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4. The Top 5 Banking Companies in the World, 1999 Bank Name Country Total assets Deutsche Bank AG Germany $735 billion UBS Group Switzerland $687 billion Citigroup United States $669 billion Bank of America United States $618 billion Bank of Tokyo Japan $580 billion

8. Interest Rates as a Function of Supply and Demand for Funds

11. “ Real” Versus “Nominal” Rates k* = Real risk-free rate. T-bond rate if no inflation; 1% to 4%. = Any nominal rate. = Rate on Treasury securities. k k RF

15. Treasury Yield Curve 0 5 10 15 10 20 30 Years to Maturity Interest Rate (%) 1 yr 5.2% 5 yr 5.8% 10 yr 5.9% 30 yr 6.0% Yield Curve (August 1999)

16. Yield Curve Construction Step 1:Find the average expected inflation rate over Years 1 to n: IP n = . n

18. Step 2: Find MRP Based on This Equation: MRP t = 0.1%(t – 1). MRP 1 = 0.1% x 0 = 0.0%. MRP 10 = 0.1% x 9 = 0.9%. MRP 20 = 0.1% x 19 = 1.9%.

19. Step 3: Add the IPs and MRPs to k*: k RF t = k* + IP t + MRP t . k RF = Quoted market interest rate on treasury securities. Assume k* = 3%: k RF1 = 3.0% + 5.0% + 0.0% = 8.0%. k RF10 = 3.0% + 7.5% + 0.9% = 11.4%. k RF20 = 3.00% + 7.75% + 1.90% = 12.65%.

20. Hypothetical Treasury Yield Curve 0 5 10 15 1 10 20 Years to Maturity Interest Rate (%) 1 yr 8.0% 10 yr 11.4% 20 yr 12.65% Real risk-free rate Inflation premium Maturity risk premium

23. Hypothetical Treasury and Corporate Yield Curves 0 5 10 15 0 1 5 10 15 20 Years to maturity Interest Rate (%) 5.2% 5.9% 6.0% Treasury yield curve BB-Rated AAA-Rated

24. How does the volume of corporate bond issues compare to that of Treasury securities? Recently, the volume of investment grade corporate bond issues has overtaken Treasury issues. ‘ 95 ‘96 ‘97 ‘98 ‘99 600 450 300 150 Gross U.S. Treasury Issuance (in blue) Investment Grade Corporate Bond Issuance (in red) Billions of dollars

27. Observed Treasury Rates Maturity 1 year 2 years 3 years 4 years 5 years Yield 6.0% 6.2% 6.4% 6.5% 6.5% If PEH holds, what does the market expect will be the interest rate on one-year securities, one year from now? Three-year securities, two years from now?

28. 0 1 2 5 6.0% 3 4 x% 6.2% PEH tells us that one-year securities will yield 6.4%, one year from now (x%). 6.2% = 12.4% = 6.0 + x% 6.4% = x%. (6.0% + x%) 2

29. 0 1 2 5 6.2% 3 4 x% 6.5% [ 2(6.2%) + 3(x%) ] 5 PEH tells us that three-year securities will yield 6.7%, two years from now (x%). 6.5% = 32.5% = 12.4% + 3(x%) 20.1% = 3(x%) 6.7% = x%.