Fisher Interest Rate Theory (1)
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Transcript of Fisher Interest Rate Theory (1)
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UNIT : 2
THE LEVEL AND
STRUCTURE OFINTEREST RATES
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Interest Rates
An interest rateis the price paid by aborrower to a lender for the use of
resources that will be used during sometime period then returned.
Real rate
Risk-free rateShort-term rate
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Theories of Interest Rates
Fishers Classical Approach
Loanable Funds TheoryKeynes Liquidity Preference Theory
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Fishers Classical
Approach
Supply of Savings
Marginal rate of time preference
IncomeReward for saving
Demand for Borrowed Resources
Marginal productivity of capitalRate of interest
Equilibrium Rate of Interest
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Fishers Law
Nominal Rate of Interest (i)
Real Rate of Interest (r)
Premium for Expected Inflation (p)
Fishers Law
(1 + i) = (1 + r)(1 + p)
or
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The Loanable Funds
Theory
Demand for and Supply of Funds byFirms, Governments, and Households
Changes in the money supplyGovernment deficits
Changes in preferences by households
New investment opportunities for firmsEquilibrium Rate of Interest
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The Liquidity Preference
Theory
Demand for Money Balances
Transactions demand
Precautionary demandSpeculative demand
Supply of Money
Equilibrium Rate of Interest
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Changes in the Demand for
Money and Interest Rates
Liquidity EffectIf increasing, causes the interest rate to rise.
Income EffectIf increasing, causes the interest rate to rise.
Price Expectations EffectIf increasing, causes the interest rate to rise.
Net Effect:The interest rate may rise, fall, or remain unchanged
depending on the net effect of changes in desiredliquidity, income, and price expectations.
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Features of a Bond
Time to Maturity
Principal or Par Value
Coupon Interest
Yield-to-Maturity (YTM)If YTM = coupon rate, market price = par value
If YTM > coupon rate, market price < par valueIf YTM < coupon rate, market price > par value
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Determinants of the
Structure of Interest Rates
The Base Interest Rate
Risk PremiumsAre Determined By:
Issuer TypeCredit risk
Term to maturity
Embedded options
Taxability of interest
Liquidity
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Types of Issuers
Treasury Market Sector
Corporate Market Sector
Utilities
Industrials
Finance
Banks
Intermarket and intramarket Sector
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Default or Credit Risk
Rating Companies
Moodys, S&P, Fitch
Credit RatingsInvestment grade
Non-investment grade
Credit Spread
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Term to Maturity
The volatility of a bonds price isinfluenced by its maturity.
The longer the maturity of a bond, thegreater its price sensitivity to a change inmarket yields.
Maturity spread or yield curve spread
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Embedded Options
Call optionbenefits issuer
increases required return on Treasuries
Conversion optionbenefits bondholder
reduces required return on bonds
Prepayment optionBenefits issuerIncreases required return on mortgage-backed
securities
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Tax Treatment
Yield on taxable bond
After-tax yield = Pretax yield x (1 - Marginal tax rate)
Equivalent taxable yield
Taxable yield = Tax-exempt yield/(1 - Marginal tax
rate)
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Liquidity
The greater the expected liquidity ofasecurity issue, the lower the required
yield.The size of the issue is an important
factor that affects its liquidity.
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