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This 0 page Class Notes was uploaded by Suzanne Senger on Sunday November 1, 2015. The Class Notes belongs to FIN301 at Miami University taught by TerryNixon in Fall. Since its upload, it has received 11 views. For similar materials see /class/233309/fin301-miami-university in Finance at Miami University.
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Date Created: 11/01/15
9162010 93300 AM INTEREST RATES IN THE ECONOMY Questions that we hope to answer from this chapter What are determinants of market interest rates How does the length to maturity affect interest rates on securities of equivalent risk The Cost of Money Money funds can be raised eitherthrough the issuance of debt or equity In this section we will discuss interest rates When discussing interest rates we are implicitly referring to as only debt pays interest to its holders Equityrate of return The Financial System and the Structure of Interest Rates business sector net demander of capital household sector net saver supplier of capital What do households do with their savings and where can businesses go to borrow Financial system Channel through which savings of surplus sectors flow to deficit sectors lntermediary banks insurance companies etc Q What determines the amount businesses want to borrow and households wish to savelend ie the supply and demand for capital Cost of money I Lecture 6 page 36 I Interest Rate r LowRisk HighRisk r r s L Q quot L6 3 D l I Dollars Dollars Supply and Demand for funds investment capital in capital markets highrisk lowrisk etc interact to determine interest rates Once again the above diagrams illustrate the relationship of risk relative to expected return in capital markets All else constant how would a business recession impact interest rates in our economy Business recession refers to demand for cash decreases REFER TO EX 8 All else constant how would a loosening of credit by the Federal Reserve impact interest rates in the economy REFER TO EX 9 Are credit markets such as the highrisk and lowrisk markets independent of each other No As risk premium rHrL increases more people will take risk Supply moves from low to high Low risk supply shift left rL up High risk supply9 shift right rH down until this reaches equilibrium Shortterm and Longterm interest rates see Figure 62 on page 166 Richard T Bliss Babson University and TerryD Nixon Miami University I Lecture 6 page 37 I Historically are longterm rates generally higher or lowerthan shortterm rates We ll explain this result later Longterm rates are typically greater than shortterm rates Historically do shortterm or longterm interest rates exhibit greater variability Why Shortterm is more volatile Longterm rates are averages inflation etc Averages are stable Finally what is the historical relationship since 1972 between actual annual in ation rates and longterm interest rates TBills See Figure 63 on page 167 They tend to move together positive correlation Interest rates seem to include inflation Fisher equation NominalRealnflation 1Nom1Real1inflation Richard T Bliss Babson University and TerryD Nixon Miami University I Lecture 6 page 38 I The Determinants of Market Interest Rates nominal rate quoted observed rate of return real rate shows actual change in buying power Note that real return is what we are concerned with since it is what determines what we can actually buy or our purchasing power Example You are considering an MP3 player which costs 200 today You decide to wait for one year too busy with school to enjoy it and put your 200 into a oneyear CD certificate of deposit NOT compact disc which pays a 10 annual return When you return to Best Buy a year later the MP3 player s price is now 209 What is the nominal interest rate in this problem What is the real return you earned over the year Nominal 10 lnflation 209200200 04545 Real 1045 55 Example Alison goes to the bank and gets quoted a 56 annual return for a one year CD Her roommate Mary studies macroeconomics and estimates that the CPI which is currently at 175 will rise to 191 overthe coming year What is the nominal oneyear return on bank CDs 56 If Mary s estimate is correct what will be Alison s real return at the end of one year 191175175 091 91 Real 5691 35 Richard T Bliss Babson University and TerryD Nixon Miami University I Lecture 6 page 39 I CPI stands for Consumer Price Index and is a widely quoted measure of inflation Nominal Quoted Interest Rate r r IP RP r IP DRP LP MRP Where r the nominal quoted rate of interest r the gal riskfree rate of interest no inflation no risk IP in ation premium average expected inflation over life of security Note r IP rRF the nominal quoted riskfree rate of interest Risk Premia RP DRP default risk premium chance of not being repaid TBill AAA B Everything else s constant among securities 2 4 7 LP liquidity premium Sell quickly at true value Less liquid 9 higher premium MRP maturity risk premium Longer time until maturity greater interest rate risk Risk of capital loss due to changes in interest rates Rememberthe Guiding Principles of Financerisk and expected return Richard T Bliss Babson University and TerryD Nixon Miami University Lecture 6 page 40 I Whenever we see a nominal rate of interest 999 of quoted rates are nominal the rate incorporates all ofthe expected risk of borrowing or investing Nominal Interest Rate Real RiskFree Rate Expected In ation Risk Premia liquidity maturity etc Nominal Riskfree rate Risk Premia The nominal riskfree rate represents the pure time value of money on a shortterm government security ie an US Treasury bill The risk premia forthis security is practically zero The Term Structure of Interest Rates Term structure of interest rates This is the relationship between bond yields and maturities All other bond characteristics are held constant as possible Yield Curve The graphical depiction ofthe term structure of interest rates Competing Theories on the Shape of the Yield Curve The Pure Expectations Hypothesis Says that the shape ofthe yield curve depends on investors expectations about future interest rates and that longterm rates are essentially an average of future expected shortterm rates What does this theory say about an individual s preferences for short vs longerterm bonds Indifferent just want the best return Richard T Bliss Babson University and TerryD Nixon Miami University I Lecture 6 page 41 I Richard T Bliss Babson University and TerryD Nixon Miami University I Lecture 6 page 42 I Example A bond with 2 years to maturity is currently yielding 8 per year for the next 2 years You also know that the currently yield on a bond with 1 yearto maturity is 6 lfthe pure expectations hypothesis is correct what should be the yield on a bond with 1 yearto maturity 1 year from today REFER TO EX 10 Example The yield on a bond with 4 years to maturity is 7 per year for the next 4 years The current yield on a bond with 1 year to maturity is 6 The yield on a bond with 1 year to maturity one year from today is expected to be 9 Finally the yield on a bond with 1 year to maturity two years from today is expected to be 8 1 What is the expected yield on a bond with 1 year to maturity three years from today 2 What is the annual expected yield on a twoyear bond issued two years from today REFER TO EX 11 What does an upward sloping yield curve imply per the pure expectations hypothesis Note We will use arithmetic average for calculations relating to the pure expectations hypothesis NOT geometric averages Richard T Bliss Babson University and TerryD Nixon Miami University I Lecture 6 page 43 I Liquidity Preference Hypothesis This theory indicates that investors lenders prefer shortterm bonds and are willing to accept a lower rate of return on shortterm bonds relative to longterm bonds due to this preference Investors view shortterm bonds as being less risky relative to longerterm bonds Borrowers on the other hand prefer making longterm loans as they are able to avoid re nancing risk They are therefore willing to pay a higher rate of return for longterm bonds than shorterterm bonds What shape must the yield curve take under the liquidity preference hypothesis Time to maturity Expect short term rates to increase in the future Note This explanation differs a bit from the one you may have gotten in your Economics course It is a stricter version ofthe liquidity preference hypothesis and does not allow expectations to play a part You are responsible for the definition as presented in this class In general which theory is supported by long and shortterm bonds yields Fact long term rates are generally greater than short term Both theories are generally supported Expectations can take any shape Liquidity preference calls for an upward slope Richard T Bliss Babson University and TerryD Nixon Miami University
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