circulation and a consequent increase in credit supply thus a decrease in the price of borrowing. Deferment of payments by lenders causes a decrease in credit availability and thus the consequent increase in interest rates (Bean, 2017).
Question 2: Yield Curves
The US Treasury yield curve is used in the comparison of the issued short term Treasury bills with the Treasury notes and bonds that have been issued for the long term. Treasury bills maturity duration is usually less than an year while the Treasury notes are issued for periods of 2, 3, 5 and 10 years. Treasury bonds are issued for 20- and 30-years maturity periods.
Table 1
Yield Curve Data
| US Treasury Bonds Times to maturity | US Treasury Bond’s Yields to Maturity |
| 1 Mo |
8% |
| 2 Mo |
8% |
| 3 Mo |
8% |
| 6 Mo |
9% |
| 1 Yr |
10% |
| 2 Yr |
14% |
| 3 Yr |
24% |
| 5 Yr |
49% |
| 7 Yr |
81% |
| 10 Yr |
113% |
| 20 Yr |
167% |
| 30 Yr |
187% |
Source: (US Department of the Treasury, 2021)
The yield curve is a graphical representation of the relationship between the maturity of the issued bonds and the bond yields. The curve denotes the risks that are related to the bonds in respect to the maturity of the bonds. The time range in the curve is influenced by the maturity duration of the bonds issued by the US Treasury Department. The US Treasury Department issues bonds with maturities ranging from one month to 30 years. A long maturity duration is associated with increased risks, while a short maturity duration has lesser associated risks.
The three main types of yield curves are as discussed below:
The normal yield curve in which the yield curve slopes upwards. The normal yield curves are representative of long-term rates that are typically placed above short-term rates due to maturity risk premium ( Brigham & Houston, 2018) .
Figure 1
Illustration of Normal Yield Curve
Inverted yield curve that slopes downwards. The long-term bonds have lesser yield amounts than short term bonds. The curve predicts the occurrence of an economic downturn (Amadeo, 2020).
Figure 2
Illustration of the Inverted Yield Curve
Flat yield curves in which the short and the long-term maturities are almost similar. The curve indicates that investors anticipate slow economic growth (Amadeo, 2020)
Figure 3
Illustration of the Inverted Yield Curve
Question 3: Types of Debt Securities
According to Brigham & Houston (2018), debt securities are classified into three groups depending with the issuer. The various securities in each class are discussed below:
Treasury bonds or treasuries or government bonds. Treasury bonds are the debt securities that are issued by the federal government. These bonds have no default risks since it is generally assumed that the US government will honor its promised payments. The bond’s prices are, however, impacted by increasing interest rates, which cause them to decrease. The various types of treasury bonds are as listed below:
Savings bonds issued by the US Treasury and selling at face value. Their interest rate is fixed (Chen, 2020).
Treasury notes issued by US Treasury have maturity durations of either 2, 5, or 10 years. Such bonds offer fixed coupon returns (Chen, 2020). They are essential in offsetting deficits in the federal budget and regulating the money supply.
Treasury bonds (T-Bonds) are long term bonds with maturity periods ranging from 10 to 30 years (Chen, 2020). their interest or coupon payments are made semi-annually
Corporate bonds. These are the debt securities that are issued by business firms. These debt securities are prone to default risk in the event that the issuing company runs into financial troubles. The issuing company may fail to honor its promised interest and principal payments. Corporate bonds having high default risks attract high-interest rates from investors. According to Brigham & Houston (2018), the various types of corporate bonds are listed as follows:
Subordinated debentures in which in the event of a bankruptcy, the assets can only be claimed after the senior debt has been fully paid. In scenarios where the issuing firm is to be liquidated or reorganized, the holders of such debt securities receive no payments until all the senior debt has been fully repaid.
Debentures which are the unsecured bonds. There is no particular collateral which is used as security. The holders of such bonds are regarded as general creditors since the property which can act as security for the bonds is not pledged.
Mortgage bonds in which the issuing corporation promises particular assets as the security for the bond. In the event of a default by the issuing company, the holders of such bonds can sell the pledged assets and settle their claims.
Municipal bonds or munis. These are the debt securities issued by state and local governments. They are exposed to default risk. However, they are considered advantages since they are exempted from federal taxes and state taxes in situations where the holder is a resident of the issuing state. The market interest rates on municipal bonds is lesser than that of corporate bond of equal risk. The various types of municipal bonds are as listed below:
General obligation bonds. These types of debt securities are issued by counties, states, or counties. They are not secured by any assets and are only held in the faith of the issuer (US Securities and Exchange Commission (SEC), n.d.). The bonds are, however, backed by the taxing power of the issuing government.
Revenue bonds that are backed by the revenues generated by the issuer from particular projects, e.g., the lease fees or highway tolls. In some of the revenue bonds, if the revenue stream is no longer available, the bondholders do not bear any claims on the revenue source (SEC, n.d.).
Foreign bonds that are issued by foreign governments and are exposed to default risk.
Question 4
| Future Value |
$1,000 |
Paid semi annualy | ||
| Maturity Time | 20Years | |||
| Coupon Interest rate |
7% |
|||
| Yield maturity |
4% |
|||
| The semi-annual interest is calculated as follows | ||||
| FV* coupon interest rate * 1/2 = $1000 * 7% * ½ = |
$35 |
|||
| Number of pay periods = 20 years * 2 times an year |
40 |
|||
| Semi annual yield to maturity = 4% * 1/2 = |
2% |
|||
The present value is calculated as $1410.33
Question 5
From the earlier problem, the bond yields more than the coupon rate and the investment duration. The value of the bond yield will decrease in the successive years until it become equal to the maturity value in the 20 th year as evidenced below:
Year 2 = coupon per term * CPVF (1%, 72 terms) + maturity value * PVF(4%, 18 th year)
= 17.5 * 51.15 + 1000*0.49363 = $1388.755
Year 4 = 17.5 * 47.10 + 1000 * 0.533 = $1357.25
Year 6 = 17.5 * 42.72 + 1000 * 0.577 = $ 1324.60
Year 8 = 17.5 * 37.97 + 1000 * 0.624 = $ 1288.47
Year 10 = 17.5* 32.835 + 1000 * 0.675 = $ 1249.6125
Year 12 = 17.5 * 27.27 + 1000 * 0.731 = $1161.75
Year 14 = 17.5 * 21.243 + 1000 * 0.790 = $ 1161.75
Year 16 = 17.5 * 14.718 + 1000 * 0.854 = $ 1111.565
Year 18 = 17.5 * 7.652 + 1000* 0.924 = $ 1057.91
Year 20 = 17.5 * 7.652 + 1000 * 0.924 = $1057.91
The graphical representation is as shown below
References
Amadeo, K. (2020). Treasury yield curve . The Balance. Retrieved 11 January 2021, from https://www.thebalance.com/treasury-yield-curve-3305902#:~:text=The%20U.S.%20Treasury%20yield%20curve,of%2020%20and%2030%20years .
Bean, M. A., & FCIA, F. (2017). Determinants of Interest Rates. Society of Actuaries .
Brigham, E., & Houston, J. (2018). Fundamentals of financial management (15th ed., pp. 148-182). Cengage Learning.
Chen, J. (2020). Government bond definition . Investopedia. https://www.investopedia.com/terms/g/government-bond.asp
Heakal, R. (2019). What are the forces behind interest rates and what causes them to rise? . Investopedia. Retrieved 11 January 2021, from https://www.investopedia.com/insights/forces-behind-interest-rates/#:~:text=Supply%20and%20Demand-,Interest%20rate%20levels%20are%20a%20factor%20of%20the%20supply%20and,for%20credit%20will%20decrease%20them.&text=An%20increase%20in%20the%20amount,increases%20the%20supply%20of%20credit.
US Department of the Treasury. (2021). Daily treasury yield curve rates . Front page | US Department of the Treasury. Retrieved January 11, 2021, from https://www.treasury.gov/resource-center/data-chart-center/interest-rates/pages/TextView.aspx?data=yieldYear&year=2021
US Securities and Exchange Commission (SEC). (n.d.). Municipal bonds . Investor.gov. https://www.investor.gov/introduction-investing/investing-basics/investment-products/bonds-or-fixed-income-products-0
