RESUME VINEY P. ANEJA U.S. Citizen VINEY [email protected] …
Viney - Financial Markets and Institutions
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Transcript of Viney - Financial Markets and Institutions
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Week 41
Week Four
Market participants and reasons for trading
Price behaviour The impact of maturity date
The risk and term structures of interest rates
Trading strategies and rate forecasting Viney Chapter 13
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Week 42
Learning Objectives
Explain the reasons for a change in the
Central Bank interest rate policy Describe how changes in official interest
rates affect the rest of the economy
Describe how a yield curve is constructed
Explain the theories that describe how a yieldcurve obtains its shape
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Week 43
Introduction
In most developed economies monetary
policy actions are directed at influencinginterest rates
By understanding what motivates a centralbank in its implementation of interest rates
policy Financial market participants can anticipate
changes in interest rate policy
Lenders and borrowers can make better-informed
decisions
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Week 44
RBA Responsibilities
"It is the duty of the Reserve Bank Board, within the limits of itspowers, to ensure that the monetary and banking policy of theBank is directed to the greatest advantage of the people of
Australia and that the powers of the Bank ... are exercised insuch a manner as, in the opinion of the Reserve Bank Board,will best contribute to:
(a) the stability of the currency of Australia;(b) the maintenance of full employment in Australia; and(c) the economic prosperity and welfare of the people of
Australia." Source http://www.rba.gov.au/MonetaryPolicy/about_monetary_policy.html Monetary policy seeks to achieve this over the medium term,
and subject to that, encourage strong and sustainable growth inthe long-term.
http://www.rba.gov.au/MonetaryPolicy/about_monetary_policy.htmlhttp://www.rba.gov.au/MonetaryPolicy/about_monetary_policy.html -
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Week 45
Macroeconomic Context of
Interest Rate Determination
A central bank may increase interest rates if
there is Inflation above three per cent (in Australia)
Excessive growth in GDP
A large deficit in the balance of payments
Rapid growth in credit and debt levels Excessive downward pressure on the domestic
currency
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Week 46
Macroeconomic Context of Interest
Rate Determination (cont.)
An expected increase in interest rates (i.e.tightening of monetary policy) will
Eventually increase long-term rates (if it has notalready done so).
Slow consumer spending Reducing inflation and demand for imports
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Week 47
Macroeconomic Context of Interest
Rate Determination (cont.)
Effects of changes in interest rates Economic indicators provide market participants
with insight into possible future economic growthand the likelihood of central bank intervention
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Week 48
Macroeconomic Context of Interest
Rate Determination (cont.)
Economic indicators Leading indicators (Examples??)
Economic series that tend to rise or fall in advance ofthe rest of the economy.
Coincident indicators (Examples ??)
Economic series that change at the same time as therest of the economy.
Lagging indicators (Examples??) Economic series that change after the rest of the
economy.
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Week 49
Macroeconomic Context of Interest
Rate Determination (cont.)
Economic indicators (cont.)
Difficulties exist with Knowing the extent of the timing lead or lag of such
indicators
Consistently performing indicators e.g. rates of growth inmoney measures were once lead indicators and are now
lagging indicators
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Week 410
So Which Indicators Should you
Watch?
CPI
Unemployment Retail sales
Home sales
New car sales Surveysconsumer or business sentiment,
business investment plans and expectations
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Week 411
Term & Risk Structure of Rates
Definition: the term structure of interest ratesis thespread of yields of a security with a given issuer
across different maturities of that security Known as a YIELD CURVE
Definition: the risk structure of interest ratesis thespread of yields on securities with the same maturityacross different issuers at that maturity
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Week 412
Term Structure of Interest Rates
The yield curve is a chart showing theschedule of yields for various maturities of asecurity
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Week 413
Term Structure - continued
Two basic types of yield curve:normal - upward sloping
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Week 414
Term Structure - continued
inverse - downward sloping
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Week 415
Term Structure - continued
The gap between the yield curves on two securitiesindicates their different credit risk
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Week 416
Term Structure - continued
The term structure affects borrowing and investingstrategies
Example : an investor decides to purchase bondsover a 10-year horizon. From the last chart thechoices include:
1. Buy a single 10-yr bond at 6%
2. Buy a 5-yr bond at 7% then another 5-yr bond3. Buy a 2-yr bond at 8% then four 2-yr bonds
4. Buy a 15-yr bond at 7% and sell after 10 years
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Week 417
Term Structure - continued
The term structure can be used to lock infuture interest rates
Definition: the forward rate is an interest ratewhich is fixed for a future transaction
By a correct combination of spot transactionswe can fix a forward interest rate today
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Week 418
Term Structure - continued
Example: a company knows it will need to borrow$104,000 for a term of one year in exactly twelve
months time and wishes to fix the interest rate inadvance
Solution: assuming the yield curve on the next slidethe forward rate is secured by:
1. borrowing for 2 years at 5%, and
2. investing the proceeds for 1 year at 4%
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Week 419
Term Structure - continued
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Week 420
Term Structure - continued
Example continued: the cash flow from the
borrowing is $110,250/(1.05)
2
= $100,000and the company then invests this at 4% togive $100,000(1.04) = $104,000 in 12months
The net ratio is $110,250/$104,000 = 1.0601.That is, the company has secured a 1-yearforward rate of 6.01%.
We observe that (1.0601)1= (1.05)2/(1.04)1
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Week 421
Term Structure - continued
Generalising from the above example: the
forward interest rate rx.yon a security thatcommences in year x and matures in year ycan be found by combining spot rates:
(rx,y)1= (1 + r0,y)
y / (1 + r0,x)x
E.g. if the 3-year spot is 6% and 2-year spotis 5% then (1+r2,3)
1= (1.06)3 / (1.05)2 =1.0803
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Week 422
Term Structure
Theories : PET
Pure Expectations Theory (PET) says the shape ofthe yield curve is determined solely by market
interest rate expectations Assumptions:
- no transactions costs
- investors view securities with different
maturities as perfect substitutes- long dated securities carry same risk as short
dated securities
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Week 423
Theories of the Term Structure
PET continued
Implications of PET:
upward sloping yield curve always means themarket expects rising future rates
investing a single n-year bond will yield thesame return as n 1-year bonds
observed forward rates equal (unobservable)expected future spot rates
the term structure embodies predictions of
future spot rates
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Week 424
Theories of the Term Structure
PET continued
Empirical evidence:
PET explains the phenomenon ofinverse yield curves
The role of expectations helps explain
volatility in yield curves The yield curve can often predict the
economic cycle
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Week 425
Term Structure
Theories : LPT
Liquidity Premium Theory (LPT) sayscompensation is included in longer termyields to reward investors for tying theirmoney up for extended periods
Longer dated bonds therefore contain a riskpremium
E.g: if the expected future rate is 6% and therisk premium is 1%, the forward rate is 7%
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Week 426
Theories of the Term Structure
LPT continued
Implications of LPT:
the yield curve should slope upwards moreoften than downwards
investing in consecutive short term bonds willnot provide same return as investing in a
single long term bond implied forward rates are greater than
expected future spot rates
the term structure cannot tell us much
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Week 427
Term Structure
Theories : SMT
Segmented Markets Theory (SMT) says themarkets for different maturities of a securityare segmented so that the yield on eachmaturity is determined by supply anddemand in that maturity band
Bond markets are seen as dominated bylarge institutional players with preferences forcertain maturities
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Week 428
Theories of the Term Structure
SMT continued
Implications of Segmented Markets Theory
An upward sloping yield curve is due toexcess demand for short term securitiesand/or excess supply of long term ones
The yield curve contains no informationabout the markets expectations
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Week 429
Term Structure
Theories : PHT
Preferred Habitat Theory (PHT) combinesPET, LPT and SMT
Investors have a preferred habitat (SMT),demand a premium to move out of this
maturity (LPT) and base their decisions onexpected future spot rates (PET)
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Week 430
Risk Structure of Interest Rates
The yield spread is the gap between theyields on two securities with the samematurity but different issuers
Three factors influence the yield spread:
Credit risk
Liquidity Supply of securities
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Week 431
Risk Structure - continued
Credit risk is the risk that a borrower will notrepay the interest and/or principal on a debt.
Also known as default risk.
CGS are regarded by the market as havingzero default risk
Private sector bonds have non-zero defaultrisk, reflected in a risk premium over CGS
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Week 432
Risk Structure - continued
Credit Ratings measure the likelihood ofdefault and are made by an independent
rating agency Ratings are based on factors such as the
issuers financial accounts, managementquality and strategic direction
Ratings allow the market to price paper forcredit risk
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Week 433
Risk structure - continued
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Week 434
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Week 435
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Week 436
Conclusion
This lecture has covered
The role of the Central Bank in the interest ratemarkets
The factors that influence the Central Bank
Term structure of interest ratesyield curve
Risk structure of interest rates.
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W k 437
Week Five
The roles of government in the financialmarkets
Reasons for borrowing by government.
The dual role of the central bank - monetarymanagement and financial stability.
The implementation of monetary policy. The relationship between the central bank
and government