Determinants of Intrest Rates

8/13/2019 Determinants of Intrest Rates

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POOJA KARVAT A21

NAITIK MODI A25

PANKAJ SHARMA A43

SHAILESH BAJAJ PG66

BHAVIN VYAS A60

SHUBHANGI SHRINIVASAN B53


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Objectives

Explain The Concepts, Like Pure And Gross Interest Rates, Bond

Price Etc

Summarise The Important Theories Of Term Structure Of

Interest Rates

Identify The Factors Influencing Market Interest Rates

Describe The Effects Of Changes In Interest Rates


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Interest RatesIntroduction

Types

Yield Curve

Real vs. Nominal

What do we call the price, or cost, of debt capital?

The interest rate

What do we call the price, or cost, of equity capital?

Required Dividend Capitalreturn yield gain= +


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Real And Nominal Interest RatesIntroduction

Types

Yield Curve

Real vs. Nominal


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Real And Nominal Interest RatesIntroduction

Types

Yield Curve

Real vs. Nominal

Nominal Interest Rate = Real Interest Rate + Expected Inflation

Where Nominal Rate Is Advertised Market Rate

Real Rate Is Extra Purchasing Power Lender Demands Of

Borrower.


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Real And Nominal Interest Rates

a) In zero inflation world, if M&Ms cost $1.00 and you lend $10.00, your

lending 10 bags of M&Ms

b) If you want a real return of 10%, you need 11 bags so you charge 10%

interest and get $11.00 back

c) If inflation is 20%, then you need $1.20 x 11 = $13.20 back to buy 11

bags and get your 10% real return. This means you must charge a

nominal rate of 32%

d) 32% = 10% + 20% + 2%

Nominal real expected

Rate = rate + inflation + real rate inflation

Conclusion

Two fundamental determinants of interest rates are

strength of economy

expected (not past) inflation


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What four factors affect the level of

interest rates?

Introduction

Types

Yield Curve

Real vs. Nominal

Production opportunities

Time preferences for consumption

Risk

Expected inflation

I d i


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Determinants of Interest RatesIntroduction

Types

Yield Curve

Real vs. Nominal

R = required return on a debt security

r* = real risk-free rate of interest

IP = inflation premium

DRP = default risk premium

LP = liquidity premium

MRP = maturity risk premium

R = r* + IP + DRP + LP + MRP

I t d ti


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Fishers Classical ApproachIntroduction

Types

Yield Curve

Real vs. Nominal

Fisher Effect: creating to much money causes more money chasing some amount of goods. So,

price of goods goes up. But if price increases cause inflation, interest rates will rise!

So, Money Inflation Interest Rates

Fisher Equation : i = real rate + expected inf lation

I t d ti


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Fishers Classical ApproachIntroduction

Types

Yield Curve

Real vs. NominalSupply of Savings

Marginal rate of time preference

Income

Reward for saving

Demand for Borrowed Resources

Marginal productivity of capital

Rate of interest

Equilibrium Rate of Interest

Introduction


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Fishers LawIntroduction

Types

Yield Curve

Real vs. Nominal

Nominal Rate of Interest (i)Real Rate of Interest (r)

Premium for Expected Inflation (p)

Fishers Law

(1 + i) = (1 + r)(1 + p)

or

i = r + p

h h h ff


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Changes in e: the Fisher Effect

If e1. Relative RETe, Bd

shifts in to left

2. Bs, Bsshifts outto right

3. P, i


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INTEREST RATE MECHANICS

Bond prices and interest rates move in opposite directions

If bond prices rise, interest rates on those bonds fall.

If bond prices fall, interest rates on those bonds rise.

Q. If interest rates equal 10%, what would you pay for a zero coupon bond that pays $100 one

year from now?

A. About $91 (because your interest income would be $9 and $9/91 as about 10%).

Q. If interest rates equal 1%, what would you pay for the same bond?

A. About $99

So, Interest Rate Price

10% $91

1% $99


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INTEREST RATE MECHANICS

Suppose you have a 4% bond with

Face Value $100

Coupon $4

If it sells for $100, its current return is 4% ($4/$100). Now suppose

interest rates in the economy go up to 8%! Would someone pay you$100 for this bond? No, because if Price = $100 and coupon = $4, the

return is 4%, not 8%.

What would someone pay? About $96.00 because

%8)about(96$

gaincapital4$coupon4$


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Discount vs. Yield

Suppose you pay $90 for one year T-bill that returns $100 facevalue in one year.

But the amount below face that the bill sold for (i.e. itsDiscount price) is

%

$

$

ValueFace

FaceBelowAmtDiscount 10

100

10

%11

90$

10$

Price

Interest(roughly)Yield


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Determinants of Asset Demand


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Supply and

Demand

Analysis ofthe Bond

Market

Market Equilibrium

1. Occurs whenBd

=Bs

, atP* =

$850, i* = 17.6%

2. WhenP= $950, i= 5.3%,Bs

>

Bd

(excess supply):PtoP*, ito i*

3. WhenP= $750, i= 33.0,Bd

>

Bs

(excess demand):PtoP*,ito i*

Shift i th B d D d C


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Shifts in the Bond Demand Curve

Factors that Shift the Bond Demand Curv1. Wealth


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Factors that Shift the Bond Demand Curv1. Wealth

A. Economy grows, wealth ,Bd ,Bdshifts out to right

2. Expected Return

A. iin future,Refor long-term bonds ,Bdshifts out to rightB. e, RelativeRe ,Bdshifts out to rightC. Expected return relative to other assests ,Bd ,Bdshifts out to right

3. Risk

A. Risk of bonds ,Bd ,Bdshifts out to rightB. Risk of other assets ,Bd ,Bdshifts out to right

4. Liquidity

A. Liquidity of Bonds ,Bd ,Bdshifts out to right

B. Liquidity of other assets ,Bd ,Bdshifts out to right


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Shifts in the Bond Supply Curve

1. Profitability of Investment

Opportunities

Business cycle expansion,

investment opportunities

, Bs,Bsshifts out toright

2. Expected Inflatione,Bs,Bsshifts out to

right

3. Government Activities

Deficits ,Bs,Bsshiftsout to right


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Factors that Shift the Bond Supply Curve

1. Profitability of Investments

A. Profitability ,Bs,Bsshifts out to right

2. Expected Inflation

A. i,Bs ,Bsshifts out to right

3. Government Deficit

A. Government Deficit Increases ,Bs ,Bsshifts out to right

Introduction


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BOND PRICE AND YIELD TO MATURITYTypes

Yield Curve

Real vs. Nominal

Internal Factors :

Business risk

Financial Risk

External Factors :

Purchasing Power Risk

Real Return/Nominal Return

Market Risk

Yield Spread

Introduction


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BOND PRICE AND YIELD TO MATURITYTypes

Yield Curve

Real vs. Nominal

Real Return/Nominal Return

Assume That A Saving Deposit Earns A Nominal

Interest Rate Of 5% During One-year Period. Thus, If Rs. 100

Are Deposited, It Would Grow To 100 (1 + 0.05) = Rs 105

100 (1.0 + 0.05/ 1.0 + 0.05) = Rs. 100

Inflation @ 5%

f


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What is the term structure of interestrates? What is a yield curve?

Term Structure: The Relationship BetweenInterest Rates (Or Yields) And Maturities.

A Graph Of The Term Structure Is Called TheYield Curve.


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Yield Curve Construction

Step 1:Find the average expected

inflation rate over Years 1 to n:

IPn= .

n

1t

tINFL

n


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Suppose, that inflation is expected to be 5%

next year, 6% the following year, and 8%

thereafter.

IP1 = 5%/1.0 = 5.00%.

IP10 = [5 + 6 + 8(8)]/10 = 7.50%.

IP20 = [5 + 6 + 8(18)]/20 = 7.75%.


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Step 2: Find MRP Based on This

Equation:

MRPt= 0.1%(t 1).

MRP1 = 0.1% x 0 = 0.0%.

MRP10 = 0.1% x 9 = 0.9%.

MRP20 = 0.1% x 19 = 1.9%.


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Step 3: Add the IPs and MRPs to k*:

kRFt= k* + IPt + MRPt .

kRF= Quoted market interest rate on treasury securitie

Assume k* = 3%:

kRF1 = 3.0% + 5.0% + 0.0% = 8.0%.

kRF10= 3.0% + 7.5% + 0.9% = 11.4%.kRF20= 3.00% + 7.75% + 1.90% = 12.65%.


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Hypothetical Treasury Yield Curve

0

5

10

15

1 10 20Years to Maturity

InterestRate (%) 1 yr 8.0%

10 yr 11.4%

20 yr 12.65%

Real risk-free rate

Inflation premium

Maturity risk premium

Factors that Shift Supply Curve for Bonds

M Of M S l


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Measures Of Money Supply

M1, M2, M3 and M4.Controlling Inflation

In order to control the money supply, regulators have to

decide which particular measureof the money supply to

target .


M1


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M1

One Measure Of The Money Supply That Includes All Coins Currency

Held By The Public

+

Travelers Cheque

+

Checking Account Balances

+

New Account

Transfers Service Accounts


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M1consists of the most highly liquid assets. That is, M1 includes

all forms of assets that are easily exchangeable as payment for

goods and services. It consists of coin and currency in circulation

traveler's checks, demand deposits, and other checkable deposits


M2


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M2

M1

Savings And Small Time Deposits Overnight Repos At Commercial

Banks

Non-institutional Money Market Accounts


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M2 is a broader measure of money than M1. It includes all of M1,

the most liquid assets, and a collection of additional assets that are

slightly less liquid. These additional assets include savings

accounts, money market deposit accounts, small time deposits an

retail money market mutual funds.


M3


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M3

M2

Plus Large Time Deposits

Institutional Money Market Institutions


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M3is an even broader definition of the money supply, including M

and other assets even less liquid than M2. As the number gets

larger, 1 2 3, the assets included become less and less

liquid.


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FIXED RATE MORTGAGE


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TYPES OF MORTGAGE


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The 2 basic types are:1) Fixed rate mortgage (FRM).

2) Adjustable rate mortgage (ARM) (also known as

Floating Rate or Variable Rate Mortgage).

Combinations of fixed and floating rate are also available

TYPES OF MORTGAGE

FIXED RATE MORTGAGE


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A fixed rate mortgage (FRM) is a mortgage loan where

the interest rate on the note remains the same through the

entire term of the loan, as opposed to loans where theinterest rate may adjust or float.

FIXED RATE MORTGAGE

DETERMINANTS OF MORTGAGE INTEREST RATES


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MORTGAGE INTEREST RATES ARE BASED ON A DERIVED DEMAND -- THE DEMAND

FOR HOUSING AND SUPPLY SIDE FACTORS.

NOMINAL INTEREST RATE (Contract Rate).

The nominal interest rate is simply the interest rate stated on the loan or investment

agreement.

REAL INTEREST RATE.

An interest rate that has been adjusted to remove the effects of inflation to reflect the real

cost of funds to the borrower, and the real yield to the lender.

REAL INTEREST RATE = NOMINAL INTEREST RATEINFLATION.

DETERMINANTS OF MORTGAGE

INTEREST RATES


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Interest Rate Risk.

Default Risk.

Prepayment Risk.

INTEREST RATES

MORTGAGE PAYMENT PATTERNS


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Constant Amortization Mortgage (CAM)

Constant Payment Mortgage (CPM)

Graduated Payment Mortgage (GPM)

Constant Amortization Mortgage (CAM)


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Amortization - the process of loan repayment over

time.

Constant amortization of principal.

Interest computed on Outstanding Loan Balance (OLB).

Changing monthly payments.

Monthly payment = Constant amortization of

principal + interest due on OLB.

EXAMPLE


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$100,000 LOAN, 10% INTEREST, 30 YEARS (360 PAYMENTS)

MONTH 1 PAYMENT = 100,000/360 = 277.78

+100,000(.10/12)= 833.33

= $1,111.11

MONTH 2 PAYMENT = 277.78 + ((100,000-277.78)(.10/12)

= 277.78 + 827.69

= $1,105.47

Constant Payment Mortgage (CPM)


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Monthly payment is constant over life of loan

Portion of payment that is principal versus interest changes every

month

Easier to qualify than CAM because initial payment is lowMonthly payment = original loan amt*[r/1-(1+r)^(-n)]

where, rinterest rate

ntotal number of installments.


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CAM V/S CPM


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/

Graduated Payment Mortgage

(GPM)


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low initial monthly payments which gradually increase over a

specified time frame.

For those who cannot afford large payments initially, but can

realistically expect to do better financially in the future.

For example, a borrower may have a 30-year graduated payment

mortgage with monthly payments that increase by 7 % every year

for five years. At the end of five years, the increment stops. The

borrower would then pay this new increased amount monthly for

the rest of the 25-year loan term.

(GPM)

CAM V/S CPM V/S GPM


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THE TERM STRUCTURE OF INTEREST RATESTerm structure

Liquidity preference theory


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The term structure of interest rates or the yield curve compares

the interest rates on securities ,assuming all the characteristics

except maturity are the same

There are two types of yield curves

Normal yield curve

Inverted yield curve

Expectations theory

Market segmentations theory

TERM STRUCTURE OF INTEREST RATESTerm structure


Term structure



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Expectations theory

YIELDTOMATURITY

TIME TO MATURITYTIME TO MATURITY

YIELDTOMATURITY

NORMAL YIELD CURVE INVERTED YIELD CURVE

Expectations theory


M

LIQUIDITY PREFERENCE THEORY OF INTERESTLiquidity preference theory

Motives

Term structure



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People prefer absolute liquidity to other forms of wealth in the

short run

Determination of interest rate is dependent upon the demand for

and supply of money in the economy

Liquidity preference

Peoples fondness for cash or liquid money

MLiquidity preference curve

Liquidity trap

Expectations theory


M

MOTIVESLiquidity preference theory

Motives


Motives


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Transaction motive

Demand for liquid money to carry out day-to-day transactions

Factors

Income earned

Time period between the successive receipts of income

Spending habits

Precautionary motive

Demand for liquidity to safeguard their future

Factors

Size of the income

Nature of the people

MLiquidity preference curve

Liquidity trap

T=f(i)

P=f(i)

T+P=M1f(i)

Liquidity preference curve

The liquidity trap


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M

THE LIQUIDITY PREFERENCE CURVELiquidity preference theory

Motives


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i

i1

O

ba

S2S1S0

lpc

RateOfInterest

Demand for money for Speculative Motive

Liquidity trap

M

THE LIQUIDITY TRAPLiquidity preference theory

Motives

Li idi f


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There is certain limit below which the interest rate cannot fall

The portion where the interest rate remains same even if there is increase in

supply of money

The rate of interest cannot be zero


Liquidity trap

AD=M1+M

2

MMONEY SUPPLY


Money supply

D t i ti


Money supply

D t i ti


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Determination

O

S

S

The Supply Curve

Rate

OfInterest

Determination

M

DETERMINATION OF INTEREST RATELiquidity preference theory

Money supply

Determination


Money supply

Determination


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Determination

Demand and Supply of Money

a

b1

b

e

i2

i

i1

S

a1

S

S

RateOf

Interest

lpc

Determination

M

SHIFT IN LIQUIDITY PREFERENCE CURVELiquidity preference theory

Money supply

Determination


Money supply

Determination


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Determination

lpc

so

i2

i

i1

e2

e

lpc1

lpc2

e1

Demand and Supply of Money

Determination

RateOfInt

erest

Unbiased expectations theoryTheory

Equilibrium

Mathematical Equation


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The markets current expectations of future short term rates.

Eg:- Investor having 5 year horizon

Current 5 year bond or

Five successive 1 year bond

In Mathematical Equation, each interest rate has two subscripts.

Period in which the security is bought.

Maturity on the security.

Eg:- 1R5, 2ER1


Construction of Yield Curve


Equilibrium



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Return on bonds having long term maturity = return on successive bonds of

short term maturity.

If not there exists an arbitrage opportunity.

EG:-

Conclusion:

Rising curve

Constant curve

Falling curve




Equilibrium



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Theory says that current long term interest rates are the averages of current &

expected future short term rates.

Mathematical equation:

1RN= Actual N period rate today

N = Term to maturity

1R1= Actual current 1 year rate today



1RN= [1R1+E(2r1)+E(3r1)+E(Nr1)]/N


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Market segmentation theory

TheoryYield curve


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Individual investors & financial institutions have different maturity preference

Relationship between short & long term rates are independent.

Securities having different maturities are not considered as substitutes.

Demand & supply are determined by nature of their liability.

For eg: Insurance firms, Banks, etc.

Hence demand supply of each of this segment helps determine the interest

rate in each of this segment.


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Uses of The Term StructureForecast interest ratesForecast recessions

Investment and financing


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The market provides a consensus forecast of expected future

interest rates

Short term or long term


decisions




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Flat or inverted yield curves have been a good predictor o

recessions.


decisions


Investment and


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Lenders/borrowers attempt to time investment / financing

based on expectations shown by the yield curve.

Investment and

financing decisions

FACTORS AFFECTING INTERESTRATES


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Economic Conditions

Expected Rate of Inflation

Savings by Individuals

Continued


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Monetary PolicyBank Rate

Open Market Operations

Cash Reserve Ratio

Supply of Money


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Determinants of Intrest Rates

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