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Money & Banking
Video 04—Interest Rates II
The Behavior of Interest Rates (Chapter 5)Interest Rate Determination (Chapter 6)
Hal W. Snarr8/20/2015
Chapter 5
The Behavior of Interest Rates
Bond Demand
P D
The quantity of bonds demanded increases as p falls.
B
Bond Demand
D
The quantity of bonds demanded increases as p falls.
Bond demand increases in• Expected return relative to other assets • Liquidity relative to other assets • Wealth
P
B
The quantity of bonds demanded increases as p falls.
Bond demand increases in• Expected return relative to other assets • Liquidity relative to other assets • Wealth
Bond demand decreases in • Riskiness relative to other assets• Expected inflation• Expected interest rate
Bond Demand
DP
B
Expected return relative to other assets
For 1-year discount bonds held for 1 year,
R = i
S
Bond Supply
P
The quantity of bonds supplied increases as p rises.
B
The quantity of bonds supplied increases as p rises.
Bond supply increases in• Expected profitability of investment opportunities• Expected inflation• Government budget deficits
Bond Supply
S
P
B
Supply and Demand
DP
B
S
Excess supply: the price suppliers are asking for is too high
95
15 25
Supply and Demand
DP
B
S
Excess supply: the price suppliers are asking for is too high• For a zero-coupon $100 bond held for one year
95 1F
P i
i
100
955.3
15 25
Supply and Demand
DP
B
S
Equilibrium: the quantities of bonds supplied and demanded equal• For a zero-coupon $100 bond held for one year
95
15 25
92
20
i
5.3
Supply and Demand
DP
B
S
Equilibrium: the quantities of bonds supplied and demanded equal• For a zero-coupon $100 bond held for one year
95
92
20
i
5.3
1F
P i
100
928.7
Supply and Demand
DP
B
S
Excess demand: the price suppliers are asking for is low• For a zero-coupon $100 bond held for one year
90
15 25
i
5.3
8.7
95
92
Supply and Demand
DP
B
S
Excess demand: the price suppliers are asking for is low• For a zero-coupon $100 bond held for one year
1F
P i
i
100
9011.190
15 25
5.3
8.7
95
92
Supply and Demand
DP
B
S
Equilibrium: the quantities of bonds supplied and demanded equal• For a zero-coupon $100 bond held for one year
i
11.190
15 25
5.3
8.7
95
92
20
The Fisher Effect
DP
B
S
Suppose expected inflation rise by 6 percentage-points.
i
5.395
20
The Fisher Effect
DP
B
S
Suppose expected inflation rise by 6 percentage-points.
i
15
5.3
8.7
95
92
20
D
The Fisher Effect
DP
B
S
Suppose expected inflation rise by 6 percentage-points.
i
11.190
15
5.3
8.7
95
92
20
SD
The nominal rate of interest rises by 5.8 pct. pts.
Source: Mishkin (1981) “The Real Interest Rate: An Empirical Investigation” Carnegie-Rochester Conference Series on Public Policy 15: 151–200. These procedures involve estimating expected inflation as a function of past interest rates, inflation, and time trends.
The Fisher Effect
Source: FRED
The Fisher Effect
0 2 4 6 8 10 120
2
4
6
8
10
12
14
16
18
f(x) = 1.13529243123702 x + 1.67610504602249R² = 0.474925680118875
1978-2007
The Business Cycle and Interest Rates
SPD
i
5.395
B18
Suppose economic growth is accelerating.
The Business Cycle and Interest Rates
SP
B
Di
23
5.3
8.7
95
92
18
S
Suppose economic growth is accelerating.
The Business Cycle and Interest Rates
Suppose economic growth is accelerating.
The quantity and price of bonds both increase
SP
B
Di
23
5.3
8.7
95
92
18
S
D
23
7.593
The Business Cycle and Interest Rates
Source: Federal Reserve: www.federalreserve.gov/releases/H15/data.htm.
The quantity and price of bonds both increase
= 0 if bond market in
equilibrium
= 0 if loanable funds market in
equilibrium
Keynes’ liquidity preference framework
i
8.7
Bond Market
B
92
BD
BS
Loanable funds Market
LS
LDP
L 15
• holding money and buying bonds are the only stores of wealth• the quantity of loanable funds people and firms supply = the value of bonds purchased
Total Wealth = Bs + Ms = Bd + Md
Bs – Bd =Ms – Md
= 0 if the market for money is in
equilibrium
Keynes’ liquidity preference framework
• holding money and buying bonds are the only stores of wealth• the quantity of loanable funds people and firms supply = the value of bonds purchased
Loanable funds Market
15
8.7
LS
LD i
L 15
8.7
LS
LDi
L
Keynes’ liquidity preference framework
.
Loanable funds Market
15
8.7
LS
LDi
L
i
MD
M
• holding money and buying bonds are the only stores of wealth• the quantity of loanable funds people and firms supply = the value of bonds purchased• The interest rate in these markets are the same
The market for money
15
8.7
LS
LDi
L
.
Loanable funds Market
i
MD
M
The market for money
7.5
• Money supply shifts to the right (increases) ifo The Fed injects money into the banking system with OMPo Banking lending increases
The Liquidity Effect
B
95
BD BS
P
L 15
15
5.3
LSLD
i
L
i
MD
M
Bond Market Loanable funds Market The market for money
92
8.7
5.3
8.7
• A one time increase in MS permanently raises the price level by end of year: i = r + p o bond demand falls because the return falls o bond supply rises because the cost of borrowing fallso money demand increases
(the supply of loanable funds falls)(demand for loanable funds rises)
The Price-level Effect
• An increase in MS causes inflation expectations to rise, which may diminish over time.o bond demand falls (the supply of loanable funds falls)o bond supply rises (demand for loanable funds rises)o money demand increases
15
5.3
LSLD
i
L
i
MD
M
Loanable funds Market The market for money
The Expected-Inflation Effect
5.3
8.7 8.7
• An increase in MS is an expansionary influence on the economy.o demand for loanable funds riseso money demand increases
15
5.3
LSLD
i
L
i
MD
M
Loanable funds Market The market for money
The Income Effect
5.3
7.1 7.1
Figure 11 Response to an
Increase in MS Growth
The Total Effect
Figure 11 Response to an
Increase in MS Growth
The Total Effect
Figure 12 Annual M2 Growth and 3-month T-bill (1950–2011)
Sources: Federal Reserve: www.federalreserve.gov/releases/h6/hist/h6hist1.txt.
The Total Effect
2
2
3
34
4
5
5
6
6
88 9
9
a
a
1
1
bb
7 7
Chapter 6
Interest Rate Determination
Interest Rate Determination
Nominal Rate (i) = Real Rate (r) + Expected Inflation (p e)
+ Default Risk Premium (d)+ Illiquidity Risk Premium (l)– Tax exemption discount (t)+ Maturity Premium (int – it)+ Liquidity Premium (lnt)
Interest Rate Determination
Nominal Rate (i) = Real Rate (r) + Expected Inflation (p e)
+ Default Risk Premium (d)+ Illiquidity Risk Premium (l)– Tax exemption discount (t)
Risk structure
The Risk and Term Structures of Interest Rates
• Risk structure: Bonds with the same maturity (n) have different interest rates because of – default risk premium (d)– illiquidity risk premium (l)– income tax risk discount (t)
• Term structure: For bonds with identical characteristics, the interest rate (i) increases as maturity (n) increases– maturity premium (int – it)
– liquidity premium (lnt)
– The yield curve is the relationship between i and n.
Risk Structure Default risk premium
• Default risk is the probability that the issuer of the bond is unable or unwilling to make interest payments or pay off the face valueo U.S. Treasury bonds are considered default free
o Default risk premium (d) is the spread between the interest rates on bonds with default risk and the interest rates on Treasury bonds, holding l, t, n, lnt, and int – it equal
TABLE 1
Risk Structure Default risk premium
Corporate Bond Market
U.S. Treasury Bond Market
P Pi i
950 5
DcDt
Q Q
Risk Structure Default risk premium
Sc St
950 5
Corporate Bond Market
U.S. Treasury Bond Market
P Pi iSc St
DcDc
Q Q
Risk Structure Default risk premium
950 5 950 5
6925
Dt
Corporate Bond Market
U.S. Treasury Bond Market
P Pi iSc St
DcDcDt
Dt
Q Q
Risk Structure Default risk premium
950 5 950 5
6
4975
925
Corporate Bond Market
U.S. Treasury Bond Market
P Pi iSc St
DcDcDt
Dt
Q Q
Risk Structure Default risk premium
6
4975
925
2
Pre-bailout
N = 1I% = APV = -1068PMT = 100FV = 1000
Post-bailout
N = 1I% = APV = -1023PMT = 100FV = 1000
You own a $1000, 10% GM bond that matures next year. The Obama Administration abrogated 100 years of bankruptcy law when it stripped primary bond holders of their first claim rights on corporate assets during the GM bailout. Explain why corporate bond prices would be lower in the post bailout era, holding all else equal. If the GM bond sold for $1068 before the bailout but sells for $1023, compute the yields on the bonds before and after the bailout.
Risk Structure Default risk premium
Pre-bailout
N = 1I% = 2.996PV = -1068PMT = 100FV = 1000
Post-bailout
N = 1I% = 7.527PV = -1023PMT = 100FV = 1000
You own a $1000, 10% GM bond that matures next year. The Obama Administration abrogated 100 years of bankruptcy law when it stripped primary bond holders of their first claim rights on corporate assets during the GM bailout. Explain why corporate bond prices would be lower in the post bailout era, holding all else equal. If the GM bond sold for $1068 before the bailout but sells for $1023, compute the yields on the bonds before and after the bailout.
Risk Structure Default risk premium
• Liquidity is the relative ease with which an asset can be converted into casho Cost of selling a bond
o Number of buyers/sellers in a bond market
o Illiquidity risk premium (l) is the spread between the interest rate on a bond that is illiquid and the interest rate on Treasury bonds, holding d, t, n, lnt, and int – it equal.
o E.g., assume an investor is looking at buying two corporate bonds that have the same coupon rates and maturities, but only one is traded on a public exchange. The investor is not be willing to pay as much for the non-public bond. The difference in yields the investor is willing to pay for each bond is the liquidity premium.
Risk Structure Illiquidity risk premium
Corporate Bond Market
U.S. Treasury Bond Market
P Pi i
950 5
DcDt
Q Q
Sc St
950 5
Risk Structure Illiquidity risk premium
Corporate Bond Market
U.S. Treasury Bond Market
P Pi iSc St
DcDc
Q Q
950 5 950 5
6925
Dt
Risk Structure Illiquidity risk premium
Corporate Bond Market
U.S. Treasury Bond Market
P Pi iSc St
DcDcDt
Dt
Q Q
950 5 950 5
6
4975
925
Risk Structure Illiquidity risk premium
Corporate Bond Market
U.S. Treasury Bond Market
P Pi iSc St
DcDcDt
Dt
Q Q
6
4975
925
2
Risk Structure Illiquidity risk premium
Treasury
N = 1I% = APV = -1058PMT = 80FV = 1000
Corporate
N = 1I% = APV = 1001PMT = 80FV = 1000
You are considering owning two $1000 bonds that mature next year. One is a corporate bond, the other is a Treasury, and both have an 8% coupon rate. Why is the price of Treasuries higher than corporate bonds with the same attributes? If the price of treasuries is $1058 and the price of a similar corporate bond with the same bond rating is $1001, compute the yields on the two bonds.
Risk Structure Illiquidity risk premium
Risk Structure Illiquidity risk premium
Treasury
N = 1I% = 2.079PV = -1058PMT = 80FV = 1000
Corporate
N = 1I% = 7.892PV = 1001PMT = 80FV = 1000
You are considering owning two $1000 bonds that mature next year. One is a corporate bond, the other is a Treasury, and both have an 8% coupon rate. Why is the price of Treasuries higher than corporate bonds with the same attributes? If the price of treasuries is $1058 and the price of a similar corporate bond with the same bond rating is $1001, compute the yields on the two bonds.
• Income tax considerationso Interest payments on municipal bonds are exempt from federal income
taxes.
o Tax exemption risk discount (t) is the spread between the interest rate on a tax exempt municipal bond and the interest rate on Treasury bonds, holding d, l, n, lnt, and int – it equal.
o The discount shrinks ifo federal income taxes are lowered or there is talk of doing so
o politicians seriously consider ending the exemption
o the exemption is repealed.
Risk Structure Tax exemption risk discount
Municipal Bond Market
U.S. Treasury Bond Market
PP ii
950 5
DtDm
ScSt
950 5
Risk Structure Tax exemption risk discount
U.S. Treasury Bond Market
PP iiScSt
DtDt
950 5950 5
6925
Dm
Risk Structure Tax exemption risk discount
Municipal Bond Market
U.S. Treasury Bond Market
PP iiScSt
DcDcDt
Dm
950 5950 5
6
4975
925
Risk Structure Tax exemption risk discount
Municipal Bond Market
U.S. Treasury Bond Market
PP iiScSt
DtDtDt
Dt
6
4975
925
-2
Risk Structure Tax exemption risk discount
Municipal Bond Market
Tax-free municipal
N = 1I% = 3.5PV = APMT = 80FV = 1000
Risk Structure Tax exemption risk discount
Corporate
N = 1I% = 3.5PV = APMT = 40FV = 1000
You are considering owning two $1000 bonds that mature next year. One is a corporate bond, the other is a tax-free municipal, and both have an 8% coupon rate. If the bonds have a current yield of 3.5%, and you intend to hold them for their final year, compute the price you would be willing to pay assuming a federal income tax rate of 50%.
You are considering owning two $1000 bonds that mature next year. One is a corporate bond, the other is a tax-free municipal, and both have an 8% coupon rate. If the bonds have a current yield of 3.5%, and you intend to hold them for their final year, compute the price you would be willing to pay assuming a federal income tax rate of 50%.
Risk Structure Tax exemption risk discount
Tax-free municipal
N = 1I% = 3.5PV = -1043.48PMT = 80FV = 1000
Corporate
N = 1I% = 3.5PV = -1004.83PMT = 40FV = 1000
Figure 1—Long-Term Bond Yields, 1919–2011
Sources: Board of Governors of the Federal Reserve System, Banking and Monetary Statistics, 1941–1970; Federal Reserve; www.federalreserve.gov/releases/h15/data.htm.
Risk Structure
Interest Rate Determination
Nominal Rate (i) = Real Rate (r) + Expected Inflation (p e)
+ Default Risk Premium (d)+ Illiquidity Risk Premium (l)– Tax exemption discount (t)+ Maturity Premium (int – it)+ Liquidity Premium (lnt)
Interest Rate Determination
Nominal Rate (i) = Real Rate (r) + Expected Inflation (p e)
+ Default Risk Premium (d)+ Illiquidity Risk Premium (l)– Tax exemption discount (t)+ Maturity Premium (int – it)+ Liquidity Premium (lnt)
Risk structure
Term structure
Term Structure
• Time to maturity affects interest rates because– Time increases exposure to risk, causing investors to
demand higher yields on securities with longer maturities.
• The term structure of interest rates refers to difference in the yields on instruments that are identical except for term to maturity.
• Term structure is represented graphically by a yield curve.– Yield curves consider only the relationship between
maturity or term of a security and its yield at a moment in time, otrs.
Facts that the theory must explain:1. Interest rates on bonds of different maturities move together over time
Term Structure
Figure 4—Interest rate movements on Treasuries with different maturities
Sources: Federal Reserve; www.federalreserve.gov/releases/h15/data.htm.
Term Structure
Facts that the theory must explain:1. Interest rates on bonds of different maturities move together over time
2. When short-term interest rates are low, yield curves are more likely to have an upward slope; when short-term rates are high, yield curves are more likely to slope downward and be inverted
3. Yield curves almost always slope upward
Term Structure
68February 4, 2005
Term Structure
Figure 7 Yield Curves for U.S. Government Bonds
Term Structure
Figure 6
Term Structure
Facts that the theory must explain:1. Interest rates on bonds of different maturities move together over time
2. When short-term interest rates are low, yield curves are more likely to have an upward slope; when short-term rates are high, yield curves are more likely to slope downward and be inverted
3. Yield curves almost always slope upward
Term Structure
Three Theories that explain these facts1. Segmented markets theory explains fact three but not the first two
2. Expectations theory explains the first two facts but not the third
3. Liquidity premium theory combines the two theories to explain all three facts
Term Structurematurity premium
• Expectations theory says the yield on a long-term bond equals the average of the short-term interest rates people expect to occur over its life
– Maturity Premium is the spread between the interest rates on bonds with n years and 1 year to maturity, holding d, l, t, and lnt equal.
int – it
– Buyers of bonds o do not prefer bonds of one maturity over anothero do not hold any quantity of a bond if its expected return is less
than that of another bond with a different maturity o consider bonds with different maturities to be perfect
substitute
1 2 ( 1)...e e et t t t n
nt
i i i ii
n
The table below shows current and expected future one-year interest rates, as well as current interest rates on multiyear bonds. Use the table to calculate the liquidity premium for each multiyear bond.
i 1 2 3 4 5e e e e e
t t t t t ti i i i i i
n
nt
Term Structurematurity premium
1 2 3 4 5e e e e e
t t t t t ti i i i i i
n
nt
The table below shows current and expected future one-year interest rates, as well as current interest rates on multiyear bonds. Use the table to calculate the liquidity premium for each multiyear bond.
1ti
Term Structurematurity premium
The table below shows current and expected future one-year interest rates, as well as current interest rates on multiyear bonds. Use the table to calculate the liquidity premium for each multiyear bond.
1 2 3 4 5e e e e e
t t t t t ti i i i i i
n
2ti
Term Structurematurity premium
The table below shows current and expected future one-year interest rates, as well as current interest rates on multiyear bonds. Use the table to calculate the liquidity premium for each multiyear bond.
1 2 3 4 5e e e e e
t t t t t ti i i i i i
n
3ti
Term Structurematurity premium
4t
The table below shows current and expected future one-year interest rates, as well as current interest rates on multiyear bonds. Use the table to calculate the liquidity premium for each multiyear bond.
1 2 3 4 5e e e e e
t t t t t ti i i i i i
n
i
Term Structurematurity premium
5t
The table below shows current and expected future one-year interest rates, as well as current interest rates on multiyear bonds. Use the table to calculate the liquidity premium for each multiyear bond.
1 2 3 4 5e e e e e
t t t t t ti i i i i i
n
i
Term Structurematurity premium
6t
The table below shows current and expected future one-year interest rates, as well as current interest rates on multiyear bonds. Use the table to calculate the liquidity premium for each multiyear bond.
1 2 3 4 5e e e e e
t t t t t ti i i i i i
n
i
Term Structurematurity premium
Graph the maturity adjusted yields over maturity
Term Structurematurity premium
i
n
1.00
1.20
1.40
1.60
1.80
2.00
2.20
1 2 3 4 5 61.00
1.20
1.40
1.60
1.80
2.00
2.20
1 2 3 4 5 61.00
1.20
1.40
1.60
1.80
2.00
2.20
1 2 3 4 5 61.00
1.20
1.40
1.60
1.80
2.00
2.20
1 2 3 4 5 61.00
1.20
1.40
1.60
1.80
2.00
2.20
1 2 3 4 5 61.00
1.20
1.40
1.60
1.80
2.00
2.20
1 2 3 4 5 6
Graph the maturity adjusted yields over maturity
Term Structurematurity premium
1.00
1.20
1.40
1.60
1.80
2.00
2.20
1 2 3 4 5 6
i
n
maturity premium for a 1-year bond0%
Term Structurematurity premium
1.00
1.20
1.40
1.60
1.80
2.00
2.20
1 2 3 4 5 6
Graph the maturity adjusted yields over maturity
i
n
maturity premium for a 2-year bond0.325%
Term Structurematurity premium
1.00
1.20
1.40
1.60
1.80
2.00
2.20
1 2 3 4 5 6
Graph the maturity adjusted yields over maturity
i
n
maturity premium for a 3-year bond0.57%
Term Structurematurity premium
1.00
1.20
1.40
1.60
1.80
2.00
2.20
1 2 3 4 5 6
Graph the maturity adjusted yields over maturity
i
n
maturity premium for a 4-year bond0.7675%
Term Structurematurity premium
1.00
1.20
1.40
1.60
1.80
2.00
2.20
1 2 3 4 5 6
Graph the maturity adjusted yields over maturity
i
n
maturity premium for a 5-year bond0.93%
Term Structurematurity premium
1.00
1.20
1.40
1.60
1.80
2.00
2.20
1 2 3 4 5 6
Graph the maturity adjusted yields over maturity
i
n
maturity premium for a 6-year bond1.06%
Term StructureExpectations Theory
1.00
1.20
1.40
1.60
1.80
2.00
2.20
1 2 3 4 5 6
i
n
Yield Curve
Term Structureliquidity premium
• The interest rate on a long-term bond will equal an average of short-term interest rates expected to occur over the life of the long-term bond plus a liquidity premium that responds to supply and demand conditions for that bond
• Bonds of different maturities are partial (not perfect) substitutes– Liquidity premium is the spread between the interest
rates on bonds with n and one years to maturity, holding d, l, t, and int – it equal
lnt
Suppose the liquidity premium is linear in maturity:
lnt = 0.08n
Term Structureliquidity premium
1 2 ( 1)...e e et t t t
n tt nni i i
nl
ii
Term StructureExpectations Theory
1.00
1.25
1.50
1.75
2.00
2.25
2.50
2.75
1 2 3 4 5 6
Yield Curve
Term StructureLiquidity Premium Theory
1.00
1.25
1.50
1.75
2.00
2.25
2.50
2.75
1 2 3 4 5 61.00
1.25
1.50
1.75
2.00
2.25
2.50
2.75
1 2 3 4 5 61.00
1.25
1.50
1.75
2.00
2.25
2.50
2.75
1 2 3 4 5 61.00
1.25
1.50
1.75
2.00
2.25
2.50
2.75
1 2 3 4 5 61.00
1.25
1.50
1.75
2.00
2.25
2.50
2.75
1 2 3 4 5 61.00
1.25
1.50
1.75
2.00
2.25
2.50
2.75
1 2 3 4 5 6
1 2 ( 1)...e e et t t t
n tt nni i i
nl
ii
Yield Curve
Nominal Rate (i) = Real Rate (r) + Expected Inflation (p e)
+ Default Risk Premium (d)+ Illiquidity Risk Premium (l)– Tax exemption discount (t)+ Maturity Premium (int – it)+ Liquidity Premium (lnt)
Interest Rate Determination
Risk structure
Term structure