2 Determinant of Int Rate
-
Upload
govind-duragkar -
Category
Documents
-
view
217 -
download
0
Transcript of 2 Determinant of Int Rate
-
8/3/2019 2 Determinant of Int Rate
1/23
Click to edit Master subtitle style5/5/12
DETERMINANTS OFINTEREST RATE
PROF. AMRUTA R. GAIKAR
-
8/3/2019 2 Determinant of Int Rate
2/23
5/5/12
Nominal Interest Rate
Nominal Interest Rates are determined by:
v Real rate f interest
v Expected Inflation
v Maturity Risk
v Default Risk
v
Liquidity Risk
-
8/3/2019 2 Determinant of Int Rate
3/23
5/5/12
Real Interest Rate
Compensates for the lenders lost opportunity to consume.
The minimum rate Im willing to accept in this market (overand above inflation) that convinces me to invest rather thanspend my money.
The real rate of interest, by definition, would be risk free .
In this market, risk free can drive the real rate of interest tozero.
-
8/3/2019 2 Determinant of Int Rate
4/23
5/5/12
Expected Inflation Inflation erodes the purchasing power of money.
Example: If you loan someone $1,000 and they pay itback one year later with 10% interest, you will have
$1,100. But if prices have increased by 5%, thensomething that would have cost $1,000 at the outset ofthe loan will now cost $1,000(1.05) = $1,050.
-
8/3/2019 2 Determinant of Int Rate
5/23
5/5/12
Nominal Risk-Free Rate The real rate of interest, plus
The inflation risk premium
Example: The T-Bill
Current Yield: 2.125%
So, if inflation rate is 1.80%, then
Real Rate of return is 2.125 1.80 or .325%
-
8/3/2019 2 Determinant of Int Rate
6/23
5/5/12
Maturity Risk If interest rates rise, lenders may find that their loans are earning
rates that are lower than what they could get on new loans.
The risk of this occurring is higher for longer maturity loans.
Lenders will demand a premium to cover this risk depending on if
they think long term rates will go up or down.
10 years Treasury Note yielding 2.84% (0.7% premium over T-Billrate)
-
8/3/2019 2 Determinant of Int Rate
7/23
5/5/12
Default Risk For most securities, there is some risk that the borrower
will not repay the interest and/or principal on time, or at
all.
The greater the chance of default, the greater the interestrate the investor demands and the issuer must pay.
(risk/return trade-off)
Example: Junk bonds have a high risk of default and
requires a high default risk premium. Current yield12.20%
-
8/3/2019 2 Determinant of Int Rate
8/23
5/5/12
Liquidity Risk Investments that are easy to sell without losing value are
more liquid.
Illiquid securities have a higher interest rate premium tocompensate the lender for the inconvenience of not beingable to sell the bond easily.
Mortgage backed securities became illiquid! Cause ofmarket collapse!
-
8/3/2019 2 Determinant of Int Rate
9/23
5/5/12
Term Structure of Interest Rate
The relationship between maturity and yield.
The Yield Curve is the plot of current interest
yields versus time to maturity.
Unbiased expectation theory
Forward rate calculations
Forward rate = Expected short rates
Different maturities are perfect substitutes
-
8/3/2019 2 Determinant of Int Rate
10/23
5/5/12
Expectation Theory The Expectation theory hypothesises that investors expectation alone
shape the yield curve. This theory assumes that the yield on a long-term bond is an average of the short-term yields that are expected toprevail over the life of the long-term bond. Its validity rests on theassumption that investors are indifferent to any variation in risks
associated with different maturities. They consider long term andshort-term bonds to be perfect substitutes for one another, and,therefore, move freely from one maturity to another always lookingfor highest expected return.
This implies that when all investors expect the rates to -
i) rise, the yield curve would slope upward
ii) remain unchanged, the yield would be horizontal or
iii) fall, the yield curve would slope downward.
-
8/3/2019 2 Determinant of Int Rate
11/23
5/5/12Liquidity Preference Theory
Lenders prefer short-term securities over long term securities,unless the yield on the longer-term securities are high enough tocompensate for the greater interest rate risk.
Risk is related to variability of return or dispersion of market value.
So interest rate risk increases with term to maturity of a bond. Thelong-term bonds have more interest rate risk than short term bondsbecause of their long duration and because their interest elasticity islarger. As a result, the prices of long-term bonds fluctuate more thanthe prices of short-term bonds. The large price fluctuations are the
basis of liquidity premium hypothesis.
Thus, generally, lenders are averse to long-term securities (becauseof the higher risk involved), and borrowers are averse to short-termsecurities. These aversions on the part of lenders and borrowersinfluence the term structure of interest rates. However, the term
-
8/3/2019 2 Determinant of Int Rate
12/23
5/5/12
Market Segmentation Theory According to market segmentation theory, interest rates
for various maturities are determined by demand and
supply conditions in the relevant segments of the market.
Investors are not indifferent to difference in maturities.
Instead they have definite maturity preferences, which are
based largely on the nature of their business.
-
8/3/2019 2 Determinant of Int Rate
13/23
5/5/12
Uses of Term Structure
Forecast interest rates
The market provides a consensus forecast of expected futureinterest rates
Expectations theory dominates the shape of the yield curve
Forecast recessions
Flat or inverted yield curves have been a good predictor of
recessions.
Investment and financing decisions
Lenders/borrowers attempt to time investment/financingbased on ex ectations shown by the yield curve
-
8/3/2019 2 Determinant of Int Rate
14/23
5/5/12
Monetary Policy Monetary policy is the set of actions a government takes
usually through some form of a central bank that influencesthe economy.
A government has several options at its disposal and mostconcentrate on establishing short-term interest rates intended toexpand or contract the economy, depending on the latestinflation concerns.
By influencing the demand for currency through interest rates,the central bank attempts to maintain a favorable environmentfor economic growth as well as the preservation of value for the
currency.
-
8/3/2019 2 Determinant of Int Rate
15/23
5/5/12
Role played by Central Bank Direct purchase of foreign currency the central bank
buys foreign currency and holds it in reserve to be sold ata time when it wants to decrease the supply of its owncurrency. Foreign currency is a common security forcentral banks to hold as it can easily be converted back tonative currency.
Reverse Operations or Repos Repos are contracts for
the temporary lending of money and are traded on theRepo market. Repos are an agreement between the buyerand seller with a fixed maturity (usually one week or onemonth).
-
8/3/2019 2 Determinant of Int Rate
16/23
5/5/12
Factors affecting Market InterestRateThere are many interest rates in the market andthey do not always move in the same direction or to
the same extent. Therefore, it is sometimes useful toselect one rate to represent the short-term market.It is commonly believed that four factors aredominant in determining interest rate levels.
-
8/3/2019 2 Determinant of Int Rate
17/23
5/5/12
These are:
1) Economic Condition
2) Monetary Policy
Bank rate
Open market operations
Cash Reserve Ratio
Supply of Money
-
8/3/2019 2 Determinant of Int Rate
18/23
5/5/12
Money Supply
The money supply is controlled by the Fed through:
Open-market operations
Changing the reserve requirements
Changing the discount rate
Thus the quantity of money supplied does not depend on the
-
8/3/2019 2 Determinant of Int Rate
19/23
5/5/12
Money Demand Money demand is determined by several factors.
According to the theory of liquidity preference,one of the most important factors is the interestrate.
People choose to hold money because money can
be used to buy other goods and services. The opportunity cost of holding money is the
interest that could be earned on interest-earning
assets.
-
8/3/2019 2 Determinant of Int Rate
20/23
5/5/12
Equilibrium in the Money Market
According to the theory of liquidity preference:
v The interest rate adjusts to balance the supply anddemand for money.
v There is one interest rate, called the equilibrium
interest rate, at which the quantity of money demanded
equals the quantity of money supplied.
Harcourt Inc items and derived items copyright 2001 by
-
8/3/2019 2 Determinant of Int Rate
21/23
5/5/12Equilibrium in the Money Market...
Quantityof Mon
Interest Rate
0
MoneyemandQuantityfixedy the
Moneyupply
r2
M2
r1
Md1
Equilibriuminterestrate
Harcourt, Inc. items and derived items copyright 2001 byHarcourt, Inc.
-
8/3/2019 2 Determinant of Int Rate
22/23
5/5/12
Measures of Money Supply
-
8/3/2019 2 Determinant of Int Rate
23/23
5/5/12