Chapter 2

Money, Credit, and the Determination of Interest Rates

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Chapter 2 Learning Objectives Understand how the supply and demand for money

and credit affect (and are affected by) the economy and the general level of interest rates

Understand how yields on individual debt instruments are determined

Understand why securities of different maturities may have different yields

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The General Level of Interest Rates Assume that only one type of credit instrument exists (e.g. a bond)

The bond is riskless

No inflation expectation

The price of the bond is inversely related to and determined by the market-required yield

Market value of the bonds can be defined in terms of either their price or their yield.

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The General Level of Interest Rates Interest rate on an instrument reflects general market rates and the risk of the

specific instrument

Transition mechanism of money and interest rates: Money supply → economy → inflation → inflationary expectations → credit markets → interest

rates

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The General Level of Interest Rates Equation of Exchange MV = PT

M = money supply V = velocity of circulation (the average number of

time$1 turns over in 1 year) P = general price level T = the volume of trade

Monetary theory of inflation The greater the rate of growth in money, the grater the rate

of inflation

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The Fisher Equation The inflation rate plays an important role in the

determination of market rates Fisher equation: I = r + p

I – the equilibrium nominal rate of interest observed in the credit market

r – the real interest rate P – the expected inflation over the maturity of the

instrument

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The Relationship between Inflation and T-Bill Yield

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The Gibson Paradox An increase in money supply leads to increases in

demand for bonds and goods and services, resulting in upward pressure on bond prices, forcing interest rates down.

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Liquidity, Income and Price-Anticipation Effects

Liquidity effect (short-run) Money supply goes up

Demand for bonds goes up

Interest rates go down

Income effect Income goes up

Demand for credit goes up

Interest rates go up

Price anticipation effect Future expected inflation

Decrease in supply of credit

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Liquidity, Income and Price-Anticipation Effects

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Risks In Real Estate Finance

Default risk Risk that the borrower will not repay the mortgage per the contract

Callability risk Borrower may repay the debt before maturity

Maturity risk Other things held constant, the longer the maturity the greater the change in value for a

given change in interest rates

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Risks In Real Estate Finance

Marketability risk Risk that the asset doesn’t trade in a large, organized market I = r + p + k, where k is risk premium associated with noninflationary risks

Inflation risk Risk in loss of purchasing power

Interest rate risk Risk of loss due to changes in market interest rates Fixed-income assets are most susceptible

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Description of Agency Ratings

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Income Tax Considerations Municipal bonds – issued by government jurisdictions

other than the federal government Interest from municipal bonds is tax free The tax-free nature of these instruments implies that

investors will receive lower return on these bonds MY = TY(1 – T)

where MY is the yield on a municipal bond, TY is the taxable yield on a comparable non-municipal bond, T is the investor’s tax rate.

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The Yield Curve

Relates maturity and yield at the same point in time

Theories explaining the structure of the yield curve: Liquidity Premium Theory

Long-term rates tend to be higher that short-term rates

Market Segmentation Theory

There are two (or more) markets for securities of different maturities

Assumes that investors will not change their preferences as a result of yield discrepancies

Expectations Theory

The long-term rate for some period is the average of the short-term rates over that period

Upward-sloping (downward-sloping) curves indicate that market participants expect rates to rise (fall) in the future.

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Yield Curve

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Explaining the Yield Curve

Liquidity premium Premium paid for liquidity

Segmented markets Market divided into distinct segments

Expectations theory Current rates are the average of expected future rates

The current two-year rate is the average of the current one-year rate and the one-year rate a year from now

Examples of Yield Curves

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