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,Click to edit Master title style,Click to edit Master text styles,Second level,Third level,Fourth level,Fifth level,*,Click to edit Master title style,Click to edit Master text styles,Second level,Third level,Fourth level,Fifth level,*,Click to edit Master title style,Click to edit Master text styles,Second level,Third level,Fourth level,Fifth level,*,Click to edit Master title style,Click to edit Master text styles,Second level,Third level,Fourth level,Fifth level,*,THE DETERMINATES OF INTEREST RATES,Chapter 7,Bank Management,1,Determinates of Interest Rate Levels,Two general models can be categorized under the labels:,liquidity preference theory,loanable,funds theory,2,Loanable Funds Theory,Supply of and Demand for Loanable Funds,The demand for loanable funds represents the behavior of borrowers and thus the supply of all debt instruments.,The supply of loanable funds represents the behavior of lenders and thus the demand for owning debt instruments.,3,The level of interest rates is determined as the market clearing rate, i,f,.,Any change in the risk-free rate represents a movement along D,F,and S,F,.,S,F,(lenders),Supply of loanable funds,D,F,(borrowers),Demand for loanable funds,Loanable Funds $,Risk free rate %,i,f,Q,L,4,Factors affecting the,Supply of Loanable Funds.,Individuals with excess income, may simply choose to reduce their holdings of money and substitute earnings assets.,The primary catalysts are the expected rate of return and degree of risk associated with different investments.,Individuals buy securities as part of financial plans for future expenditures.,Nonfinancial businesses often have excess cash that they invest temporarily.,5,Supply of loanable funds (continued).,State and local governments invest excess cash in securities.,The federal government, through the Federal Reserve System, expands and contracts the growth rate in the banking systems reserves.,Foreign investors view U.S. securities as alternatives to their own domestic securities and purchase those with the most attractive risk/return features.,6,Factors affecting the,Demand for Loanable Funds.,Individuals borrow to finance housing and durable goods.,Businesses borrow to finance working capital needs and capital expenditures.,State and local government units regularly issue debt to finance temporary imbalances between operating revenues and expenses.,The federal government has operated at a substantial budget deficit during the past two decades.,7,Changes in supply and demand for Loanable Funds,Increased borrowing by State and local governments from an increase their capital expenditures on roads and utilities.,Flow of funds, FR Board of Governors,SF,DF,1,Loanable Funds $,Risk free rate %,DF,2,q,1,q,2,q,3,ii,f,The impact on rates and the quantity of loanable funds is represented by a shift from DF,1,to DF,2,8,Japanese investors refrain from buying U.S. interest-bearing securities.,This represents a decrease in the supply of loanable funds from SF,1,to SF,2,Loanable Funds $,Risk free rate %,SF,1,DF,SF,2,I,I,f,q,2,q,1,9,The relationship between inflation and the level of interest rates,The Fisher relation decomposes the nominal market interest rate (i) into:,an expected real interest rate component (r),an expected inflation premium (p,e,), and,the cross-product between the real rate and expected inflation premium:,(1 + i) = (1 + r) (1 + p,e,), or,i = r + p,e,+ r x p,e,The cross product term r x p,e,is often ignored, hence the nominal rate is composed of the real rate of interest plus expected inflation:,i = r + p,e,10,The Fisher Relation:,i = r + p,e,The expected real rate, r, represents the required return to investors to compensate them for postponing consumption.,The inflation premium is the return needed to compensate investors for the loss of purchasing power.,11,The relationship between nominal interest rates and inflation.,Fisher effect implies a one-to-one relationship between changes in expected inflation and changes in nominal interest rates.,i = r + p,e,Fisher assumed that the ex ante real rate is constant, hence a,p,e,does not affect r:,i =,p,e,The nominal interest rate fully adjusts to changes in expected inflation.,As expected inflation increases from 2 to 5%, the market rate changes from 5 to 8%.,12,The relationship between changes in expected inflation and the real rate, expected inflation, and nominal interest rates (percentages)The Fisher effect,13,Mundell-Tobin,less than one-to-one relationship between changes in nominal interest rates and expected inflation due to a real money balance effect.,With inflation - money balances depreciate, in real terms,Since money is part of wealth, real wealth decreases.,Savings are stimulated to make up for the loss in real wealth.,As savings is increased, the supply of loanable funds increases, hence the real rate of interest falls.,14,Mundell-Tobin (continued),Since r falls, from an increase in savings, as p,e,increases, what is the impact on i?,? i =,r +,p,e,We do know that:,i ,p,e,.,Hence, a less that a one-to-one relationship between changes in nominal rates, i, and expected inflation, p,e,.,15,The relationship between changes in expected inflation and the real rate, expected inflation, and nominal interest rates (Percentages),Mundell-Tobin,less than one-to-one relationship between changes in nominal interest rates and expected inflation.,16,Darby-Feldstein,greater than one-to-one relationship between changes in nominal interest rates and expected inflation.,Assumes lenders are concerned primarily with expected after-tax real rates,r,at,= i (1 - t) - p,e,.,Solving for i,i = r,at,/ (1 - t) + p,e,/ (1 - t).,Market interest rates change by more than the change in expected inflation to compensate investors for the additional taxes paid on higher nominal returns.,17,Darby-Feldstein,the difference between Fisher and Darby-Feldstein is the tax factor 1/(1-t),Fisher: i = r + p,e,Darby-Feldstein: i = r,at,/ (1 - t) + p,e,/ (1 - t),Example:,a 20 percent marginal tax rate means the tax factor equals 1.25 (1/(1-0.2),assuming a constant,ex ante,real rate of 3%.,an increase in expected inflation from 2% to 5% (3% increase) means market rates, from 6.25% to 10% (a 3% x 1.25 increase).,18,The relationship between changes in expected inflation and the real rate, expected inflation, and nominal interest rates (percentages),Darby-Feldstein,Greater less than one-to-one relationship between changes in nominal interest rates and expected inflation.,19,Actual inflation and market interest rates,It is difficult to test the theories empirically because expected inflation and the ex ante real rate are not known.,We can calculate ex post real rates (r*) by subtracting actual inflation (p) from the observed market rate:,r* = i - p,The ex post real rate can be positive or negative, depending on whether market participants over estimate or underestimate actual inflation.,20,Relationship between market rate and annual inflation rate:,Ex Post,Real Rate,0.00%,2.00%,4.00%,6.00%,8.00%,10.00%,12.00%,14.00%,16.00%,18.00%,Jan-58,Jan-62,Jan-66,Jan-70,Jan-74,Jan-78,Jan-82,Jan-86,Jan-90,Jan-94,Jan-98,Jan-02,Annual Inflation Rate (CPI),1-,Year Treasury Bill Rate,21,Selected nominal yields and interest rates,20,17,14,11,8,5,2,1970,1975,1980,1985,1990,1995,2000,Percent,Year,Effective federal funds rate,Moodys seasonal Aaa yield,30-,year conventional mortgage rate,22,Selected real yields and interest rates,12,9,6,3,0,-,3,-,6,1970,1975,1980,1985,1990,1995,2000,Percent,Year,Effective federal funds rate,30-,year conventional mortgage rate,Moodys seasonal Aaa yield,23,Interest rates and the business cycle,The level of interest rates and economic growth vary coincidentally over time.,Expansion:,Increasing Consumer Spending, Inventory Accumulation, and Rising Loan Demand.,Peak:,Monetary Restraint, High Loan Demand, Little Liquidity.,Contraction:,Falling Consumer Spending, Inventory Contraction, Falling Loan Demand.,Trough:,Limited Loan Demand, Excess Liquidity.,24,Interest rates and the business cycle,Expansion: Increasing Consumer Spending, Inventory Accumulation, and Rising Loan Demand; Federal Reserve Begins to Slow Money Growth.,Peak: Monetary restraint, High Loan Demand, Little Liquidity.,Contraction: Falling Consumer Spending, Inventory Contraction, Falling Loan Demand; Federal Reserve Accelerates Money Growth.,Trough: Monetary Ease, Limited Loan Demand, Excess Liquidity.,25,The Money and Capital Markets,The money market is characterized by the trading of short term funds, less than one year.,One of the principal functions of the money market is to finance the working capital needs of corporations and governments.,Typical denominations are large, over 1 million.,The instruments of the money market are characterized as being low risk, highly liquid and issued by highly visible players.,The capital market, in contrast, is designed to finance long term funding needs.,Instruments in the capital market have original maturities of more than one year and minimum denominations can be large or small.,26,Yields on money market instruments,Prime rate,Federal Funds Rate,3-month Treasury,Discount rate,27,Yields on capital market instruments,Moodys corporate Baa,Conventional home mortgage,Moodys corporate Aaa,30-yr Treasury constant maturity,Municipal bond,28,Why do interest rates differ between securities?,The difference in yields between various debt instruments is termed the structure of interest rates.,Rates among securities differ for different:,Terms to maturity,Default risk,Marketability and liquidity,Special features such as convertibility, and call and put features.,Income tax effects,29,Term to final maturity,In general, the longer the maturity, the greater are these risks.,Yield Curve,a diagram that compares the market yields on securities that differ only in terms of maturity.,The general relationship is also referred to as the term structure of interest rates.,30,Most recent yield curves,31,General shape of yield curves,32,Theories of the term structure of interest rates,There are three common theories of the term structure of interest rates:,the pure expectations theory (PET),the liquidity premium theory, and,the market segmentation theory.,33,Unbiased expectations theory,Attributes the relationship between yields on different maturity securities entirely to difference in expectations of future interest rates.,Long-term interest rates are an average of current and expected short-term interest rates.,The expected short-term interest rate is the markets unbiased forecast of future interest rates.,34,Liquidity premium theory,extends the unbiased expectations theory by incorporating investor expectations of price risk in establishing market rates.,The unbiased expectations theory assumes that securities that differ only in terms of maturity are perfect substitutes.,If the expected return on a series of short-term securities equals the expected return on a long-term security, investors will prefer the short-term securities.,35,Market segmentation theory, Interest rates on securities with different maturities are determined by distinct supply and demand conditions within each maturity.,Borrowers and lenders concentrate their transactions within preferred maturities and cannot be induced to substitute between maturities by small yield changes.,36,Market segmentation theory (continued),Market segmentation theory is based on the premise that investors and borrowers do not view securities with different maturities as perfect substitutes.,Market participants tend to concentrate their transactions within specific maturity ranges, regardless of interest rates on securities outside the preferred maturities.,Interest rates are thus determined by distinct supply and demand conditions within each maturity group, and changes in interest rates do not induce any substitution.,37,Market segmentation theory (continued),Maturity restrictions resulting from government regulation create what can be seen as strong form market segmentation.,Borrowers and lenders have rigid, legal restrictions that prohibit maturity substitution.,38,Pure market segmentation,Short-term and long term markets are segmented.,Short-term market,D,s.t. funds,S,s.t. funds,i,short-term,Quantity of loanable funds,yield curve,Long-term market,D,l.t. funds,S,loan funds,Quantity of loanable funds,i,long-term,39,The yield curve and the business cycle,During the early stages of expansion, unemployment and inflation are relative low, typically we see and upward sloping yield curve.,At the peak, loan demand is high, inflation is high and rising and the Fed acts to reduce the growth in loanable funds, thus we often see a flat or downward sloping yield curve.,40,Term to repricing for variable rate and floating rate securities,A security is classified as variable rate if the applicable market interest rate is reset at predetermined intervals.,The security is classified as floating rate if the applicable market interest rate is tied to some index and changes whenever the index changes.,LIBOR, a popular floating rate index, is the London Interbank Offer Rate.,41,Bond ratings,Several private firms evaluate a securitys default risk and assign a credit rating, charging borrowers a one-time fee prior to the release of the rating.,Standard & Poors:,Investment Grades are:,AAA, AA, A and BBB,Noninvestment Grades:,BB, B, CCC, CC, C, D,42,Municipal Notes and Commercial Paper,43,Marketability and liquidity,All assets can be converted to cash if the holder has enough time to find a buyer and negotiate terms.,Liquidity Effects,Liquidity refers to the speed and ease with which an asset can be converted to cash and to the certainty of the price received.,Marketability refers to the speed and ease with which an asset can be sold and converted to cash.,Liquidity Premiums,Highly liquid assets carry the lowest rates, low liquidity securities typically pay a liquidity premium.,44,Special features or options,Some bonds have,call or put options,.,With a call option, the issuer can repurchase a bond, prior to maturity, with a call option.,Bonds with put options give the right to the lender, or investor, to require the issuer to buy back the bond at a predetermined price.,Some bonds are issued which can be,converted into the common stock,of the company.,This option gives the investor the right to convert the bonds fixed payments into common stock and hence reap the benefits of exceptional performance of the company.,45,Call provisions,enables the issuer of a security to call an outstanding bond for repayment at a predetermined price prior to final maturity.,A call option has value to a borrower and is priced accordingly.,Investors demand a higher interest rate on callable bonds since they generally assume the bond will be called.,Callable bonds are usually price in term of yield to first call.,46,Put options,gives the lender the right to put, or sell, a security back to the issuer at a predetermined price prior to final maturity.,A put option has value to an investor because the predetermined price is typically at least par, and the investor can sell the security without a loss if interest rates rise.,47,Convertibility,make fixed coupon payments (like straight bonds) but allow holders to convert the bonds to common stock at a predetermined price.,The conversion feature has value, investors are willing to accept a yield below that offered on straight debt.,Convertibles are riskier than straight bonds because the claims of their owners are subordinated to the claims of straight bondholders.,48,THE DETERMINATES OF INTEREST RATES,Chapter 7,Bank Management,49,
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