Understanding Yield Spreads by Frank J. Fabozzi,Copyright 2007 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express permission of the copyright owner is unlawful. Request for futher information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages caused by the use of these programs or from the use of the information contained herein.,PowerPoint Slides by David S. Krause, Ph.D., Marquette University,Chapter 4 Understanding Yield Spreads,Major learning outcomes: The different yields offered by bonds in different sectors of the bond market Assessing the relative value of individual securities Ranking individual securities with respect to expected return potential The relationship between interest rates offered on different bond issues at a point in time The relationship of interest rates in different sectors of the economy at a given point in time,Key Learning Outcomes,Identify the interest rate policy tools used by the U.S. Federal Reserve Board.Explain the Treasury yield curve and describe the various shapes of the yield curve.Describe the term structure of interest rates.Describe the three theories of the term structure of interest rates: pure expectations theory, liquidity preference theory, and market segmentation theory.For each theory of the term structure of interest rates, explain the implication that the shape of the yield curve suggests regarding the markets expectation about future interest rates.Define a Treasury spot rate.Define a spread product and a spread sector.,Key Learning Outcomes,Explain the different types of yield spread measures (absolute yield spread, relative yield spread, and yield ratio) and how to calculate yield spread measures given the yields for two securities.Distinguish between intermarket and intramarket sector spreads.Describe an issuers on-the-run yield curve.Describe a credit spread and the suggested relationship between credit spreads and the well being of the economy.Identify the relationship between embedded options and yield spreads.Define a nominal spread.Explain an option-adjusted spread.Explain how the liquidity of an issue affects its yield spread,Key Learning Outcomes,Explain the relationship between the yield on Treasury securities and the yield on tax-exempt municipal securities.Calculate the after-tax yield of a taxable security and the tax-equivalent yield of a tax-exempt security.Define LIBOR and why it is an important measure to funded investors who borrow short term.Describe an interest rate swap, the swap rate, the swap spread, and the swap spread curve.Explain how an interest rate swap can be used to create synthetic fixed-rate assets or floating-rate assets.Describe the factors that determine the swap spread.Discuss the observed relationship between swap spreads and credit spreads.,Interest Rate Determination,The interest rate offered on a particular bond issue depends on the interest rate that can be earned on risk-free instruments and the perceived risks associated with the issue.,Federal Reserve Board,The U.S. Federal Reserve Board is the policy making body whose interest rate policy tools directly influence short-term interest rates and indirectly influence long-term interest rates in the United States.The Feds most frequently employed interest rate policy tools are open market operations and changing the discount rate; less frequently used tools are changing bank reserve requirements and verbal persuasion to influence how bankers supply credit to businesses and consumers.,Interest Rate Determination,The actions of the Federal Reserve (Fed) influence the level of interest rates as well as the state of the U.S. economyThe Fed is the policy making body whose interest rate policy tools directly influence short-term interest rates and indirectly influence the long-term ratesOnce the Fed makes a policy decision it immediately announces the policy in a statement issued at the close of the meetingThe Fed also communicates its future intentions via the publishing of its meeting minutes, speeches, and testimony before CongressBond managers pursuing an active portfolio management strategy closely watch the economy to anticipate a change in Federal Reserve policy.,Interest Rate Determination,Bond managers closely follow: Non-farm payrolls Industrial production Housing starts Motor vehicle sales Durable goods orders National Association of Purchasing Management supplier deliveries Commodity prices Hurricanes, wars, and other international events,Interest Rate Determination,In implementing monetary policy, the Fed uses the following tools: Open market operations (most commonly used tool) Discount rate Bank reserve requirements Verbal persuasion to influence how bankers supply credit to business and customers,