Chapter 6

Determining Market Interest Rates

Bond Market• Economists use supply and demand to analyze

markets for non-differentiated goods like flour or corn.

• In real world financial markets, there is a wide variety of bonds with different qualities and different prices/yields at any given time.

• In theory, we will abstract from these differences to analyze the price/yield of a generic, representative bond.

• Next chapter, we ask “Why do interest rates vary among bonds?”

Savers & Borrowers

• The bond market is made up of two types of traders. Savers have excess funds today and are trying to exchange them for bonds (savers). Borrowers are trying to exchange bonds for funds today (borrowers).

• We can think of this market from two inverse perspectives.

1. Bond Market Perspective2. Loan Market Perspective

Bond Market Perspective

• Borrowers are sellers of bonds represented by a supply curve relating the quantity of bonds they sell at a given bond price, P.

• Savers are buyers of bonds represented by a demand curve relating the quantity of bonds they buy at a given bond price, P.

• Quantity: Dollar value of bonds• Price: Dollar price of bonds.

Loanable Funds Market Perspective

• Savers are providers of funds to the bond market represented by a supply curve relating the quantity of funds they provide at a given bond interest yield, i.

• Borrowers are takers of funds represented by a demand curve relating the quantity of funds they take at a given interest yield, i.

• Quantity: Dollar value of funds• Price: Bond yields

Views of Excess Funds Holders : Loanable Funds Perspective

Views of Excess Funds Holders: Bond Market Perspective

• Q: Why does the Supply Curve for Loanable Funds Slope Up?

A: Holding expected inflation constant, a high interest rate on bonds increases the attractiveness of bonds and attracts more funds.

• Q: Why does the Demand Curve for Bonds Slope Down. A high price for a given future face value reduces the attractiveness of bonds and attracts fewer funds.

• Q: Why does the Demand Curve for Loanable Funds Slope Down?

A: If bond issuers must offer a high interest payment to borrow, the attractiveness of borrowing or financing borrowing in the bond market will drop.

• Q: Why does the Supply Curve for Bonds Slope Up.

A: If bond issuers receive a high price for a given future face value, the attractiveness of borrowing or financing in the bond market rises.

Views of Bond Issuers

Excess Supply, Excess Demand, and Equilibrium

• Q: What causes the the Supply Curve for Loanable Funds (Demand Curve for Bonds ) to shift?

• A: The elements of portfolio allocation. 1. An increase in wealth shifts supply of loanable funds and demand

for bonds to the right as investors increase the size of their portfolio.

2. An increase in expected inflation reduces the real returns from bonds. This shifts the supply of loanable funds in bond markets and demand for bonds to the left .

3. An increase in the expected returns on other assets besides bonds will shift the supply of loanable funds and demand for bonds to the left as portfolio holders shift to other assets.

4. An increase in the risk of bonds (relative to other assets) or an increase in the cost of acquiring information (relative to other assets) will shifts the supply of loanable funds and demand for bonds to the left as portfolio holders shift to other assets.

5. An increase in the liquidity of bonds (relative to other assets) will shift the supply of loanable funds and demand for bonds to the right as portfolio holders shift to other assets.

Shift Chart Event Shifts LS Shifts BD

Wealth

E

Alternative Asset Returns

Relative Bond Risk

Relative Bond Liquidity

Relative Bond Information Costs

9000

9500

10000

10500

11000

2

3

4

5

6

1999 2000 2001 2002

DOW TBILL

Impact of Shift in Supply of Loanable Funds (Demand for Bonds)?

Event Quantity of Loanable Funds/Bonds

Bond Prices Bond Yields

Wealth E wait wait wait

Alternative Asset Returns

Relative Bond Risk

Relative Bond Liquidity

Relative Bond Information Costs

• Q: What causes the supply of bonds or the demand for loanable funds to shift?

• New issuers of bonds will be firms financing capital investment or governments financing deficits.

• Firms will issue new bonds if expected real interest rates fall or after tax profits from capital rise.

1. If expected inflation rises, expected real interest rates fall and bond supply/loanable funds demand shifts right .

2. If productivity of capital equipment rises, profits from capital investment rises and bond supply/loanable funds demand shifts right .

3. If business taxation rises, profits from capital investment falls and bond supply/loanable funds demand shifts left.

• Government will issue new bonds if government deficits increase.

1. If deficits increase, bond supply/loanable funds shifts right .

Event Demand for Loanable Funds

Supply of Bonds

E

Capital Productivity

Business Taxes

Deficits

Impact of Shift in Demand of Loanable Funds (Supply of Bonds)?

Event Quantity of Loanable Funds/Bonds

Bond Prices Bond Yields

E ambiguous

Capital Productivity

Business Taxes

Deficits

Hong Kong Dollar Bond Market

• Hong Kong Dollar Linked to US dollar. • Supposing the representative Hong Kong Dollar

bond was about as risky as the representative US dollar bond, the interest rate should be the same.

• If there are any differentials, the supply curve for HK loanable funds (the demand curve for HK bonds) shifts until the two interest rates are equal.

• The HK dollar bond market adjusts to the US dollar market because the US dollar market is so much larger.

• If the equilibrium HK dollar interest rate is higher than the equilibrium US dollar rate, the supply of loanable funds in Hong Kong will rise as investors shift their portfolios toward HK$ bonds. (If the equilibrium HK dollar bond price is lower than the equilibrium US dollar bond, demand for HK$ bonds will increase).

• If the equilibrium HK dollar interest rate is lower than the equilibrium US dollar rate, the supply of loanable funds in Hong Kong will fall as investors shift their portfolios toward US$ bonds. (If the equilibrium HK dollar bond price is higher than the equilibrium US dollar bond, demand for HK$ bonds will increase).

US$ Loanable Funds HK$ Loanable Funds

iUS iHK

iDiD

iS

iS

1

2

3

4

5

6

7

1999 2000 2001 2002

EFB TBILL