MDM W7: Interest rate determination
1. Macroeconomic context
2. Loanable funds approach
3. Term structure of interest rates
4. Risk structure of interest rates
liquidity effect
income effect
inflation effect
loanable fund LF
funds available in the financial system for lending
ex: as interest rate rise, demand falls but supply increases
demand for LF (B + G)
business demand (B)
gov demand (G)
short term working capital
long term capital investment
finance budget deficits
intra-year liquidity
supply of LF
3 sources
savings of household sector S
changes in monetary supply (delta M)
dishoarding (delta D)
definition: proportion of total savings in economy held as currency
ex: currency holding decrease
because interest rate rise and more securities are purchased for higher yield available
impact of disturbances on rates
expected increase in economic activity
initial effect: business sell securities, yields up (price down) -> dishoarding occurs
inflationary expectation
demand curve shifts to right
supply curve shifts to left
result
higher interest rate
unchanged equilibrium quantity
yield
total return on investment, comprising interest received and any capital gain (loss)
yield curve
a graph, at a point in time, of yields on an identical security with different terms to maturity
shapes of yield curve
normal yield curve
longer term interest rates are higher than shorter term
inverse yield curve
short term interest rates are higher than long term
hump yield curve
shape change over time from normal to inverse
3 theories
expectations theory
market segmentation theory
liquidity premium theory
assumption
securities with different maturity are imperfect substitutes for market participants
reject expectations theory
large number of investors with reasonably homogenous expectations
investors aim to maximize return and view all bonds as perfect substitutes regardless of term to maturity
participants preferences are reducing risk of portfolio
ie. minimize exposure to fluctuations in prices and yields
shape ands slope of yield curve is determined by
relative supply and demand of securities along maturity spectrum
however this theory denies investors seeking (segmented vs expectations)
arbitrage opportunities
speculative profit
investors prefer short term instruments -> greater liquidity, less maturity, less interest rate risk -> require compensation for investing long term
default risk
meaning: borrower fail to meet its interest payment obligations
investors require compensation for extra default risk
ex: corp bond has higher risk than gov bond -> corp bond has higher risk premium -> higher rate