FNCE 302, Investments H Guy Williams, Equilibrium Rates (how changes in world effect int rates)
|
|
- Lesley Wilson
- 6 years ago
- Views:
Transcription
1 Overview Real vs. Nominal Rate (consumable vs. financial) Equilibrium Rates (how changes in world effect int rates) Structure of the Yield Curve (will review 3 theories) Some of the following material comes from a variety of sources but especially Financial Markets and Institutions, Madura We need to understand interest rates, what drives them, what market conditions effect them, supply & demand, how. But most importantly we need to understand, how does the economy effect them. How do interest rates react to a change in the marketplace? We need a theory of interest rates and the structure of the yield curve. Real vs. Nominal Rate Suppose I purchase a one-year zero-coupon bond Face value $1,000 Price $930 What is the RATE OF RETURN on this investment? Invest $930 Receive $1,000 in one year if the NOMINAL RETURN is R then: investment Nominal Return, R = 1 return 930 x (1 + R) = 1,000 solve for R = (1000/930) 1 = 7.5% Real Rates are returned in the form of Consumption Goods. (returns you can eat) A Nominal Rate is a return in Dollars. (returns you can't eat) Real Rate of return is measured in terms of things you can buy. Nominal Rate only measures financial return, dollars. But now consider the effects of inflation. Say inflation is increasing the cost of living 3% per year FNCE302: Investments Lecture 3 Page 1
2 Real vs. Nominal Rate Suppose now that INFLATION is working against us making my cost of living increase by 3% over the same period Now, my $1,000 does not purchase as much as it could compared to the beginning of the period Think about it in concrete terms Imagine all I consume is pizzas At the beginning they cost $8 each Their price increases at the rate of inflation The $1000 return has been eroded. What is my return in pizzas? Pizza prices will be $8 x (1 + inflation) = $8 x 1.03 = $8.24 in one year $930 8 So at the beginning my $930 would buy pizzas And at the end my $1,000 will buy $ pizzas What is the rate of return on the investment in pizzas? I invest pizzas and receive pizzas in one year, so if the real return is r then: x (1 + r) = , r is the RETURN measured in REAL terms. Algebraically, if we define I as the inflation rate then: investment Nominal Return, R = 1 return r Closing Return 1 Opening Return r % r = (1 + R)/(1 + i) restated r = (R i)/(1 + i) Approximately, r = R i real = Nominal - Inflation (1+i) approx. = 1 because i is small. FNCE302: Investments Lecture 3 Page 2
3 Fisher Effect: interest rates are dependent on the level of inflation in the economy. Fisher Effect says the REAL rates stay roughly constant over time. Therefore, the NOMINAL rate moves in lockstep with inflation. This is just one theory of how interest rates change. This can be expressed as r = R expectation of Inflation (or expected inflation). An Interest Rate is the price of money, the price of credit. The price I pay or extract in the process of barrowing. It is the price of money! As such the interest rate is a factor of the supply and demand of money. The more people are willing to lend the lower interest rates should be. The more people want to barrow the higher interest rates should be. Supply of credit are those people who are supplying funds, deman for credit are those people who want to barrow funds. So we will look at different things which effect supply and demand of credit and consider what effect these things have on EQUILIBRIUM RATES Equilibrium Rates Interest rate levels are a factor of the supply and demand of credit The supply of credit is increased by an increase in the amount of money made available to borrowers. For example, The more banks can lend, the more credit there is available to the economy: As the supply of credit increases, the price of borrowing (interest) decreases If households decide to save more than 1% or their income and there will be a greater supply of credit. The more banks can lend the more credit there is available to the economy. This is the basis of the loanable funds theory What If Questions, if this happens in the real world what is likely to happen to interest rates? Say the FED lowers the reserve rate (percentage banks must keep on hand). Now more money is available to the banks to loan, but the question is, will they loan it out? Chances are they will find other ways to make money with it. Will put the money to work in some way. FNCE302: Investments Lecture 3 Page 3
4 Loanable Funds Theory Loanable funds theory suggests that the market interest rate is determined by the factors that affect the supply of and demand for loanable funds Can be used to explain movements in the general level of interest rates of a particular country Can be used to explain why interest rates among debt securities of a given country vary (why interest rates are different among different countries). LOANABLE FUNDS THEORY CAN BE USED TO EXPLAIN MOVEMENTS IN THE INTEREST RATE. IT IS NOT USED TO EXPLAIN WHAT INTEREST RATES SHOULD BE, ONLY TO TRY AND EXPLAIN THE REACTION OF INTEREST RATES TO MARKET CIRCUMSTANCES. THIS IS A DYNAMIC TOOL, IF SOMETHING CHANGES, HOW DO INTEREST RATES REACT? IT IS ALSO A COMPARITIVE TOOL. BUT YOU DO NOT USE IT TO PREDICT AN INTEREST RATE! Look at the factors in one country and look at the factors in another country, then you should be able to say "interest rates should be higher in this economy than they are in this economy" Now, who are the participants in the credit markets? Who are the suppliers of funds and who are the users of funds? Loanable Funds Theory Household demand for loanable funds Households demand loanable funds to finance what? mortgages, automobiles, consumer purchases, education, go on vacation There is an inverse relationship between the interest rate and the quantity of loanable funds demanded Wherever you see LOANABLE FUNDS think of CREDIT. Households have a demand for credit and capital. There is an inverse relationship between interest rates and the demand for loanable funds. Higher the interest rates the less households will barrow. Low int rates, more barrowing! FNCE302: Investments Lecture 3 Page 4
5 Loanable Funds Theory Business demand for loanable funds Businesses demand loanable funds to invest in fixed assets and short-term assets Businesses evaluate projects using NET PRESENT VALUE (NPV): NPV INV CFt 1 (1 k) Projects with a positive NPV are accepted There is an inverse relationship between interest rates and business demand for loanable funds Businesses use loanable funds to invest in fixed assets and short term assets. Of course they will also use it to retire debt or buy back shares but fundamentally businesses are using loanable funds to invest in projects (such as building a new plant overseas or upgrade their computer system). n t t Businesses use some form of the NPV rule to evaluate projects. k in the NPV equation is COST OF CAPITAL and it will be linked to interest rates at some level. This may be through a risk-free rate using CAP-M, a yield to maturity on bonds, it will be linked in some way. Of course, the HIGHER THE COST OF CAPITAL THE LOWER THE NPV FOR A PROJECT. Given a list of projects, with the cost of capital at one level some of them will be viable. As the cost of capital goes up the projects fall off of the NPV map. Once you get to a certain cost of capital no projects will have a positive NPV. The higher the cost of capital the less businesses invest. When the economy has high interest rates there are less positive NPV projects. This creates less of a demand from the business sector to invest in projects. FNCE302: Investments Lecture 3 Page 5
6 Loanable Funds Theory Government demand for loanable funds Governments demand funds when planned expenditures are not covered by incoming revenues Municipalities issue municipal bonds The federal government issues Treasury securities and federal agency securities Government demand for loanable funds is INTEREST-INELASTIC The government uses credit markets to barrow money because their budgets rarely balance. The inelastic effect is unique to governments. Regardless of the interest rate, if the government needs money it will barrow. Not so with households or businesses. Government really has no choice. Government also has to pay interest on its existing debt. This is even worse than being inelastic. In a high interest rate environment the budget deficit is likely to be higher because of financing costs. So in actual fact when interest rates go up governments actually barrow more! This is necessary to pay its increasing financing debt. This can lead to a crowding out effect. if government has a need for capital and barrows no matter what, iit will drive up interest rates and this will crowd out the business sector. Business will not barrow because the government is driving interest rates up. The governments rate curve is vertical! This is shown a little further in the notes. We will see more on this as well. Loanable Funds Theory Foreign Demand for loanable funds Foreign demand for U.S. funds is influenced by the interest rate differential between countries The quantity of U.S. loanable funds demanded by foreign governments or firms is inversely related to U.S. interest rates The foreign demand schedule will shift in response to economic conditions Foreigners barrow from the US markets. Foreign corporations barrow from US markets and foreign households can indirectly barrow from US markets. Foreign governments can barrow from US markets. But the main barrower of loanable funds from foreign entities is businesses. Their demand has an inverse relationship just as US businesses do. Their demand will also be driven between the competitive interest rates in the domestic market for these foreign funds and the US market. If they can barrow more cheaply in the US market then they will barrow funds here. If the US funds are more expensive they will not demand US funds. Inverse relationship between US interest rates and the demand of foreign entities for US funds. Loanable Funds Theory FNCE302: Investments Lecture 3 Page 6
7 Interest Rates FNCE 302, Investments H Guy Williams, 2008 Aggregate demand for loanable funds The sum of the quantities demanded by the separate sectors at any given interest rate is the aggregate demand for loanable funds government inelastic demand This demand curve represents the overall demand from households, businesses, government, and foreign entities to barrow money in the US. Downward sloping. High interest rates, low demand. Low interest rates, high demand inelastic is vertical, this is because the gov will barrow the same amount no matter what the interest rate is Capital FNCE302: Investments Lecture 3 Page 7
8 Loanable Funds Theory Supply of loanable funds Funds are provided to financial markets by Households (net suppliers of funds) Suppliers of loanable funds supply more funds at higher interest rates Foreign households, Governments, and Corporations supply funds by purchasing Treasury securities Foreign households have a high savings rate The supply is influenced by monetary policy implemented by the Federal Reserve System The Fed controls the amount of reserves held by depository institutions The supply curve can shift in response to economic conditions Households would save more funds during a strong economy Households are the main group who supply funds to the market. The higher the interest rate the more likely it is for a household to save, this makes more funds available to the market. Foreign households supply capital in the same way that domestic households supply capital, they buy gov securities, they invest in T-Bills, they buy corporate bonds, treasurer notes But foreign households are also comparing rates around the world and going to the place which is most competitive. Foreign governments are also supplying capital to the US market (saving). They do this because they run surpluses and in turn buy US securities. Japanese and Chinese for instance, they are running surpluses and need somewhere to invest that money. They invest in government securities as in doing so are suppliers of credit to the US market. Some people argue that the reason US interest rates are so low right now is due to foreign governments buying US government securities (China). But recently the Euro is competing effectively. Part of the reason is the supply of US securities is so large (bonds) which creates liquidity. When any entity buys a US government bond they are supplying capital to the market. The more people buy government bonds the lower interest rates should go. As the Chinese buy large amount of US securities, US interest rates go down. Foreign corporations will also, to some extent, buy US government securities and in doing so supply credit to the US market. Federal Reserve also influence the amount of capital in the US market. They control the amount of reserves held by depository institutions. If they lower the reserve rate there is more capital available in the marketplace. If they increase that reserve rate the money will be dead sitting in some bank, not invested in a productive way. Supply curve will shift according to economic conditions. FNCE302: Investments Lecture 3 Page 8
9 Interest Rates Interest Rates FNCE 302, Investments H Guy Williams, 2008 Loanable Funds Theory AGGREGATE SUPPLY CURVE: interest rates vs. the amount of capital supplied in the marketplace. Supply increases as interest rates increase. Higher the rate of interest the more households will save and the more that foreign entities will invest in US markets. High interest rate means more capital flows into the marketplace. Capital Where supply meets demand, that is, when the supply of goods equates to the demand of goods, this is where the price is set. This is the price which clears the market. Where supply of funds meets demand for funds is called the Equilibrium Interest Rate. Again, keep in mind, we are interested in how these things move given different events. We are interested in the dynamic setting not the static setting. Capital Economic Forces That Affect Interest Rates FNCE302: Investments Lecture 3 Page 9
10 ECONOMIC GROWTH Shifts the demand schedule outward (to the right) There is no obvious impact on the supply schedule Supply could increase if income increases as a result of the expansion The combined effect is an increase in the equilibrium interest rate What are some of the things which can change interest rates? These are all within the loanable funds theory. Economic growth, economy is doing well, growing. In this case the demand schedule will be shifted out to the right (D A1 moves to D A2 ). Why? If economy is doing well are households more of less likely to barrow? More likely, this means some of their money is no longer in savings. If economy is doing poorly people are more likely to hold on to their money, worried about future. They are saving so this puts money into the economy in terms of making it available for lending. The same is true for businesses. If the economy is doing well businesses are more likely to invest because they anticipate demand increasing in the future. They want to be ready, will build a new factory so they have product to sell. If the economy is doing poorly businesses do not invest. And it takes a long time to convince a CEO that a recession is over and they should start investing in assets again. Government: if the economy who knows. Some would argue that the government should run a surplus and not demand funds from the market. But in reality when the economy is doing well governments will often cut taxes and still run the same budget deficits. Tend to spend more. It is inconclusive what happens to the government when the economy is doing well. In all these cases the net effect tends to be that the demand schedule moves outwards. But we can only say "tends to be." This will often be the case, there are no hard and fast rules in economics. You will be able to find circumstances where this outward shift does not happen. But usually when the economy is expanding the demand for funds increases. Empirically there is no net effect on the supply side. Supply does not seem to increase very much. The supply tends to stay static. Can makes arguments for either many cases but the empirical evidence says the supply schedule remains relatively fixed. Now, what is the net effect? Supply remains fixed, demand shifts outwards, therefore interest rates should increase. When the economy grows interest rates tend to go up. (do not confuse a movement of the curve with a shift along the curve) Economic Forces That Affect Interest Rates FNCE302: Investments Lecture 3 Page 10
11 INFLATION SHIFTS THE SUPPLY SCHEDULE INWARD (to the left) Households increase consumption now if inflation is expected to increase Shifts the demand schedule outward (to the right) Households and businesses borrow more to purchase products before prices rise Lenders will demand higher interest rates as compensation for the decrease in the purchasing power of the money they will be repaid in the future DA1 to DA2 causes a Price shift INWARDS! Why does inflation shift the supply curve inward? If people believe that inflation is going to increase in the future they will make their big purchases today! They SPEND, no save! They believe their money is not going to be worth as much in the future I am going to do my spending now! In a hyper-inflation environment money is becoming worthless. People will not save, will just buy REAL GOODS. In general, if inflation is expected to increase people do not save as much, they spend more. Net Effect: Supply Schedule Shifts Inwards Less credit available in the market because households are saving less. Generally inflation will tend to shift the demand curve outward. Why? Not only do households not save so much, they want to barrow money today so that they can buy the real goods they seek immediately (rather than wait for the price to go up). Households will save less and barrow more! This is the main reason for the demand shift outward. Lenders will demand a higher interest rate to compensate them for the loss of purchase power. This goes back to the relationship between real and nominal interest rates. If interest rates are expected to go up people still need the same real return. Therefore, if I am lending money and inflation is going up, I tend to charge a higher rate for it. The better way to think about it is by looking what happens to supply and demand. The DEMAND schedule moves outwards, the SUPPLY schedule moves inwards. Double-Effect: not only do interest rates go up (because the demand schedule slips outwards) but because the supply schedule moves inwards they go up even further. INFLATION LEADS TO HIGHER INTEREST RATES, even without the FED acting to slow down the economy. Economic Forces That Affect Interest Rates The GOVERNMENT, through the Federal Reserve, affects interest rates FNCE302: Investments Lecture 3 Page 11
12 The federal funds rate, or the rate that institutions charge each other for extremely short-term loans, affects the interest rate that banks set on the money they lend (bonds = government securities) The FED affects interest rates by changing the targeted federal funds rate (overnight lending rate). Physically this is done by the FED bank in New York which works with brokers and dealers in the government securities market, to buy and sell bonds. To INCREASE INTEREST RATES they sell bonds, by selling the security they take cash out of the economy. This reduces supply. To DECREASE INTEREST RATES they buy bonds, this puts cash back into the marketplace. It adds supply. Increase Interest Rates by Selling Bonds / Decrease Interest Rates by Buying Bonds How does targeted FED funds rate compare to actual. Well, they are not always the same. In the above graphic we can see that at the end of 2007 the TARGETED fed funds rate was 4.25% but the ACTUAL fed funds rate went almost as low as 3.0%! If you look at the press during that period you will find that the government flooded the market with capital during that period, pumped money into the economy which dropped interest rates due to the increased supply. Why did they do this? Difficult to say, there is no official explanation. Some would say that they knew there was a problem with banks, a crisis with sub-prime loans. Pumping money into the economy allowed the banks to show more cash on their balance sheets at year end. Purely a window dressing exercise by the government. Some analyst believe this, that it was a ploy to make the economy look stronger. Government bought bonds aggressively which put a massive amount of funds in the market which dropped the interest rates. We can see that the effect rebounded quickly making us believe it was a completely artificial manipulation. The government is wanting the world to feel better about the banking system in the US yet there was nothing fundamentally different in the banking system between Dec 2007 and Jan FNCE302: Investments Lecture 3 Page 12
13 Economic Forces That Affect Interest Rates MONEY SUPPLY If the Fed increases the money supply, the supply of loanable funds increases If inflationary expectations are affected, the demand for loanable funds may also increase If the Fed reduces the money supply, the supply of loanable funds decreases. This is how they affect interest rates. During 2001, the Fed increased the growth of the money supply several times. After 9/11 they flooded the market with capital because they wanted interest rates to be lower. They drastically pushed the supply curve out. Same is true end of 2007 and beginning of 2008 (chart last page) MARKET REACTION TO VARIOUS EVENTS September 11 Firms cut back on expansion plans Households cut back on borrowing plans The demand of loanable funds declined At the same time the federal reserve was throwing cash into the market. Interest rates in the market place declined almost to 1% due to these two events. The weak economy in (this was a recession) Reduced demand for loanable funds The Fed increased the money supply growth Interest rates reached very low levels This was an example of a "double-effect" from a few pages ago. Question: if inflation were negative would the principle be adjusted lower? Answer, YES! In inflation is positive principle is increased, if inflation is negative principal is decreased. FNCE302: Investments Lecture 3 Page 13
14 FNCE 302, Investments H Guy Williams, 2008 Economic Forces That Affect Interest Rates BUDGET DEFICIT A high deficit means a high demand for loanable funds by the government Shifts the demand schedule outward (to the right) because the government needs to barrow more. Interest rates increase, less supply. Gov using it all. Government is INELASTIC The government may be willing to pay whatever is necessary to borrow funds, but the private sector may not CROWDING-OUT EFFECT The supply schedule may shift outward if the government creates more jobs by spending more funds than it collects from the public In this way, crowding out effect, government budget deficits can reduce economic activity. It is not often that the gov uses deficit spending to create jobs. 16.0% 14.0% 12.0% 10.0% 8.0% 6.0% 4.0% 2.0% 0.0% -2.0% -4.0% Deficit 10-Year recession Darker line is the US Gov budget deficit (relative government barrowing) divided by the GDP (which measures the size of the economy) and the lighter line is the yield on 10 year bonds. We have used 10 year bond because it is the yield which correlates most closely to mortgages. Mortgages are priced off of 10 year gov bonds. So the question is, do budget deficits tend to drive interest rates up? We could argue yes, they tend to track pretty well. There is a disconnect around 2000 but other things were going on in the economy. FNCE302: Investments Lecture 3 Page 14
15 Economic Forces That Affect Interest Rates FOREIGN FLOWS OF FUNDS The interest rate for a currency is determined by the supply and demand of that currency, ie, what is going on in that economy. Impacted by the economic forces that affect the equilibrium interest rate in a given country, such as: Economic growth Inflation can drive up interest rates in one country. This will cause a global flow of funds into the highest interest rate economy. Shifts in the flows of funds between countries cause adjustments in the supply of funds available in each country Must be warry of the effect of currency movements on that return. May look at the effect of interest rates on currency levels later in course. Economic Forces That Affect Interest Rates INTEREST RATE VARIATION OVER TIME Late 1970s: high interest rates as a result of strong economy and inflationary expectations (oil shock) Early 1980s: recession led to a decline in interest rates government lower interest rates because inflation was going down and they wanted to stimulate the economy (they supplied capital to the markets) Late 1980s: interest rates increased in response to a strong economy. Economic growth meant there was a demand for funds. Also government was trying to curb possible inflation. Early 1990s: interest rates declined as a result of a weak economy (mild recession in early 1990s). decline in interest rate due to low economic activity. FED wanted to stimulate. 1994: interest rates increased as economic growth increased, result was higher interest rates. Drifted lower for next several years despite strong economic growth, partly due to the U.S. budget surplus FNCE302: Investments Lecture 3 Page 15
16 FNCE 302, Investments YIELD CURVE shows NOMINAL INTEREST H Guy Williams, RATES, 2008 not real interest rates. INFLATION WILL ERODE EARNINGS! Term Structure The relationship between yield to maturity and maturity Information on expected future short term rates can be implied from yield curve The yield curve is a graph that displays the relationship between yield and maturity We will consider three major theories to explain the observed yield curve Term structure is a picture of what the yield is on 10 vs 20 vs 30 year debt (bond). How much it cost for the gov to barrow money overnight vs 1 year vs 2 years vs 30 years. Term Structure is the picture of yields vs maturity. It is interesting because it may predict recession or inflation. Many reasons why investors and economist follow the structure of the yield curve. Gives important indications about what the future holds. We will look at 3 different theories to explain yield curve. Treasury Yield Curves We usually expect to see a rising curve in the marketplace. Inverted is the same as declining. Yield Curves are annualized rate, they are per year return. What do they tell us? Generally speaking, historically, most yield curves are upward sloping. Why? Consider, if investing in a 3 month T-Bill I earn 2%, if I invest in a 30 year bond I earn 4.25% (per year). I expect to earn a higher yield on a longer term bond because duration is higher and there is more risk if int rates go up. Also, there is more liquidity for short term maturities (which requires a higher rate). FNCE302: Investments Lecture 3 Page 16
17 Consider the inverted curve. It returns 6.25% for a 6 month bond and roughly 5.8% for 30 years. Long term is less return! What economic circumstances would bring this about? People think the economy is slowing down and interest rates are going down. Downward sloping yield curve says people are predicting that yields will decline. People interpret an inverted yield curve as a signal that recession is coming. During recession the FED will cut interest rates. So the curve is predicting that future interest rates are coming down due to recession. It is a pretty good indicator. A sharply upward sloping yield curve means investors expect an economic boom. US yield curve was recently flat. People interpret this as a sign of impending recession. See it as a strong sign of recession coming. Why a dip in the yield curve? Lets say our dip is at roughly 2 years. The FED controls near term interest rates. Technically they only effect the very beginning of the curve but they can keep on effecting it until the near term does what they want (?). So this dip is a signal that people think over the next 2 years the FED is going to be aggressively cutting interest rates. So therefore the rate will come down as the short term rates are cut by the FED. After two years the market is back on course. FNCE302: Investments Lecture 3 Page 17
18 How can we make money off the yield curve? Obvious that if the yield curve is upward sloping I want to invest long term and barrow short term: long term rates are up good for investor, short term rates are down good for barrower. We will see this later in course. Comments on the Yield Curve It shows NOMINAL INTEREST RATES Inflation will erode the value of future coupon dollars and principal repayments The Federal Reserve directly manipulates only the short-term interest rate at the very start of the curve The Fed s main tool is the FEDERAL FUNDS RATE The rest of the curve is determined by supply and demand (FED has little effect on parts of the curve beyond a few months) If you were able to remove expectations of future inflation from yield curve it would look very different. You can actually do this with inflation adjusted bonds, some using them to construct a yield curve would take out future expectations of interest rates. Now we look a 3 theories which try to explain the yield curve PURE EXPECTATIONS THEORY (aka Expectations Hypothesis) Pure expectations theory suggests that the shape of the yield curve is determined solely by expectations of future interest rates (particularly short term interest rates) Assuming an initially flat yield curve: The yield curve will become upward sloping if interest rates are expected to rise The yield curve will become downward sloping if interest rates are expected to decline The yield curve is made up of short term investments over time. Therefore the path of short term bond yields is predicted by the shape of the yield curve. Jan 2006, yield curve is flat. If int rates are expected to rise the slope will go up, if int rates are expected to go down the slope will go down. We will look at some mechanics as to why this should happen. FNCE302: Investments Lecture 3 Page 18
19 Sudden Expectation of Higher Interest Rates Suppose we have a flat yield curve today and tomorrow morning we wake up, there has been some economic event and the market believes that interest rates are going to go up. They believe that the federal reserve is going to act. Suddenly the expectation of inflation goes up, say because some consumer price index comes out. At that point the whole market suddenly thinks that inflation is going to be higher than we thought yesterday. What impact will this have on interest rates? SHORT TERM INTEREST RATES The supply of short term rates will increase. If I believe that interest rates are going to go up, would I invest my money in a 1 month bond or in a 5 year bond? Of course I would buy short term investments so that I do not lock myself in to long term investments if I believe rates are going to go up. So at the short end of the yield curve the supply (of money?) increases. The amount of money invested in short term securities goes up (making the money available to the marketplace). What about the demand? Demand for short term securities is going to decline. Why? If I am a corporation do I want to barrow money on 1 month commercial paper or do I want to barrow money on a 10 year bond if I believe interest rates are going to go up? I, the corporation, would want to barrow money on a 10 year bond because I want to take advantage of the low interest rates I see today. This says that businesses do not barrow short term money if they believe interest rates are going to rise. Impact: Demand Increases, Supply Decreases, Interest Rates Increase LONG TERM INTEREST RATES The flip side of this is to look at the long term securities. Supply declines. People do not buy the 5 year CD they buy the 1 month CD. People invest less long term. Demand increases (?). A company wants to barrow long term because rates are low right now and they want to lock in a low rate. Impact: Demand Decreases, Supply Increases, Interest Rates Decrease FNCE302: Investments Lecture 3 Page 19
20 Sudden Expectation of Higher Interest Rates The expectation that interest rates are going to increase will push the yield curve up. And short term rates will go down. Long term rates are going to go up. Sudden Expectation of Lower Interest Rates People will invest less in short term funds. If I believe interest rates are going to fall I will buy the 5 year CD and not buy the 1 month CD. Because I want to lock into the high interest rate which is in place today. I do not want to invest short term because interest rates are going to fall. If interest rates are expected to fall businesses barrow short term. They sell one month commercial paper. Why? Because they think interest rates are going to fall they do not want to barrow money long term. Net Impact: Short term Interest Rates go up Here people are wanting to invest long term. They want to lock in their money at the high rate available today. In this case businesses will not demand money. They demand less long term. They do not want to lock into long term barrowing at what they believe are high rates (available today). Therefore long term rates decline. Net Effect: Short term rates go up, long term rates come down, slope of yield curve flattens or goes inverted. FNCE302: Investments Lecture 3 Page 20
21 Yield to Maturity and Prices and Prices on Zero-Coupon Bonds ($1,000 Face Value) How are yield curves constructed? If we had a sequence of zero-coupon bonds with maturities at different dates, then we can calculate the yield at different maturities based on the price of these zero-coupon bonds. Note: the yield curves we have here are not, strictly speaking, are not true yield curves. Why? Take for example the 10 year note. A 10 year note is 20 coupon payments plus the principle payment at the end. It is actually a note of a mixture of different maturities. It's not a pure 20 year zero-coupon bond. It has a duration of less than 20 years. Therefore, it really is just a combination of many bonds across the yield curve. So strictly speaking, when you calculate the yield to maturity on a 10 year bond, that is not truly a 10 year yield. Because it's a mixture of different things. Really, we should use zero-coupon bonds. When you see a published yield curve it isn't calculated from zero-coupon bonds, it's calculated from coupons. So if we make our own yield curve we should use zero-coupon bonds. A published yield curve lets us know what the interest rates are in the economy because it looks at coupon bonds. But if you are using it to predict the path of short term interest rates, it doesn't quit work. Close but not quite. So the published yield curves are going to be pretty close to the true pure zero-coupon bond yield curve but it is not going to be exactly the same. In the old days they did not have zero-coupon bonds for long term securities so you would have to use an iterative process to break apart bonds. These days we have strip bonds that go all the way up to the 30 year maturity. Easy to find these zero-coupon bonds. So what we would do to construct a yield curve is if you know the price of different zero-coupon bonds of different maturities you can infer the yield to maturity on those bonds. The yield to maturity can then be used to construct the yield curve. This thought process will push us toward an understanding of how the yield curve predicts the path of short term interest rates. Consider these two strategies: FNCE302: Investments Lecture 3 Page 21
22 Two 2-Year Investment Programs Suppose I wanted to invest for a 2 year period. Imagine I have 2 choices; 1. I can invest in a 2 year zero-coupon bond. Done, no interest rate risk, no reinvestment risk, I know what I am getting in terms of the coupon rate. 2. I invest in 2 one year zero-coupon bonds. I know what the return is over the first year because if I invest in a one year coupon bond, I am getting a certain known percent. I know the one year payout. But I do not know what the payout will be over the second year. It depends on many things such as economic conditions, what the fed is doing, what happens with inflation, the foreign flow of funds I do not know for a fact what the 1 year bond will be yielding one year from today. But I can calculate a forward rate. The way I do this is this. if I invest $890 today I can infer the 1 year rate one year from today by making the return from this strategy equal to the return from that strategy. So if the return of alternative 1 (straight 2 year investment) is $1000 and I set that return equal to the second year return of alternative 2, I can calculate what the projection is for the 1 year rate is one year from today. The (spot rate) 1 year rate 1 year from today. Short Rates versus Spot Rates So we make the two strategies payoff the same and can use the result to infer what the short term 1 year rate will be in the future. We know from our zero-coupon bond that the 1 year rate today is 5%. The solution for r 2 is the predicted 1 year rate a year from today (1 r2 ) r % This is not the same as the yield on the 2 year bond. The 1 year bond of alt 1 pays 5% whereas the 2 year bond pays 6% for two years. This means the second year of alt 2 must pay more than 6% to catch the investment up to alt 1. The "Spot Rate" graph is calculating the 1 year rate 4 years from today. Notice that it has an upward sloping yield curve, 5% 6% 7% 8%. If I believe that these strategies of investments should pay the same, then this is predicting that future short term interest rates are expected to go up. The upward sloping yield curve are predicting that short term rates are expected to go up in the future (according to PURE EXPECTATIONS THEORY). PET is saying that the yield curve predicts the path of short term interest rates. FNCE302: Investments Lecture 3 Page 22
23 (1 f ) n n (1 y ) (1 y ) n 1 n 1 f one year forward rate for period n y Forward Rates from Observed Rates n yield for a security with a maturity of n n n 1 (1 y ) (1 y ) (1 f ) n n 1 n n n Solution is for n-1, if you pick n=4 you are solving for 1 year rate 3 years in future. f n is the forward rate. y n is the yield n periods in the future. We must know the yields at n and n-1 periods in the future. EXAMPLE using the rates in the spot rate graph on last pare: f (1 y ) (1.08) % (1 y3) (1.07) This is our forward rate prediction of the 1 year rate for 3 years in the future. This result matches what the graph on last page shows if you are sitting at year 3 and looking at the next 1 year rate. SPOT RATE: an interest rate quoted today. FORWARD RATE: a prediction of the spot rate in the future based on the yield curve. Spot Rate and Forward Rates On Friday the yield on 1 year and 2 year treasury securities was 3.51% and 3.82%, respectively These are 1 and 2 year spot rates (rates available today) Thus if an investor bought $1 million of 1 year treasuries then he would have $1 mm x (1.0351) = $1,035,100 in one year (certain return) And if an investor bought $1 million of 2 year treasuries then he would have $1 mm x (1.0382) 2 = $1,077,859 in two years (also certain) What is the additional return earned over the second year? What is the forward 1 year rate? We must calculate f2 where I take the investment at the end of year 1, grow it by 1 plus the forward rate, and this gives me the two year return. Note that our yield curve is upward sloping (3.51% 3.82%). Solution is predicting that the 1 year arte 1 year from today is going to rise to 4.13% (if you believe PET). f (1 y ) (1. ) % (1 y1) ( ) $1,035,100 1 $1, 077,859 FNCE302: Investments Lecture 3 Page 23
24 Forward Rates What is the additional return earned over the second year? It will be f 2 where $1,035,100 x (1 + f 2 ) = $1,077,859 So f 2 = 4.1% This is the forward rate for year two Relationship Forward and future spot rates EXAMPLE Suppose an investor has a two-year investing horizon He wishes to invest in treasury securities and has two strategies (if only one year and two bonds existed) STRATEGY I. Invest in a one year bond and at the end, roll over the proceeds in a new one year bond STRATEGY II. Invest in a two year bond Given the above data what is the 1 year spot rate going to be 1 year from today. In order to have an identical return it would have to be 4.13%. That is what I am expecting. Given the above data, what will the one-year spot rate need to be in one year to yield identical returns? It would be 4.13% since in the above calculation f 2 was calculated from the relationship: ( %) 1 x (1 + f 2 ) = ( %) 2 The only problem is, a future spot rate is prediction (no guarantee) Many things can change to affect the future rates. FNCE302: Investments Lecture 3 Page 24
25 Relationship Forward and Future Spot Rates If we believe that forward rates are set so as to equal the spot rate over the same period then we believe in the Expectations Hypothesis Generally this will only hold if investors are risk neutral Economists believe that investors need to be induced to hold riskier long-term bonds (because there is more interest rate risk, the duration is longer) (as opposed to holding smaller bonds and rolling over) thus expected spot rates are likely smaller than their corresponding forward rate Expectations Hypothesis camp believes that forward rates are set so as to equal the spot rate over the same period. If we believe that forward rates are good predictors of future spot rates then we follow the Expectations Hypothesis. If investors are risk neutral they should be indifferent to investing in a sequence of one year bonds or investing in a longer term bond. Another way of saying this is If you believe the yield curve to be described by the path of future interest rates then you believe in the pure expectations theory (PET). but this is not the only theory LIQUIDITY PREMIUM THEORY According to the liquidity premium theory, the yield curve changes as the liquidity premium changes over time due to investor preferences Investors who prefer short-term securities will hold long-term securities only if compensated with a premium Short-term securities are typically more liquid than long-term securities The preference for short-term securities places upward pressure on the slope of the yield curve Basically this theory is saying: I need a higher yield to invest in longer term bonds because the markets tend to be less liquid in longer term bonds and, because of duration, there is greater interest rate risk in investing in longer term bonds. For these reasons the yield on a longer term bond should give me something extra. Thus the name, LIQUIDITY THEORY PREMIUM. Saying that an upward sloping yield curve may not be predicting what is happening to future interest rates, it may just simply be the fact that the longer I invest the higher return I need to compensate for the additional risk. FNCE302: Investments Lecture 3 Page 25
26 According to PET: a flat yield curve means that you expect short term interest rates to remain the same over time. An upward sloping yield curve means that you believe that short term interest rates are going to increase over time. With Liquidity Premium Theory you can have an upward sloping yield curve, because of the extra premium it may mean that you expect interest rates are going to remain the same. There is an upward bias due to the additional return (premium). Now let's look again at the equation we used to predict spot rates in the future Estimation of the FORWARD RATE based on a LIQUIDITY PREMIUM The yield on a security will not necessarily be equal to the yield from consecutive investments in shorter-term securities: 2 1 y 2 1 y1 1 f2 LP2 0 LP LP 1 LP2 LP3... The relationship between the LIQUIDITY PREMIUM and the TERM TO MATURITY is: So what the liquidity premium is saying is: "to invest in the longer term bond I am going to need more than I would receive from two short term investments in order to compensate for the risk of investing in a longer term bond." So even if short term interest rates are expected to remain unchanged over time, the yield curve is still going to be upward sloping because of the extra return investors need to compensate for the longer term. Generally it is believed that this liquidity premium increases with maturity. I need extra return for investing in a 20 year bond compared to a 10 year bond because there is that much greater risk. So there is an upward bias to the yield curve. According to the liquidity premium theory a flat yield curve means that you are actually expecting short term interest rates to decline (slight decrease in rates). Likewise, a slightly upward sloping yield curve means no expected change in interest rates, it merely reflects the liquidity premium with no change in short term rates. 20 FNCE302: Investments Lecture 3 Page 26
27 SEGMENTED MARKET THEORY Investors and borrowers choose securities with maturities that satisfy their forecasted cash needs Pension funds and life insurance companies prefer long-term investments Commercial banks prefer short-term investments Shifting by investors or borrowers between maturity markets only occurs if the timing of their cash needs change Investors and barrowers choose to invest in a certain part of the yield curve and they have no flexibility to move around in the yield curve (to get more competitive rates). For instance, insurance company has obligations it must pay out over the next 20 years. They will invest in 20 year bonds. They have no ability to invest in a 10 year bond of a 2 year bond or any other term bond. They are locked into 20 years (due to their need). If we believe the segmented market theory then we believe that each part of the yield curve is driven by its own supply and demand and there is no connection between a 10 year yield, a 20 year yield, or a 1 year yield. SEGMENTED MARKET THEORY: PREFERRED HABITAT Some borrowers and savers have the flexibility to choose among various maturity markets e.g., Corporations may initially obtain short term funds if they expect long-term interest rates to decline If markets were segmented, an adjustment in the interest rate in one market would have no impact on other markets, but evidence shows this is not true Preferred Habitat variation says investors will not behave in the manor described by straight SMT (Part A). They will give themselves flexibility. There must be some ability to move in the yield curve according to needs. Example would be an insurance company which needs to barrow and invest over a 20 year period but they can do so over 10 or 25 year terms. They have wiggle-room along the yield curve. Investors will move along the curve, even if only a little, to optimize their return, the return for their situation. Example: homeowner wants to take out a mortgage, they will choose among the 25 and 30 year mortgages, will not try to squeeze themselves into a 5 year product. Implications The preference for particular maturities can affect the prices and yields of securities with different maturities and therefore the shape of the yield curve The preferred habitat theory is a more flexible perspective Investors and borrowers may wander from their markets given certain events. FNCE302: Investments Lecture 3 Page 27
28 Which of the three theories is true? People have done a lot of research on which holds true. Interest rate expectations do have a strong influence on term structure. RESEARCH ON TERM STRUCTURE THEORIES Interest rate expectations have a strong influence on the term structure. Peoples belief about the path of short term rates do explain the term structure of interest rates. The Pure Expectation Theory does go a long way in explaining the yield curve. The forward rate from the yield curve does not accurately predict future interest rates. It does an OK job, doesn't do a great job. Variation in the yield-maturity relationship cannot be explained by interest rate expectations or liquidity General research implications Some evidence for pure expectations, liquidity premium, and segmented markets theory So which of the 3 ½ theories is correct? They all seem to tell a partial story, it seems to be a mixture of the 3 theories at work. No one is correct, all 3 effect the structure of the yield curve. Prof: I don't think the liquidity premium really explains very much. I think the preferred habitat has a lot to say, large parts of the economy that are locked into a particular segment of the yield curve. (mortgage example) Corporations and savers do have particular needs they are looking to address in the market and will respond accordingly. So preferred habitat has a lot going for it in explaining yield curve structure but if you look at how short term interest rates change over time, the yield curve does a fairly good job of predicting the path of short term interest rates. So theories 1 and 3B seem to have the biggest impact. FNCE302: Investments Lecture 3 Page 28
INTEREST RATES Overview Real vs. Nominal Rate Equilibrium Rates Interest Rate Risk Reinvestment Risk Structure of the Yield Curve Monetary Policy
INTEREST RATES Overview Real vs. Nominal Rate Equilibrium Rates Interest Rate Risk Reinvestment Risk Structure of the Yield Curve Monetary Policy Some of the following material comes from a variety of
More informationChapter 2 Determination of Interest Rates
Chapter 2 Determination of Interest Rates 1. According to the loanable funds theory, market interest rates are determined by the factors that control the supply of and demand for loanable funds. 2. The
More informationTest Bank for Financial Markets and Institutions 11th Edition by Madura
Test Bank for Financial Markets and Institutions 11th Edition by Madura Link download full: http://testbankair.com/download/test-bank-for-financialmarkets-and-institutions-11th-edition-by-madura/ Chapter
More informationChapter 2 Determination of Interest Rates
Chapter 2 Determination of Interest Rates MULTIPLE CHOICE 1. The level of installment debt as a percentage of disposable income is generally during recessionary periods. a. higher b. lower c. zero d. negative
More informationTerm Structure of Interest Rates. For 9.220, Term 1, 2002/03 02_Lecture7.ppt
Term Structure of Interest Rates For 9.220, Term 1, 2002/03 02_Lecture7.ppt Outline 1. Introduction 2. Term Structure Definitions 3. Pure Expectations Theory 4. Liquidity Premium Theory 5. Interpreting
More informationII. Determinants of Asset Demand. Figure 1
University of California, Merced EC 121-Money and Banking Chapter 5 Lecture otes Professor Jason Lee I. Introduction Figure 1 shows the interest rates for 3 month treasury bills. As evidenced by the figure,
More information3.36pt. Karl Whelan (UCD) Term Structure of Interest Rates Spring / 36
3.36pt Karl Whelan (UCD) Term Structure of Interest Rates Spring 2018 1 / 36 International Money and Banking: 12. The Term Structure of Interest Rates Karl Whelan School of Economics, UCD Spring 2018 Karl
More informationFoundations of Finance
Lecture 9 Lecture 9: Theories of the Yield Curve. I. Reading. II. Expectations Hypothesis III. Liquidity Preference Theory. IV. Preferred Habitat Theory. Lecture 9: Bond Portfolio Management. V. Reading.
More informationNotes 6: Examples in Action - The 1990 Recession, the 1974 Recession and the Expansion of the Late 1990s
Notes 6: Examples in Action - The 1990 Recession, the 1974 Recession and the Expansion of the Late 1990s Example 1: The 1990 Recession As we saw in class consumer confidence is a good predictor of household
More information1. The real risk-free rate is the increment to purchasing power that the lender earns in order to induce him or her to forego current consumption.
Chapter 02 Determinants of Interest Rates True / False Questions 1. The real risk-free rate is the increment to purchasing power that the lender earns in order to induce him or her to forego current consumption.
More informationMoney & Capital Markets Exam 1: Chapters 1, 2, 3, 4, 5 & 6. Name. Multiple Choice: 4 points each
Money & Capital Markets Exam 1: Chapters 1, 2, 3, 4, 5 & 6 Name Multiple Choice: 4 points each MULTIPLE CHOICE. Choose the one alternative that best completes the statement or answers the question. 1)
More informationThe following pages explain some commonly used bond terminology, and provide information on how bond returns are generated.
1 2 3 Corporate bonds play an important role in a diversified portfolio. The opportunity to receive regular income streams from corporate bonds can be appealing to investors, and the focus on capital preservation
More informationEcon 340: Money, Banking and Financial Markets Midterm Exam, Spring 2009
Econ 340: Money, Banking and Financial Markets Midterm Exam, Spring 2009 1. On September 18, 2007 the U.S. Federal Reserve Board began cutting its fed funds rate (short term interest rate) target. This
More informationModule 31. Monetary Policy and the Interest Rate. What you will learn in this Module:
Module 31 Monetary Policy and the Interest Rate What you will learn in this Module: How the Federal Reserve implements monetary policy, moving the interest to affect aggregate output Why monetary policy
More informationChapter 4 Interest Rate Measurement and Behavior Chapter 5 The Risk and Term Structure of Interest Rates
Chapter 4 Interest Rate Measurement and Behavior Chapter 5 The Risk and Term Structure of Interest Rates Fisher Effect (risk-free rate) Interest rate has 2 components: (1) real rate (2) inflation premium
More informationSAVING, INVESTMENT, AND THE FINANCIAL SYSTEM
26 SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM WHAT S NEW IN THE FOURTH EDITION: There are no substantial changes to this chapter. LEARNING OBJECTIVES: By the end of this chapter, students should understand:
More informationBond Basics June 2006
Yield Curve Basics The yield curve, a graph that depicts the relationship between bond yields and maturities, is an important tool in fixed-income investing. Investors use the yield curve as a reference
More informationCHAPTER 15. The Term Structure of Interest Rates INVESTMENTS BODIE, KANE, MARCUS
CHAPTER 15 The Term Structure of Interest Rates McGraw-Hill/Irwin Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved. 15-2 Overview of Term Structure The yield curve is a graph that
More informationText transcription of Chapter 8 Savings, Investment and the Financial System
Text transcription of Chapter 8 Savings, Investment and the Financial System Welcome to the Chapter 8 Lecture on Savings, Investment and the Financial System. Savings and investment are key ingredients
More informationEconomics 1012A: Introduction to Macroeconomics FALL 2007 Dr. R. E. Mueller Third Midterm Examination November 15, 2007
Economics 1012A: Introduction to Macroeconomics FALL 2007 Dr. R. E. Mueller Third Midterm Examination November 15, 2007 Answer all of the following questions by selecting the most appropriate answer on
More informationSolutions to PSet 5. October 6, More on the AS/AD Model
Solutions to PSet 5 October 6, 207 More on the AS/AD Model. If there is a zero interest rate lower bound, is fiscal policy more or less effective than otherwise? Explain using the AS/AD model. Is the United
More informationSaving, Investment and the Financial System (Chapter 26 in Mankiw & Taylor)
Saving, Investment and the Financial System (Chapter 26 in Mankiw & Taylor) We have seen that saving and investment are essential to long-run economic growth In this lecture we will see how the financial
More informationMarket Insight: Turn Down the News Volume, Listen to the Market
August 9, 2018 Market Insight: Turn Down the News Volume, Listen to the Market If you just listened to the news headlines, it would be hard to find reasons to like this market. Trade Wars ; Tariff Threats
More informationAggregate Demand and Aggregate Supply
Aggregate Demand and Aggregate Supply Aggregate Demand and Aggregate Supply The Learning Objectives in this presentation are covered in Chapter 20: Aggregate Demand and Aggregate Supply LEARNING OBJECTIVES
More informationMacroeconomics in an Open Economy
Chapter 17 (29) Macroeconomics in an Open Economy Chapter Summary Nearly all economies are open economies that trade with and invest in other economies. A closed economy has no interactions in trade or
More informationCHAPTER 5 THE COST OF MONEY (INTEREST RATES)
CHAPTER 5 THE COST OF MONEY (INTEREST RATES) 1 Learning Outcomes LO.1 Describe the cost of money and factors that affect the cost of money. LO.2 Describe how interest rates are determined. LO.3 Describe
More informationTradeoff Between Inflation and Unemployment
CHAPTER 13 Aggregate Supply and the Short-Run Tradeoff Between Inflation and Unemployment Questions for Review 1. In this chapter we looked at two models of the short-run aggregate supply curve. Both models
More informationMULTIPLE CHOICE. Choose the one alternative that best completes the statement or answers the question.
Econ 330 Spring 2015: EXAM 1 Name ID Section Number MULTIPLE CHOICE. Choose the one alternative that best completes the statement or answers the question. 1) If during the past decade the average rate
More informationInternational Finance
International Finance FINA 5331 Lecture 2: U.S. Financial System William J. Crowder Ph.D. Financial Markets Financial markets are markets in which funds are transferred from people and Firms who have an
More informationEcon 102 Final Exam Name ID Section Number
Econ 102 Final Exam Name ID Section Number 1. Which of the following is not an accurate statement of core capital goods? A) proxy for business investments B) does not include transportation equipment C)
More informationA BOND MARKET IS-LM SYNTHESIS OF INTEREST RATE DETERMINATION
A BOND MARKET IS-LM SYNTHESIS OF INTEREST RATE DETERMINATION By Greg Eubanks e-mail: dismalscience32@hotmail.com ABSTRACT: This article fills the gaps left by leading introductory macroeconomic textbooks
More informationSaving, Investment, and the Financial System
Saving, Investment, and the Financial System The Financial System The financial system consists of institutions that help to match one person s saving with another person s investment. It moves the economy
More informationMidsummer Examinations 2013
Midsummer Examinations 2013 No. of Pages: 7 No. of Questions: 34 Subject ECONOMICS Title of Paper MACROECONOMICS Time Allowed Two Hours (2 Hours) Instructions to candidates This paper is in two sections.
More informationSimple Notes on the ISLM Model (The Mundell-Fleming Model)
Simple Notes on the ISLM Model (The Mundell-Fleming Model) This is a model that describes the dynamics of economies in the short run. It has million of critiques, and rightfully so. However, even though
More informationCHAPTER 15. The Term Structure of Interest Rates INVESTMENTS BODIE, KANE, MARCUS
CHAPTER 15 The Term Structure of Interest Rates INVESTMENTS BODIE, KANE, MARCUS McGraw-Hill/Irwin Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved. INVESTMENTS BODIE, KANE, MARCUS
More informationChapter# The Level and Structure of Interest Rates
Chapter# The Level and Structure of Interest Rates Outline The Theory of Interest Rates o Fisher s Classical Approach o The Loanable Funds Theory o The Liquidity Preference Theory o Changes in the Money
More informationIN THIS LECTURE, YOU WILL LEARN:
IN THIS LECTURE, YOU WILL LEARN: Am simple perfect competition production medium-run model view of what determines the economy s total output/income how the prices of the factors of production are determined
More informationTheory of Consumer Behavior First, we need to define the agents' goals and limitations (if any) in their ability to achieve those goals.
Theory of Consumer Behavior First, we need to define the agents' goals and limitations (if any) in their ability to achieve those goals. We will deal with a particular set of assumptions, but we can modify
More informationDetermination of Interest Rates
Chapter 2 Determination of Interest Rates Outline Loanable Funds Theory Household Demand for Loanable Funds Business Demand for Loanable Funds Government Demand for Loanable Funds Foreign Demand for Loanable
More informationLecture Materials Topic 3 Yield Curves and Interest Forecasts ECONOMICS, MONEY MARKETS AND BANKING
Lecture Materials Topic 3 Yield Curves and Interest Forecasts ECONOMICS, MONEY MARKETS AND BANKING Todd Patrick Senior Vice President - Capital Markets CenterState Bank Atlanta, Georgia tpatrick@centerstatebank.com
More informationdownload instant at
Exam Name MULTIPLE CHOICE. Choose the one alternative that best completes the statement or answers the question. 1) The aggregate supply curve 1) A) shows what each producer is willing and able to produce
More informationMoney and the Economy CHAPTER
Money and the Economy 14 CHAPTER Money and the Price Level Classical economists believed that changes in the money supply affect the price level in the economy. Their position was based on the equation
More informationThe Foreign Exchange Market
INTRO Go to page: Go to chapter Bookmarks Printed Page 421 The Foreign Exchange Module 43: Exchange Policy 43.1 Exchange Policy Module 44: Exchange s and 44.1 Exchange s and The role of the foreign exchange
More informationINTRODUCTION TO YIELD CURVES. Amanda Goldman
INTRODUCTION TO YIELD CURVES Amanda Goldman Agenda 1. Bond Market and Interest Rate Overview 1. What is the Yield Curve? 1. Shape and Forces that Change the Yield Curve 1. Real-World Examples 1. TIPS Important
More informationObjectives for Chapter 24: Monetarism (Continued) Chapter 24: The Basic Theory of Monetarism (Continued) (latest revision October 2004)
1 Objectives for Chapter 24: Monetarism (Continued) At the end of Chapter 24, you will be able to answer the following: 1. What is the short-run? 2. Use the theory of job searching in a period of unanticipated
More informationConsumption. Basic Determinants. the stream of income
Consumption Consumption commands nearly twothirds of total output in the United States. Most of what the people of a country produce, they consume. What is left over after twothirds of output is consumed
More information7. Bonds and Interest rates
1 7. Bonds and Interest rates Fixed income may seem boring, but it s not. It s a huge and very dynamic market. Much larger than equities. Bond traders can take on similar levels of risk and earn similar
More informationThe investment map that we will develop in this book works so well
CHAPTER 1 Demystifying the Investment World The investment map that we will develop in this book works so well because it is rooted in fundamental economics. These fundamentals will be our first screen
More informationChapter 2 Self Study Questions
Chapter 2 Self Study Questions True/False Indicate whether the sentence or statement is true or false. 1. If an individual investor buys and sells existing stocks through a broker, these are primary market
More informationAND INVESTMENT * Chapt er. Key Concepts
Chapt er 7 FINANCE, SAVING, AND INVESTMENT * Key Concepts Financial Institutions and Financial Markets Finance and money are different: Finance refers to raising the funds used for investment in physical
More informationEC202 Macroeconomics
EC202 Macroeconomics Koç University, Summer 2014 by Arhan Ertan Study Questions - 3 1. Suppose a government is able to permanently reduce its budget deficit. Use the Solow growth model of Chapter 9 to
More informationThe Yield Curve WHAT IT IS AND WHY IT MATTERS. UWA Student Managed Investment Fund ECONOMICS TEAM ALEX DYKES ARKA CHANDA ANDRE CHINNERY
The Yield Curve WHAT IT IS AND WHY IT MATTERS UWA Student Managed Investment Fund ECONOMICS TEAM ALEX DYKES ARKA CHANDA ANDRE CHINNERY What is it? The Yield Curve: What It Is and Why It Matters The yield
More informationReview Material for Exam I
Class Materials from January-March 2014 Review Material for Exam I Econ 331 Spring 2014 Bernardo Topics Included in Exam I Money and the Financial System Money Supply and Monetary Policy Credit Market
More informationFINAL EXAM (Two Hours) DECEMBER 21, 2016 SECTION #
COURSE 180.101 MACROECONOMICS FINAL EXAM (Two Hours) DECEMBER 21, 2016 NAME TA Part I (20 points) SECTION # 1 POINT EACH QUESTION 1. China s GDP appears to be roughly 55% of U.S. GDP, if we use what currency
More informationGame Theory and Economics Prof. Dr. Debarshi Das Department of Humanities and Social Sciences Indian Institute of Technology, Guwahati
Game Theory and Economics Prof. Dr. Debarshi Das Department of Humanities and Social Sciences Indian Institute of Technology, Guwahati Module No. # 03 Illustrations of Nash Equilibrium Lecture No. # 02
More informationWhat Should the Fed Do?
Peterson Perspectives Interviews on Current Topics What Should the Fed Do? Joseph E. Gagnon and Michael Mussa discuss the latest steps by the Federal Reserve to help the economy and what tools might be
More informationInternational Money and Banking: 14. Real Interest Rates, Lower Bounds and Quantitative Easing
International Money and Banking: 14. Real Interest Rates, Lower Bounds and Quantitative Easing Karl Whelan School of Economics, UCD Spring 2018 Karl Whelan (UCD) Real Interest Rates Spring 2018 1 / 23
More informationFinancial Markets I The Stock, Bond, and Money Markets Every economy must solve the basic problems of production and distribution of goods and
Financial Markets I The Stock, Bond, and Money Markets Every economy must solve the basic problems of production and distribution of goods and services. Financial markets perform an important function
More informationBuoyant Economies. Formula for the Current Account Balance
Buoyant Economies Formula for the Current Account Balance Introduction This paper presents models that explain how growth in the quantity of money determines the current account balance. Money should constrain
More informationA Macroeconomic Theory of the Open Economy. Lecture 9
1 A Macroeconomic Theory of the Open Economy Lecture 9 2 What we learn in this Chapter? In Chapter 29 we defined the basic concepts of an open economy, such as the Balance of Payments, NX = NFI and the
More informationLecture 11: The Demand for Money and the Price Level
Lecture 11: The Demand for Money and the Price Level See Barro Ch. 10 Trevor Gallen Spring, 2016 1 / 77 Where are we? Taking stock 1. We ve spent the last 7 of 9 chapters building up an equilibrium model
More informationThe Financial System. FINANCIAL INSTITUTIONS IN THE U.S. ECONOMY Financial Markets Stock Market Bond Market
Chapter 26. Saving, Investment, and the Financial System important financial institutions in the U.S. economy. how the financial system is related to key macroeconomic variables. the model of the supply
More informationBusiness 33001: Microeconomics
Business 33001: Microeconomics Owen Zidar University of Chicago Booth School of Business Week 6 Owen Zidar (Chicago Booth) Microeconomics Week 6: Capital & Investment 1 / 80 Today s Class 1 Preliminaries
More informationChapter 4 Inflation and Interest Rates in the Consumption-Savings Model
Chapter 4 Inflation and Interest Rates in the Consumption-Savings Model The lifetime budget constraint (LBC) from the two-period consumption-savings model is a useful vehicle for introducing and analyzing
More informationMacroeconomics, Spring 2007, Exam 3, several versions, Late April-Early May
Name: _ Days/Times Class Meets: Today s Date: Macroeconomics, Spring 2007, Exam 3, several versions, Late April-Early May Read these Instructions carefully! You must follow them exactly! I) On your Scantron
More informationCHAPTER 4 INTEREST RATES AND PRESENT VALUE
CHAPTER 4 INTEREST RATES AND PRESENT VALUE CHAPTER OBJECTIVES Once you have read this chapter you will understand what interest rates are, why economists delineate nominal from real interest rates, how
More informationECO 209Y MACROECONOMIC THEORY AND POLICY. Term Test #2. December 13, 2017
ECO 209Y MACROECONOMIC THEORY AND POLICY Term Test #2 December 13, 2017 U of T E-MAIL: @MAIL.UTORONTO.CA SURNAME (LAST NAME): GIVEN NAME (FIRST NAME): UTORID (e.g., LIHAO118): INSTRUCTIONS: The total time
More informationIn this chapter, look for the answers to these questions
In this chapter, look for the answers to these questions What are the main types of financial institutions and what is their function? What are the three kinds of saving? What s the difference between
More informationThe August 9 FOMC Decision Ineffective at Best, Dangerous at Worst
Northern Trust Global Economic Research 5 South LaSalle Street Chicago, Illinois 663 Paul L. Kasriel Chief Economist 312.444.4145 312.557.2675 fax plk1@ntrs.com The August 9 FOMC Decision Ineffective at
More informationEcon 102 Exam 2 Name ID Section Number
Econ 102 Exam 2 Name ID Section Number 1. Suppose investment spending increases by $50 billion and as a result the equilibrium income increases by $200 billion. The investment multiplier is: A) 10. B)
More informationProb(it+1) it+1 (Percent)
I. Essay/Problem Section (15 points) You purchase a 30 year coupon bond which has par of $100,000 and a (annual) coupon rate of 4 percent for $96,624.05. What is the formula you would use to calculate
More informationTWO VIEWS OF THE ECONOMY
TWO VIEWS OF THE ECONOMY Macroeconomics is the study of economics from an overall point of view. Instead of looking so much at individual people and businesses and their economic decisions, macroeconomics
More information1. Parallel and nonparallel shifts in the yield curve. 2. Factors that drive U.S. Treasury security returns.
LEARNING OUTCOMES 1. Parallel and nonparallel shifts in the yield curve. 2. Factors that drive U.S. Treasury security returns. 3. Construct the theoretical spot rate curve. 4. The swap rate curve (LIBOR
More informationPrinciples of Macroeconomics December 17th, 2005 name: Final Exam (100 points)
EC132.02 Serge Kasyanenko Principles of Macroeconomics December 17th, 2005 name: Final Exam (100 points) This is a closed-book exam - you may not use your notes and textbooks. Calculators are not allowed.
More informationFETP/MPP8/Macroeconomics/Riedel. General Equilibrium in the Short Run II The IS-LM model
FETP/MPP8/Macroeconomics/iedel General Equilibrium in the Short un II The -LM model The -LM Model Like the AA-DD model, the -LM model is a general equilibrium model, which derives the conditions for simultaneous
More informationCost Shocks in the AD/ AS Model
Cost Shocks in the AD/ AS Model 13 CHAPTER OUTLINE Fiscal Policy Effects Fiscal Policy Effects in the Long Run Monetary Policy Effects The Fed s Response to the Z Factors Shape of the AD Curve When the
More informationMIDTERM EXAMINATION FALL
MIDTERM EXAMINATION FALL 2010 MGT411-Money & Banking By VIRTUALIANS.PK SOLVED MCQ s FILE:- Question # 1 Wider the range of outcome wider will be the. Risk Profit Probability Lose Question # 2 Prepared
More informationLecture 12: Economic Fluctuations. Rob Godby University of Wyoming
Lecture 12: Economic Fluctuations Rob Godby University of Wyoming Short-Run Economic Fluctuations Economic activity fluctuates from year to year. In some years, the production of goods and services rises.
More informationSAVING, INVESTMENT, AND THE FINANCIAL SYSTEM
13 SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM LEARNING OBJECTIVES: By the end of this chapter, students should understand: some of the important financial institutions in the U.S. economy. how the financial
More informationSAMPLE FINAL QUESTIONS. William L. Silber
SAMPLE FINAL QUESTIONS William L. Silber HOW TO PREPARE FOR THE FINAL: 1. Study in a group 2. Review the concept questions in the Before and After book 3. When you review the questions listed below, make
More informationInternational Macroeconomics
Slides for Chapter 3: Theory of Current Account Determination International Macroeconomics Schmitt-Grohé Uribe Woodford Columbia University May 1, 2016 1 Motivation Build a model of an open economy to
More informationExam Number. Section
Exam Number Section MACROECONOMICS IN THE GLOBAL ECONOMY Core Course ANSWER KEY Final Exam March 1, 2010 Note: These are only suggested answers. You may have received partial or full credit for your answers
More informationSavings and Investment
Lecture Notes for Chapter 3 of MACROECONOMICS: An Introduction Savings and Investment Copyright 2000-2009 by Charles R. Nelson 1/8/09 In this chapter we will discuss- How savings becomes investment. Banks
More information3. OPEN ECONOMY MACROECONOMICS
3. OEN ECONOMY MACROECONOMICS The overall context within which open economy relationships operate to determine the exchange rates will be considered in this chapter. It is simply an extension of the closed
More informationIf a model were to predict that prices and money are inversely related, that prediction would be evidence against that model.
The Classical Model This lecture will begin by discussing macroeconomic models in general. This material is not covered in Froyen. We will then develop and discuss the Classical Model. Students should
More informationThe Current Environment for Bond Investing
JOEY THOMPSON 2013-06-21 The Current Environment for Bond Investing U. S. Government bonds are often thought of as safe investments, but like all investments, there is risk involved. When yields and inflation
More informationCHAPTER 14. Bond Characteristics. Bonds are debt. Issuers are borrowers and holders are creditors.
Bond Characteristics 14-2 CHAPTER 14 Bond Prices and Yields Bonds are debt. Issuers are borrowers and holders are creditors. The indenture is the contract between the issuer and the bondholder. The indenture
More informationElements of Macroeconomics: Homework #4. 1. Households supply loanable funds to firms and the government.
Elements of Macroeconomics: Homework # Due 0/08 or 0/09 in assigned Section Name: Section: Section I Fill in the blanks. Households supply loanable funds to firms and the government.. Equilibrium in the
More informationPractical Problems with Discretionary Fiscal Policy
Practical Problems with Discretionary Fiscal Policy By: OpenStaxCollege In the early 1960s, many leading economists believed that the problem of the business cycle, and the swings between cyclical unemployment
More informationReplies to one minute memos, 9/21/03
Replies to one minute memos, 9/21/03 Dear Students, Thank you for asking these great questions. The answer to my question (what is the difference b/n the covered & uncovered interest rate arbitrage? If
More information[Image of Investments: Analysis and Behavior textbook]
Finance 527: Lecture 19, Bond Valuation V1 [John Nofsinger]: This is the first video for bond valuation. The previous bond topics were more the characteristics of bonds and different kinds of bonds. And
More informationChapter 19: Compensating and Equivalent Variations
Chapter 19: Compensating and Equivalent Variations 19.1: Introduction This chapter is interesting and important. It also helps to answer a question you may well have been asking ever since we studied quasi-linear
More informationChapter 6: Supply and Demand with Income in the Form of Endowments
Chapter 6: Supply and Demand with Income in the Form of Endowments 6.1: Introduction This chapter and the next contain almost identical analyses concerning the supply and demand implied by different kinds
More informationThe Demand for Money. Lecture Notes for Chapter 7 of Macroeconomics: An Introduction. In this chapter we will discuss -
Lecture Notes for Chapter 7 of Macroeconomics: An Introduction The Demand for Money Copyright 1999-2008 by Charles R. Nelson 2/19/08 In this chapter we will discuss - What does demand for money mean? Why
More informationFINAL EXAM STUDY GUIDE
AP MACROECONOMICS-2017 Name: FINAL EXAM STUDY GUIDE Instructions: DUE: Day of FINAL EXAM => Friday 12/22 nd (1 st & 2 nd Periods) Thursday 12/21 st (4 th period) Section 1: PRODUCTION POSSIBLITIES FRONTIER
More informationEcon 100B: Macroeconomic Analysis Fall 2008
Econ 100B: Macroeconomic Analysis Fall 2008 Problem Set #7 ANSWERS (Due September 24-25, 2008) A. Small Open Economy Saving-Investment Model: 1. Clearly and accurately draw and label a diagram of the Small
More informationEcon 98- Chiu Spring 2005 Final Exam Review: Macroeconomics
Disclaimer: The review may help you prepare for the exam. The review is not comprehensive and the selected topics may not be representative of the exam. In fact, we do not know what will be on the exam.
More informationINTRODUCTION TO YIELD CURVES. Amanda Goldman
INTRODUCTION TO YIELD CURVES Amanda Goldman Agenda 1. Bond Market and Interest Rate Overview 1. What is the Yield Curve? 1. Shape and Forces that Change the Yield Curve 1. Real-World Examples 1. TIPS Important
More informationFINAL EXAM STUDY GUIDE
AP MACROECONOMICS-2018 Name: FINAL EXAM STUDY GUIDE Instructions: DUE: Day of FINAL EXAM => Friday 12/21 st (1 st & 2 nd Periods) Thursday 12/20 th (4 th period) Section 1: PRODUCTION POSSIBLITIES FRONTIER
More informationArchimedean Upper Conservatory Economics, October 2016
Multiple Choice Identify the choice that best completes the statement or answers the question. 1. The marginal propensity to consume is equal to: A. the proportion of consumer spending as a function of
More information