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This 0 page Class Notes was uploaded by Rachel Fikse on Thursday January 21, 2016. The Class Notes belongs to FINA 30203 at Texas Christian University taught by Dr. Ed Ireland in Spring 2016. Since its upload, it has received 70 views. For similar materials see Money and Banking in Finance at Texas Christian University.
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Date Created: 01/21/16
Chapter 4 Determining Interest Rates I Introduction a Interest rates below in ation rate real interest rate on deposits bank savings accounts is negative b An increase in market interest rates cause prices of existing bonds to fall ll How to Build an Investment Portfolio a The Determinants of Portfolio Choice i Investors use the following determinants of portfolio choice or determinants of asset demand to evaluate different investment oonns 1 The saver39s wealth or total amount of savings to be allocated among investments 2 The expected rate ofreturn from an investment compared with the expected rates of return on other investments 3 The degree of risk in an investment compared with the degree of risk in other investments 4 The liquidity of an investment compared with the liquidity of other investments 5 The cost of acquiring information about an investment compared with the cost of acquiring information about other investments ii Wealth 1 Income is a person39s earnings during a particular period 2 Wealth is the total value of assets a person owns minus the total value of any liabilities that a person owes iii Expected Rate of Return 1 The rate of return for a particular holding period includes the rate of capital gain which an investor can calculate only at the end of the period 2 Expected return the rate of return expected on an asset during a future period a Expected Return Probability of event 1 occurring x Value of event 1 Probability of event 2 occurring x Value of event 2 iv Risk 1 Risk the degree of uncertainty in the return on an asset 2 Most investors are risk adverse when choosing between two assets with the same expected return they would choose the asset with the lower risk a Will invest in an asset that has greater risk only if they are compensated by receiving a higher return 3 Some investors are risk loving they prefer to gamble by holding a rislq asset with the possibility of maximizing returns 4 Some are risk neutral they would make their investment decisions on the basis of expected returns ignoring risk v Liquidity 1 Liquidity is the ease with which an asset can be exchanged for money 2 Assets with greater liquidity help savers to smooth spending over time or to access funds for emergencies a The greater an asset39s liquidity the more desirable the asset is to investors 3 Willing to accept a very low possibly zero interest rate on your checking account because you have immediate access to those funds vi The cost of acquiring information 1 Investors nd assets more desirable if they don39t have to spend much time or money acquiring information about them 2 Tradeoff between the cost of acquiring information and return 3 For example if a new company issues bonds investors must spend time and money collecting and analyzing information about the company before deciding to invest vii Summary of determinants 1 Desirable characteristics of a nancial asset cause the quantity of the asset demanded by investors to increase and undesirable characteristics of a nancial asset cause the quantity of the asset demanded to decrease 2 Refer to Table 41 on page 93 for comparison of all determinants b Diversi cation the division of wealth among many different assets to reduce risk i Market systematic risk risk that is common to all assets of a certain type such as the increases and decreases in stocks resulting from the business cycle ii Idiosyncratic unsystematic risk risk that pertains to a particular asset rather than to the market as a whole as when the price of a particular rm39s stock uctuates because of the success or failure of a new product iii Diversi cation can eliminate idiosyncratic risk but not systematic risk iv Depending on the investment your real aftertax return may be considerably different from your nominal pretax return III Market Interest Rates and the Demand and Supply for Bonds a We know that the price of a bond P and its yield to maturity I are linked by the equation showing the price of a bond with coupon payments C that has a face value Fl and that matures in n years i Equation on p 95 ii Bond market approach once equilibrium price is determined in the bond market have also determined the equilibrium interest rate 1 Considering the bond as the quotgoodquot being traded in the market iii Market for loanabe funds approach treats the funds being traded as the good b A Demand and Supply Graph of the Bond Market i Demand curve for bonds represents the relationship bw the price of bonds and the quantity of bonds demanded by investors holding constant all other factors 1 As the price of bonds increases the interest rates on the bonds will fall and the bonds will become less desirable to investors so the quantity demanded will decline 2 The demand curve for bonds is downward sloping ii Supply curve represents the relationship bw the price of bonds and the quantity of bonds supplied by investors who own existing bonds and by rms that are considering issuing new bonds 1 As the price of bonds increases their interest rates will fall and holders of existing bonds will be more willing to sell them c Explaining Changes in Equilibrium Interest Rates i If the price of bonds changes we move along the demand or supply curve but the curve does not shift so we have a change in quantity demanded or supplied 1 If any other relevant variable such as wealth or the expected rate of in ation changes then the demand or supply curve shifts and we have a change in demand or supply d Factors That Shift the Demand Curve for Bonds Table 42 on p 101 for graphs i Wealth 1 The wealthier savers are the larger the stock of savings they have available to invest in nancial assets including bonds 2 An increase in wealth will shift the demand curve for bonds to the right 3 During a recession households will experience declining wealth and holding all other factors constant the demand curve for bonds will shift to the left reducing both the equilibrium price and the equilibrium quantity ii Expected Return on Bonds 1 If the expected return on bonds rises relative to expected returns on other assets investors will increase their demand for bonds and the demand curve for bonds will shift to the right 2 Note It is the expected return on bonds relative to the expected returns on other assets that causes the demand curve for bonds to shift iii Risk 1 An increase in the riskiness of bonds relative to the riskiness of other assets decreases the willingness of investors to buy bonds and causes the demand curve for bonds to shift to the left a It is the perceived riskiness of bonds relative to other assets that matters iv Liquidity 1 Investors value liquidity in an asset because an asset with greater liquidity can be sold more quickly and at a lower cost if the investor needs the funds 2 If the liquidity of bonds increases investors demand more bonds at any given price and the demand curve for bonds shifts to the right v Information Costs 1 The information costs investors must pay to evaluate assets affect their willingness to buy those assets 2 As a result of the lowest information costs the demand curve for bonds shifts to the right e Factors That Shift the Supply Curve for Bonds i Note 1 Shifts in the supply curve for bonds result from changes in factors other than the price of bonds that affect either the willingness of investors who own bonds to sell them or the willingness of rms and governments to issue additional bonds ii Expected Pretax Pro tability of Physical Capital Investment 1 The more pro table rms expected investment in physical assets to be the more funds rms want to borrow by issuing bonds 2 An increase in rms39 expectations of the pro tability of investment in physical capital will holding all other factors constant shift the supply curve for bonds to the right as rms issue more bonds at any given price a Look at Table 44 on p 102 that provides a graph iii Business Taxes 1 Firms focus on the pro ts they have left after paying taxes 2 When business taxes are raised the pro ts rms earn on new investment in physical capital decline and rms issue fewer bonds 3 When the federal government cuts business taxes by enacting an investment tax credit rms reduce their tax payments by a fraction of their spending on new physical capital iv Expected In ation 1 From the point of view of a rm issuing a bond a lower expected real interest rate is attractive because it means the rm pays less in real terms to borrow funds 2 An increase in the expected in ation rate results in the supply curve for bonds shifting to the right as rms supply a greater quantity of bonds at every price v Government Borrowing 1 When talking about the quotgovernment sectorquot include local state and federal governments 2 In recent years the federal govt has borrowed an enormous amount from US and foreign investors as tax receipts have fallen far short of spending a Result has been Iarge federal budget de cits 3 When the economy enters a recession tax receipts automatically decline as household incomes and business pro ts fall and the federal govt automatically increases spending on unemployment insurance and other programs for the unemployed a When government nances the resulting de cit by issuing bonds the supply curve for bonds will shift to the right b Result of govt budget de cit holding other factors constant is to cause the equilibrium price of bonds to faland the equilibrium quantity of bonds to rise c Equilibrium interest rate will rise 4 In summary a An increase in government borrowing shifts the bond supply curve to the right reducing the price of bonds and increasing the interest rate b A fall in government borrowing shifts the bond supply curve to the left increasing the price of bonds and decreasing the interest rate IV The Bond Market Model and Changes in Interest Rates a In this section consider two examples of using the bond market model to explain changes in interest rates i The movement of interest rates over the business cycle which refers to the alternating periods of economic expansion and economic recession experienced by the United States and most other economies ii The Fisher effect which describes the movement of interest rates in response to changes in the rate of in ation b Why Do Interest Rates Fall During Recession i Declining household wealth causes the demand curve for bonds to shift to the left and firms39 declining expectations of the pro tability of investments in physical capital cause them to issue fewer bonds which shifts the supply curve for bonds to the left 1 Equilibrium price of bonds rises which results in a decline in the equilibrium interest rate c How Do Changes in Expected In ation Affect Interest Rates The Fisher Effect i Equilibrium in the bond market determines the price of bonds and the nominal interest rate ii Equilibrium in the bond market then should re ect the beliefs of borrowers and lenders about the expected real interest rate which equals the nominal interest rate minus the expected in ation rate iii Fisher effect the assertion by Irving Fisher that the nominal interest rises or falls pointforpoint with changes in the expected in ation rate iv In response to the rise in expected in ation both the demand curve and supply curve for bonds shift v Economists have found that various realworld frictions result in nominal interest rates not always increasing or decreasing by exactly the amount of a change in expected in ation 1 Frictions include the payments brokers and dealers charge when buying and selling bonds for investors and the taxes investors must pay on some purchases and sales of bonds vi Fisher effect alerts us to 2 important factors about the bond market 1 Higher in ation rates result in higher nominal interest rates and lower in ation rates result in lower nominal interest rates 2 Changes in expectedin ation can lead to changes in nominal interest rates before a change in actual in ation has occurred V The Loanable Funds Model and the International Capital Market a Loanable funds approach the borrower is the buyer because the borrower purchases the use of the funds the lender is the seller because the lender provides the funds being borrowed i More useful when looking at the ow of funds between the US and foreign nancial markets b The Demand and Supply for Loanable Funds From the viewpoint of investors purchasing bonds the bond market approach the lower price increases the quantity of bonds demanded 1 From the viewpoint of investors providing IoanabIe funds to borrowers the IoanabIe funds approach the higher interest rate increases the quantity of IoanabIe funds suppHed From the viewpoint of rms selling bonds the bond market approach the lower price decreases the quantity of bonds suppHed 1 From the viewpoint of rms demanding IoanabIe funds from borrowers the IoanabIe funds approach the higher interest rate decreases the quantity of IoanabIe funds demanded c Equilibrium in the Bond Market from the Loanable Funds Perspective Equilibrium occurs when the quantity of IoanabIe funds demanded is equal to the quantity of IoanabIe funds supplied d The International Capital Market and the Interest Rate Foreign households rms and govts May want to lend funds to borrowers in the US if the expected returns are higher than in other countries and vice versa Assume that the interest rate is the expected reaI rate of interest that is the nominal interest rate minus the expected rate of in ation Closed economy an economy in which households rms and governments do not borrow or lend internationally Open economy an economy in which households rms and governments borrow and lend internationally 1 What nearly all economies are 2 Financial capital loanable funds is internally mobile e Small Open Economy f iv Have been assuming that we were analyzing a closed economy up to this point 1 Equilibrium domestic interest rate is determined by the intersection of the demand curve and supply curve for IoanabIe funds in the country 2 Ignore the world interest rate In open economy the world real interest rate is determined in the international capital market Small open economy an economy in which the quantity of IoanabIe funds supplied or demanded is too small to affect the world real interest rate The real interest rate in a small open economy is the same as the interest rate in the international capital market Large Open Economy Large open economy an economy in which changes in the demand and supply for loanable funds are large enough to affect the world real interest rate 1 Cannot assume that the domestic real interest rate is equal to the world real interest rate Real interest rate in the international capital market equates desired international lending borrowing by the US with desired international borrowing lending by the rest of the world Interest rate will rise until the excess supply of loanable funds from the US equals the excess demand for loanable funds in the rest of the world
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