Chapter 2: Financial Institutions and Markets

Interest Rates determinationI.Determining interest ratesA.Four key factors affect the level of interest rates1.Production opportunities = investment opportunities in productive (cash-generating) assets2.Time preferences for consumption = preferences of consumers for current consumption as opposed to saving for future consumption3.Risk = in a financial market context, the chance that an investment will provide a low or negative return

4.Inflation = the amount by which prices increase over time = the percentage change in the price indexB.Determinants of interest rate

1.r = r* + IP + DRP + LP + MRP

a.r = the nominal interest rate on a government securityb.r* = real risk free rate of interest = rate that would exist on a riskless security in a world with no inflation

r* r & r* r

c.IP = inflation premium = average expected inflation rate over the life of a security

IP r & IP r

d.DRP = default risk premium = reflects possibility that issuer of security will not pay interest or principal at stated time and in the stated amount

DRP r & DRP r

e.LP = liquidity premium = premium charged by lenders because some securities cannot be converted to cash in short run at a reasonable notice

LP r & LP r

f.MRP = maturity risk premium = longer term bonds are exposed to significant risk of price declines due to increases in inflation and interest rates

MRP r & MRP r

2.Let rRF = r* + IP = quoted rate on risk-free bond such as U.S. Treasury bill which is very liquid and free of most types of risk

r = rRF + IP + DRP + LP + MRP

3.Note:

a.r* = rate of interest that would exist on default-free U.S. Treasury securities if no inflation were expected

b.DRP = default risk premium = difference between the interest rate on U.S. Treasury bond and a corporate bond of equal maturity and marketability

c.Long-term bonds also suffer reinvestment rate risk = risk that a decline in interest rates will lead to lower income when bonds mature and funds are reinvested

C.The loanable funds market

1.Two equations (the demand and supply for loanable funds) and two unknowns (the interest rate and the amount of money borrowed)

2.Curve describing borrowers behavior = supply of bonds = demand for loanable fundsa.If the interest rate is on the vertical axis and the amount of funds demanded is on the horizontal axis, the demand for loanable funds is downward sloping

b.Why? interest rate cost of borrowing quantity of loanable funds demanded

3.Curve describing lenders behavior = demand for bonds = supply of loanable funds a.If the interest rate is on the vertical axis and the amount of funds demanded is on the horizontal axis, the supply of loanable funds is upward sloping

b.Why? interest rate return from lending quantity of loanable funds supplied

4.Why is the loanable funds market important? It determines the interest rate.a.The equilibrium interest rate is that interest rate where the demand and supply curve of loanable funds intersect

b.If the current interest rate > equilibrium rate excess supply of loanable funds surplus of loanable funds interest rate move down the demand and supply of loanable funds to the equilibrium interest rate

c.If the current interest rate < equilibrium rate excess demand of loanable funds shortage of loanable funds interest rate move up the demand and supply of loanable funds to the equilibrium interest rate

5.Shifts in the demand for loanable funds (will affect the equilibrium interest rate)a. attractiveness of investment opportunities demand for loanable funds the demand curve for loanable funds shifts to the right at every interest rate, borrowers want to borrow more money

b. government deficits demand for loanable funds the demand curve for loanable funds shifts to the right at every interest rate, borrowers want to borrow more money

c. expected inflation demand for loanable funds the demand curve for loanable funds shifts to the right at every interest rate, borrowers want to borrow more money

i.Consumers viewpoint: expected inflation expect future prices to borrow more now to buy cheaper product now

ii.Producers viewpoint: expected inflation expect future prices to profits if revenue grows faster than costs (costs constrained by long-term contracts) attractiveness of investment opportunities borrow more now to finance investment projects (new product, new physical capital, etc.)

iii.Debtors viewpoint: expected inflation expect future prices to borrow more to pay back money worth less borrow more now as the real cost of debt is cheaper

6.Shifts in the supply of loanable funds (will affect the equilibrium interest rate)

a. wealth supply of loanable funds supply curve for loanable funds shifts to the right lenders will provide more money at every interest rate

b. price level money balances will now buy more goods and services wealth supply curve for loanable funds shifts to the right lenders will provide more money at every interest ratec. relative risk of bonds savers invest more money in the bond market supply of loanable funds supply curve for loanable funds shifts to the right lenders will provide more money at every interest rate

d. relative liquidity of bonds savers invest more money in the bond market supply of loanable funds supply curve for loanable funds shifts to the right lenders will provide more money at every interest rate

e. relative expected return on bonds savers invest more money in the bond market supply of loanable funds supply curve for loanable funds shifts to the right lenders will provide more money at every interest rate

f. expected inflation savers will receive a higher real return on their investment in bonds supply of loanable funds supply curve for loanable funds shifts to the right lenders will provide more money at every interest rate

g. Money Supply supply of loanable funds supply curve for loanable funds shifts to the right lenders will provide more money at every interest rate

7.Some exercisesa.The effect of an increase in GDP

i.Are interest rates procyclical or countercyclical?

ii.Generally: GDP interest rate

b.Increase in government deficit: government deficit interest ratec. in expected inflation interest rate

d. in the relative riskiness of stocks interest rate

e. in the expected relative return of bonds interest rate

III.Term structure of interest rates or yield curve

A.Introduction

1.Term structure of interest rates or yield curve relates the interest rate to the time to maturity for securities with a common risk profile

2.Typically U.S. government securities used to construct yield curves: securities span wide range of securities and have no default risk

3.Could construct yield curve with corporate bonds with comparable risk

4.Yield curve shows cross-sectional data. Shows interest rates at any one instant.

5.What does slope of yield curve reveal?

6.Theories of term structure:

a.The expectations theory

b.Market segmentation theory

c.Liquidity premium theory

B.Expectations theory

1.Assumptions

a.Market participants have no preference between short-run and long-run maturities. Different maturities are perfect substitutes.

b.Investors risk neutral. Seek only highest expected return.

c.Transactions cost of shifting between short-run and long-run securities is not relevant.

d.People have expectations about future interest rates

2.Implications:

a.Key result: Yield on security with N year maturity is the geometrically weighted average of current short-term rates and future expected short term rates

b.Some (nasty) notation:

trN = interest rate on N-year security in year t

tr1 = interest rate on one-year security in year t

t+1r1 = the implied one-year rate in year t + 1

t+2r1 = the implied one-year rate in year t + 2

t+ir1 = the implied one-year rate in year t + i

(1+trN)N = (1+ tr1) (1+ t+1r1) (1+ t+2r1) (1+ t+3r1). . . (1+ t+Ni1)

c.Ex: Suppose we are interested in two periods, time t and time t + 1. Let tri = 8% and t+1ri = 12%. What is the interest rate on a current two-year security where consumer indifferent between buying a two-year security or successive one-year securities?

(1+tr2)2 = (1+tr1) (1+t+1r1)

(1+tr2)2=(1.08)(1.12)=1.2096

(1+tr2)=(1.2096)1/2=1.0998

tr2=10%

i.If tr2>10% two-year security gives more return than successive one-year securities increased demand for two-year securities price of two-year security increases return on two-year securities falls toward 10%

ii.If tr2