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PROF. AMRUTA R. GAIKAR
Nominal Interest Rate
Nominal Interest Rates are determined by:
Real rate f interest Expected Inflation Maturity Risk Default Risk Liquidity Risk
risk free can drive the real rate of interest to zero. by definition. would be risk free . The minimum rate I’m willing to accept in this market (over and above inflation) that convinces me to invest rather than spend my money. In this market. The real rate of interest. • • • .5/5/12 Real Interest Rate Compensates for the lender’s lost opportunity to consume.
5/5/12 Expected Inflation • Inflation erodes the purchasing power of money.000 at the outset of the loan will now cost $1. .050.000(1. • Example: If you loan someone $1.000 and they pay it back one year later with 10% interest.100.05) = $1. you will have $1. then something that would have cost $1. But if prices have increased by 5%.
if inflation rate is 1.80 or .125 – 1.125% So. then Real Rate of return is 2.80%. plus The inflation risk premium • Example: The T-Bill Current Yield: 2.5/5/12 Nominal Risk-Free Rate • The real rate of interest.325% .
lenders may find that their loans are earning rates that are lower than what they could get on new loans.84% (0.7% premium over T-Bill rate) .5/5/12 Maturity Risk • If interest rates rise. • Lenders will demand a premium to cover this risk depending on if they think long term rates will go up or down. • The risk of this occurring is higher for longer maturity loans. • 10 years Treasury Note yielding 2.
or at all. Current yield 12. (risk/return trade-off) Example: Junk bonds have a high risk of default and requires a high default risk premium.5/5/12 Default Risk • For most securities.20% • • . the greater the interest rate the investor demands and the issuer must pay. there is some risk that the borrower will not repay the interest and/or principal on time. The greater the chance of default.
Mortgage backed securities became illiquid! market collapse! Cause of • • . Illiquid securities have a higher interest rate premium to compensate the lender for the inconvenience of not being able to sell the bond easily.5/5/12 Liquidity Risk • Investments that are easy to sell without losing value are more liquid.
Unbiased expectation theory ü ü ü • Forward rate calculations Forward rate = Expected short rates Different maturities are perfect substitutes . • 5/5/12 The Yield Curve is the plot of current interest yields versus time to maturity.Term Structure of Interest Rate The relationship between maturity and yield.
and. the yield curve would slope downward. therefore. They consider long term and short-term bonds to be perfect substitutes for one another. This implies that when all investors expect the rates to i) rise. the yield would be horizontal or iii) fall. This theory assumes that the yield on a longterm bond is an average of the short-term yields that are expected to prevail over the life of the long-term bond. Its validity rests on the assumption that investors are indifferent to any variation in risks associated with different maturities. move freely from one maturity to another always looking for highest expected return. the yield curve would slope upward ii) remain unchanged. .Expectation Theory • 5/5/12 The Expectation theory hypothesises that investors‘ expectation alone shape the yield curve.
the prices of long-term bonds fluctuate more than the prices of short-term bonds.Liquidity Preference Theory • 5/5/12 Lenders prefer short-term securities over long term securities. and borrowers are averse to short-term securities. As a result. These aversions on the part of lenders and borrowers influence the term structure of interest rates. • Thus. So interest rate risk increases with term to maturity of a bond. However. unless the yield on the longer-term securities are high enough to compensate for the greater interest rate risk. The large price fluctuations are the basis of liquidity premium hypothesis. generally. lenders are averse to long-term securities (because of the higher risk involved). • Risk is related to variability of return or dispersion of market value. the term . The long-term bonds have more interest rate risk than short term bonds because of their long duration and because their interest elasticity is larger.
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.5/5/12 Market Segmentation Theory • According to market segmentation theory. Instead they have definite maturity preferences. which are based largely on the nature of their business.
Uses of Term Structure • 5/5/12 Forecast interest rates The market provides a consensus forecast of expected future interest rates theory dominates the shape of the yield curve Expectations • Forecast recessions Flat or inverted yield curves have been a good predictor of recessions. • Investment and financing decisions Lenders/borrowers attempt to time investment/financing based on expectations shown by the yield curve .
A government has several options at its disposal and most concentrate on establishing short-term interest rates intended to expand or contract the economy.5/5/12 Monetary Policy • Monetary policy is the set of actions a government takes – usually through some form of a central bank – that influences the economy. the central bank attempts to maintain a favorable environment for economic growth as well as the preservation of value for the currency. • • . depending on the latest inflation concerns. By influencing the demand for currency through interest rates.
Repos are an agreement between the buyer and seller with a fixed maturity (usually one week or one month).Role played by Central Bank • 5/5/12 Direct purchase of foreign currency – the central bank buys foreign currency and holds it in reserve to be sold at a time when it wants to decrease the supply of its own currency. Foreign currency is a common security for central banks to hold as it can easily be converted back to native currency. • . Reverse Operations or “Repos” – Repos are contracts for the temporary lending of money and are traded on the Repo market.
5/5/12 Factors affecting Market Interest Rate There are many interest rates in the market and they do not always move in the same direction or to the same extent. it is sometimes useful to select one rate to represent the short-term market. Therefore. It is commonly believed that four factors are dominant in determining interest rate levels. .
5/5/12 These are: 1) 2) • • Economic Condition Monetary Policy Bank rate Open market operations Cash Reserve Ratio Supply of Money • • .
Money Supply • 5/5/12 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 .
one of the most important factors is the interest rate. The opportunity cost of holding money is the interest that could be earned on interest-earning assets. • • • .5/5/12 Money Demand • Money demand is determined by several factors. People choose to hold money because money can be used to buy other goods and services. According to the theory of liquidity preference.
. v There is one interest rate. called the equilibrium interest rate. at which the quantity of money demanded equals the quantity of money supplied.Equilibrium in the Money Market According to the theory of liquidity preference: 5/5/12 v The interest rate adjusts to balance the supply and demand for money.
. Inc. items and derived items copyright © 2001 by Harcourt. Intere st Ra te Mon supp ey ly 5/5/12 r Equilibrium 1 interest rate r 2 0 d 1 M Quantity by fixedthe d 2 M Mon dema ey nd Quantity of Mon . Inc.Harcourt.. Equilibrium in the Money Market.
Measures of Money Supply 5/5/12 .
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