8/17/2019 FINS1612 Summaries - Week 09 - Interest Rate Determination

1/12

FINS1612 – SUMMARIES

Week 09Introduction to Interest Rate determination and

Forecasting

1! " Macroeconomic conte#t o$ Interest Rate

%etermination&

• By understanding the motivations of the central bank, participants of the

nancial market can anticipate changes in a government’s interest rate

policy.

o

Lenders and borrowers can also make better informed decisions.

• When does it increase interest rates ('I()'EN monetary policy!"

o #n$ation above target range

o %&cessive growth in ')

o Large decit in the *balance of payments’

o +apid growth in credit and debt levels

o %&cessive *downward’ pressure on - markets

 

W*at does it do+

o #t eventually increases longterm rates

o /lows consumer spending (reducing in$ation and demand for

imports

o ecreases the si0e of the current account

o )ossibly attract foreign investment, causing domestic currency to

appreciate

Note – ,-. / The Balance of payments accounts are an accounting record of all

monetary transactions between a country and the rest of the world. 

• #t has the current account which is a measure of net income.

o Balance of trade (net earnings on e&port minus payments on imports

o actor income (earnings on foreign investments minus payments

made to foreign investors

o 1ash transfers

8/17/2019 FINS1612 Summaries - Week 09 - Interest Rate Determination

2/12

• 2lso the 1apital3nancial account which is net changes in national

ownership of assets

o 4nlike the current account, a surplus in this account means that,

whilst funds are $owing into the country, it is from borrowing or sales

of assets rather than earnings.

o /imilarly a decit means the nation is increasing its claims on foreignassets.

  eects o$ c*anges in interest rates 13 – 4i5uidit eect&

 

 5he e6ect of the +B2’s market operations on the money supply and system

li7uidity

o +B2 increasing rates (tightening monetary policy by selling 1'

/ecurities

eects o$ c*anges in interest rates 23 – Income eect&

 

2 $owon e6ect from the li7uidity e6ect

 

#f interest rates rise, economic activity will slow, allowing rates to ease.

o

#ncreased rates reduce spending levels via e6ectively reduced incomelevels.

  eects o$ c*anges in interest rates 3 – In7ation eect&

 

2s the rate of growth in economic activity slows, demand for loans also

slows.

o  5his results in an easing of the rate of in$ation.

8/17/2019 FINS1612 Summaries - Week 09 - Interest Rate Determination

3/12

8/17/2019 FINS1612 Summaries - Week 09 - Interest Rate Determination

4/12

Economic indicators – W*+&

  #t is di8cult to forecast the e&tent of li7uidity, income and in$ation e6ects

on changes in interest rates.

o %specially when the business cycle is near a turning point (peak or

trough

  %conomic indicators provide an insight into possible future economic growth

and the likelihood of central bank intervention.

o 9owever, it should be noted that it is di8cult to know t*e e#tent o$

t*e timing 8ead or 8ag as well as nding consistent8

:er$orming indicators 

::(rates of growth in money measures were once lead indicators and

are now lagging indicators

Economic indicators&

 

Leading indicators"

o ;ariables that change before a change in the business cycle

 

1oincident indicators

o ;ariables that change at the same time as business cycle changes

  Lagging indicators

o ;ariables that change after the business cycle changes.

8/17/2019 FINS1612 Summaries - Week 09 - Interest Rate Determination

5/12

2! – 4oan"a;8e $unds a::roac* to interest ratedetermination&

• 2s opposed to the macroeconomic approach (supply and demand of

money, the L approach is preferred by many due to the conceptually

simple model.

• L are the funds available in the nancial system for lending.

•  5here is a downwardsloping demand curve and an upwardsloping supply

curve in the loanable funds market

o #nterest rates rise, demand falls

o #nterest rates rise, supply increases

%emand $or 8oan"a;8e $unds , < (3&

• Business demand for funds (B

o /hort term working capital

o Longerterm capital investment

• 'overnment demand for funds ('

o inance budget decits and intrayear li7uidity

Su::8 o$ 8oan"a;8e $unds&

• /avings of household sector (/

• 1hanges in money supply (

8/17/2019 FINS1612 Summaries - Week 09 - Interest Rate Determination

6/12

• ishoarding (=

o Where hoarding is the

proportion of total savings

held in currency. 9ence as

interest rates rise, people

purchase more securities

and *dishoard’ for thehigher yield.

8/17/2019 FINS1612 Summaries - Week 09 - Interest Rate Determination

7/12

E5ui8i;rium in 4F Market&

• % is the e7uilibrium point at rate i0

• 9owever, this is temporary as many factors cause the supply and demand

curves (which are not independent to change>

o Level of dishoarding may change

o

o #nitial e6ect is that businesses sell securities. ?ields increase (price

decreases thus and dis*oarding occurs

• #n$ationary e&pectations>

o

 5he demand curve shifts to the right and the supply curve shifts tothe left, resulting in higher interest rates and unchanged e7uilibrium

7uantity.

8/17/2019 FINS1612 Summaries - Week 09 - Interest Rate Determination

8/12

! – 'erm Structure o$ Interest Rates&

•  ?ield is the total return on an investment, comprising interest received and

any capital gain (or loss

•  ?ield curve is a graph, at a point in time, of yields on an identical security

with di6erent terms to maturity.

•

• Norma8:ositi=e ie8d cur=e has higher interest rates for longer terms

than shorter terms.

• In=erse negati=e ie8d cur=e has higher interest rates for shortterm

• )um: ie8d cur=e has the shape changing over time from normal to

inverse,

8/17/2019 FINS1612 Summaries - Week 09 - Interest Rate Determination

9/12

'*ree t*eories o$ ie8d cur=e s*a:e&

1> E#:ectations t*eor&a. 5he current shortterm interest rate and e&pectations about future

shortterm interest rates are used to e&plain the shape and changes

in shape of the yield curve.

b. Longer term rates will be e7ual to the average (ARI')EME'I? N-'(E-ME'RI? of the shortterm rates e&pected over the period

c. 5he theory is based on assumptions, e.g."

i. Large number of investors with reasonably homogenous

e&pectations

ii. @o transactions costs and no impediments to interest rates

moving to their competitive e7uilibrium levels

iii. #nvestors aim to ma&imi0e returnsiv. and view all bonds as perfect substitutes regardless of term to

maturity

@ormal yield curve occurs because future shortterm rates will be

higher than current shortterm rates.

#nverse yield curve results if the market e&pects future short term

rates to be lower than current shortterm rates.

9umped yield curve is where investors e&pect shortterm rates to rise

in the future but then fall.

8/17/2019 FINS1612 Summaries - Week 09 - Interest Rate Determination

10/12

2> Segmented Markets '*eor&

 5his assumes that securities in di6erent maturity ranges are viewed by

market participants as impacted substitutes (investors operate in a

preferred maturity range

a. 5his reAects the assumption that investors have the same

e&pectations

b. #t also reAects the assumptions that investors view all securities as

 perfect  substitutes.

 5he preferences of participants are motivated by reducing the risk of their

portfolios (e&posure to $uctuations in prices and yields

 5he s*a:e and s8o:e of the yield curve is determined by the relative

demand and supply of securities along the maturity spectrum. 

?onsider i$ t*e R,A :urc*ased s*ort term ;onds@ t*us increasing t*e a=eragematuri o$ ;onds&

/hort term yields decrease and longterm yields increase.

a. 2reas of e&penditure sensitive to short term interest rates will

e&pand.

b. 2reas of e&penditure sensitive to long term interest rates will

contract.

E#:ectations =s> Segmented markets&

8/17/2019 FINS1612 Summaries - Week 09 - Interest Rate Determination

11/12

  %&pectations theory would suggest that the +B2 increasing the average

maturity would not a6ect e&pectations on future shortterm rates and

hence not e6ect economy.

/egment markets emphasises risk management and hence denies

ar;itrage o::ortunities (without which, e&treme segmentation theory

would have discontinuities in the yield curve

  /egmented markets denies s:ecu8ati=e :rot (as actions for this are

dictated by e&pectations

> 4i5uidit .remium '*eor&

2ssumes investors prefer shorter term instruments which have greater

li7uidity and less maturity (and hence interest rate risk .

 5herefore they re7uire compensation for investing long term

 5he compensation is called the li7uidity premium (e&tra return

We can modify the e&pectations theory e7uation to

include the li7uidity premi um theory>

8/17/2019 FINS1612 Summaries - Week 09 - Interest Rate Determination

12/12

 !! – Risk Structure o$ Interest Rates&

%e$au8t risk  C risk that the borrower will fail to meet its interest payment

obligations.

o 1'B are assumed to have 0ero default risk (they are riskfree ando6er a riskfree rate of return

o /ome rms and state governments etc might have greater risk of

default, hence they will have to o6er higher rates of return for

bearing this risk.

  )o t*e risk :remium eects ie8d cur=es&

 

 Bie8d ?ur=es $or ;orroers it* dierent risk :ro8es&