Determinants of Intrest Rates
-
Upload
shailesh-bajaj -
Category
Documents
-
view
221 -
download
1
Transcript of Determinants of Intrest Rates
-
8/13/2019 Determinants of Intrest Rates
1/76
-
8/13/2019 Determinants of Intrest Rates
2/76
POOJA KARVAT A21
NAITIK MODI A25
PANKAJ SHARMA A43
SHAILESH BAJAJ PG66
BHAVIN VYAS A60
SHUBHANGI SHRINIVASAN B53
-
8/13/2019 Determinants of Intrest Rates
3/76
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
-
8/13/2019 Determinants of Intrest Rates
4/76
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= +
-
8/13/2019 Determinants of Intrest Rates
5/76
-
8/13/2019 Determinants of Intrest Rates
6/76
Real And Nominal Interest RatesIntroduction
Types
Yield Curve
Real vs. Nominal
-
8/13/2019 Determinants of Intrest Rates
7/76
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.
-
8/13/2019 Determinants of Intrest Rates
8/76
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
-
8/13/2019 Determinants of Intrest Rates
9/76
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
-
8/13/2019 Determinants of Intrest Rates
10/76
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
-
8/13/2019 Determinants of Intrest Rates
11/76
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
-
8/13/2019 Determinants of Intrest Rates
12/76
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
-
8/13/2019 Determinants of Intrest Rates
13/76
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
-
8/13/2019 Determinants of Intrest Rates
14/76
Changes in e: the Fisher Effect
If e1. Relative RETe, Bd
shifts in to left
2. Bs, Bsshifts outto right
3. P, i
-
8/13/2019 Determinants of Intrest Rates
15/76
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
-
8/13/2019 Determinants of Intrest Rates
16/76
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$coupon4$
-
8/13/2019 Determinants of Intrest Rates
17/76
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
-
8/13/2019 Determinants of Intrest Rates
18/76
Determinants of Asset Demand
-
8/13/2019 Determinants of Intrest Rates
19/76
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
-
8/13/2019 Determinants of Intrest Rates
20/76
Shifts in the Bond Demand Curve
Factors that Shift the Bond Demand Curv1. Wealth
-
8/13/2019 Determinants of Intrest Rates
21/76
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
-
8/13/2019 Determinants of Intrest Rates
22/76
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
-
8/13/2019 Determinants of Intrest Rates
23/76
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
-
8/13/2019 Determinants of Intrest Rates
24/76
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
-
8/13/2019 Determinants of Intrest Rates
25/76
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
-
8/13/2019 Determinants of Intrest Rates
26/76
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.
-
8/13/2019 Determinants of Intrest Rates
27/76
Yield Curve Construction
Step 1:Find the average expected
inflation rate over Years 1 to n:
IPn= .
n
1t
tINFL
n
-
8/13/2019 Determinants of Intrest Rates
28/76
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%.
-
8/13/2019 Determinants of Intrest Rates
29/76
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%.
-
8/13/2019 Determinants of Intrest Rates
30/76
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%.
-
8/13/2019 Determinants of Intrest Rates
31/76
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
-
8/13/2019 Determinants of Intrest Rates
32/76
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 .
Factors that Shift Supply Curve for Bonds
M1
-
8/13/2019 Determinants of Intrest Rates
33/76
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
-
8/13/2019 Determinants of Intrest Rates
34/76
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
Factors that Shift Supply Curve for Bonds
M2
-
8/13/2019 Determinants of Intrest Rates
35/76
M2
M1
Savings And Small Time Deposits Overnight Repos At Commercial
Banks
Non-institutional Money Market Accounts
-
8/13/2019 Determinants of Intrest Rates
36/76
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.
Factors that Shift Supply Curve for Bonds
M3
-
8/13/2019 Determinants of Intrest Rates
37/76
M3
M2
Plus Large Time Deposits
Institutional Money Market Institutions
-
8/13/2019 Determinants of Intrest Rates
38/76
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.
-
8/13/2019 Determinants of Intrest Rates
39/76
-
8/13/2019 Determinants of Intrest Rates
40/76
FIXED RATE MORTGAGE
-
8/13/2019 Determinants of Intrest Rates
41/76
TYPES OF MORTGAGE
-
8/13/2019 Determinants of Intrest Rates
42/76
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
-
8/13/2019 Determinants of Intrest Rates
43/76
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
-
8/13/2019 Determinants of Intrest Rates
44/76
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
-
8/13/2019 Determinants of Intrest Rates
45/76
Interest Rate Risk.
Default Risk.
Prepayment Risk.
INTEREST RATES
MORTGAGE PAYMENT PATTERNS
-
8/13/2019 Determinants of Intrest Rates
46/76
Constant Amortization Mortgage (CAM)
Constant Payment Mortgage (CPM)
Graduated Payment Mortgage (GPM)
Constant Amortization Mortgage (CAM)
-
8/13/2019 Determinants of Intrest Rates
47/76
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
-
8/13/2019 Determinants of Intrest Rates
48/76
$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)
-
8/13/2019 Determinants of Intrest Rates
49/76
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.
-
8/13/2019 Determinants of Intrest Rates
50/76
CAM V/S CPM
-
8/13/2019 Determinants of Intrest Rates
51/76
/
Graduated Payment Mortgage
(GPM)
-
8/13/2019 Determinants of Intrest Rates
52/76
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
-
8/13/2019 Determinants of Intrest Rates
53/76
THE TERM STRUCTURE OF INTEREST RATESTerm structure
Liquidity preference theory
-
8/13/2019 Determinants of Intrest Rates
54/76
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
Liquidity preference theory
Term structure
Liquidity preference theory
-
8/13/2019 Determinants of Intrest Rates
55/76
Expectations theory
YIELDTOMATURITY
TIME TO MATURITYTIME TO MATURITY
YIELDTOMATURITY
NORMAL YIELD CURVE INVERTED YIELD CURVE
Expectations theory
Market segmentations theory
M
LIQUIDITY PREFERENCE THEORY OF INTERESTLiquidity preference theory
Motives
Term structure
Liquidity preference theory
-
8/13/2019 Determinants of Intrest Rates
56/76
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
Market segmentations theory
M
MOTIVESLiquidity preference theory
Motives
Liquidity preference theory
Motives
-
8/13/2019 Determinants of Intrest Rates
57/76
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
-
8/13/2019 Determinants of Intrest Rates
58/76
M
THE LIQUIDITY PREFERENCE CURVELiquidity preference theory
Motives
-
8/13/2019 Determinants of Intrest Rates
59/76
Liquidity preference curve
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
-
8/13/2019 Determinants of Intrest Rates
60/76
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 preference curve
Liquidity trap
AD=M1+M
2
MMONEY SUPPLY
Liquidity preference theory
Money supply
D t i ti
Liquidity preference theory
Money supply
D t i ti
-
8/13/2019 Determinants of Intrest Rates
61/76
Determination
O
S
S
The Supply Curve
Rate
OfInterest
Determination
M
DETERMINATION OF INTEREST RATELiquidity preference theory
Money supply
Determination
Liquidity preference theory
Money supply
Determination
-
8/13/2019 Determinants of Intrest Rates
62/76
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
Liquidity preference theory
Money supply
Determination
-
8/13/2019 Determinants of Intrest Rates
63/76
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
-
8/13/2019 Determinants of Intrest Rates
64/76
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
Mathematical Equation
Construction of Yield Curve
Unbiased expectations theoryTheory
Equilibrium
Mathematical Equation
-
8/13/2019 Determinants of Intrest Rates
65/76
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
Mathematical Equation
Construction of Yield Curve
Unbiased expectations theoryTheory
Equilibrium
Mathematical Equation
-
8/13/2019 Determinants of Intrest Rates
66/76
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
Mathematical Equation
Construction of Yield Curve
1RN= [1R1+E(2r1)+E(3r1)+E(Nr1)]/N
-
8/13/2019 Determinants of Intrest Rates
67/76
Market segmentation theory
TheoryYield curve
-
8/13/2019 Determinants of Intrest Rates
68/76
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.
-
8/13/2019 Determinants of Intrest Rates
69/76
Uses of The Term StructureForecast interest ratesForecast recessions
Investment and financing
-
8/13/2019 Determinants of Intrest Rates
70/76
The market provides a consensus forecast of expected future
interest rates
Short term or long term
Investment and financing
decisions
Uses of The Term StructureForecast interest ratesForecast recessions
Investment and financing
-
8/13/2019 Determinants of Intrest Rates
71/76
Flat or inverted yield curves have been a good predictor o
recessions.
Investment and financing
decisions
Uses of The Term StructureForecast interest ratesForecast recessions
Investment and
-
8/13/2019 Determinants of Intrest Rates
72/76
Lenders/borrowers attempt to time investment / financing
based on expectations shown by the yield curve.
Investment and
financing decisions
FACTORS AFFECTING INTERESTRATES
-
8/13/2019 Determinants of Intrest Rates
73/76
Economic Conditions
Expected Rate of Inflation
Savings by Individuals
Continued
-
8/13/2019 Determinants of Intrest Rates
74/76
Monetary PolicyBank Rate
Open Market Operations
Cash Reserve Ratio
Supply of Money
-
8/13/2019 Determinants of Intrest Rates
75/76
-
8/13/2019 Determinants of Intrest Rates
76/76