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Chapter 6
Risk and Term Structure of
Interest Rates
The Purpose of Learning
• As we discuss theories in greater detail,
we often find these theories are not as
clear as we wish. How shall we deal with
them?
• The purpose of learning
– Learn the language of communication
– Understand the deficiencies of the theories
Finance Theory as a Language
• We learn expectation theory, market
segmentation theory so we can
communicate with other people in the
financial industry.
• This helps us land a job and be competent
in our work.
• But it won’t help us make a fortune.
Understand the deficiencies of the
theories
• Michael Milken
• His two insights
– Equities were undervalued at the end of 70s
and the beginning of 80s
– There is a gap between equity market and
risk free asset.
Under valuation of equities
• What if Milken worship Efficient Market
Theory, which is taught in every
investment textbook?
• Why market was underpriced that time?
• High inflation, high interest rate, and
hence high discount rate
• But most people do not adjust income
streams as much.
What is Inflation?
• Inflation is the increase of asset price.
• In a high inflation environment, asset price
increases rapidly. For those asset rich entities,
high inflation means their asset value increase
rapidly. Hence their share price should increase
instead of decreasing.
• Why inflation is generally considered a negative
thing?
• Most people are fixed income earners.
Some formal discussion
• The ratio of house prices to rents (a real
valuation number) should not be affected
by inflation-induced changes in mortgage
interest rates. Nevertheless, the data show
that the ratio of house prices to rents in the
U.S. economy has been trending up since
the mid-1980s as inflation and mortgage
interest rates have been trending down.
(Kevin J. Lansing, 2004)
• The observation that real valuation ratios are
correlated with movements in nominal interest
rates lends credence to the Modigliani-Cohn
hypothesis. Investors and homebuyers appear
to be adjusting their discount rates to match the
prevailing nominal interest rate. However, for
some unexplained reason, they do not
simultaneously adjust their forecasts of future
nominal cash flows, i.e., earning distributions or
imputed rents.
• The failure to take into account the
influence of inflation on future nominal
cash flows is an expectational error that is
equivalent to discounting real cash flows
using a nominal interest rate.
• Why people discount future with nominal interest
rate but estimate future earning with real rate?
• Probably it is born from most people’s personal
experiences. The borrowing cost varies with
nominal interest rate. But most people’s
earnings are not adjusted for inflation. This is
probably also true for rental incomes, minimum
wages and other relatively fixed incomes.
• Equities are seriously undervalued in early
eighties. Anyone who can buy equities in
any way can make a lot of money
• Milken put his understanding into action.
His method of financing is related to
another insight.
Figure 2
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M
D
P
R
O
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• Blume, Marshall and Irwin Friend, 1973, A new
look at the capital asset pricing model, Journal of
Finance, 28, 19 – 34.
• Because there is a gap between high volatility
equity market and low volatility risk free or near
risk free bond market, the lack of supply created
favourable prices.
• Milken read it, thought about it and put into
action to create the junk bond industry. He is one
of the rare people who read a lot of theories and
put them into action.
A technique of risk arbitrage
and its effect on the shape of yield
curve
• Buy high yield longer maturity bond
financed by lower yield short maturity
bonds.
• This tends to drive the yield curve flatter.
• Only institutions can do this because of
the transaction cost.
Definition of risk with respect to
duration
• The price volatility of longer duration
bonds is higher than the short duration
bond.
• In general, longer duration bonds are
considered riskier. Hence higher yield.
• However, for investors holding long term
bonds to maturity, there is no risk. This
poses a difficulty in defining and
understanding risk.
• Midterm: Try to catch our discussion and
insight in the classes. But mostly from
textbooks.
• Coverage: Chapter 1 to 6
Homework
• 6, 7, 8, 9, 10, 12