 ## Presentation on theme: "Copyright © 2000 Addison Wesley Longman Slide #4-1 Chapter Four BEHAVIOR OF INTEREST RATES."— Presentation transcript:

Copyright © 2000 Addison Wesley Longman Slide #4-3 Benefits of Diversification 1. Diversification almost always beneficial to risk-averse investor 2. Less returns of securities move together, greater is risk reduction from diversification

Copyright © 2000 Addison Wesley Longman Slide #4-4 Derivation of Demand Curve i = RET e = (F - P) P Point A: P = \$950 i = (\$1000 - \$950) =.053 = 5.3% \$950 B d = 100 Point B: P = \$900 i = (\$1000 - \$900) =.111 = 11.1% \$900 B d = 200

Copyright © 2000 Addison Wesley Longman Slide #4-5 Point C:P = \$850 i = 17.6% B d = 300 Point D:P = \$800 i = 25.0% B d = 400 Point E:P = \$750 i = 33.0% B d = 500 Demand Curve is B d in Figure 1 which connects points A, B, C, D, E. Has usual downward slope Derivation of Demand Curve

Copyright © 2000 Addison Wesley Longman Slide #4-7 Derivation of Supply Curve Point F:P = \$750 i = 33.0% B s = 100 Point G:P = \$800 i = 25.0% B s = 200 Point C:P = \$850 i = 17.6% B s = 300 Point H:P = \$900 i = 11.1% B s = 400 Point I:P = \$950 i = 5.3% B s = 500 Supply Curve is B s that connects points F, G, C, H, I, and has upward slope

Copyright © 2000 Addison Wesley Longman Slide #4-8 1. Occurs when B d = B s, at P* = 850, i* = 17.6% 2. When P = \$950, i = 5.3%, B s > B d (excess supply): P  to P*, i  to i* 3. When P = \$750, i = 33.0, B d > B s (excess demand): P  to P*, i  to i* Market Equilibrium

Copyright © 2000 Addison Wesley Longman Slide #4-9 Loanable Funds Terminology 1. Demand for bonds = supply of loanable funds 2. Supply of bonds = demand for loanable funds

Copyright © 2000 Addison Wesley Longman Slide #4-11 How Factors Shift the Demand Curve 1. Wealth A. Economy , wealth , B d , B d shifts out to right 2. Expected Return A. i  in future, RET e for long-term bonds , B d shifts out to right B. π e , relative RET e , B d shifts out to right 3. Risk A. Risk of bonds , B d , B d shifts out to right B. Risk of other assets , B d , B d shifts out to right 4. Liquidity A. Liquidity of bonds , B d , B d shifts out to right B. Liquidity of other assets , B d ,B d shifts out to right (RET e )  指現在的預期 1 年持有報酬率 指預期 未來 YTM 會 下降

Copyright © 2000 Addison Wesley Longman Slide #4-13 Shifts in the Supply Curve 1. Profitability of Investment Opportunities Business cycle expansion, investment opportunities , B s , B s shifts out to right 2. Expected Inflation π e , B s , B s shifts out to right 3. Government Activities Deficits , B s , B s shifts out to right

Copyright © 2000 Addison Wesley Longman Slide #4-15 Changes in π e : the Fisher Effect If π e  1. Relative RET e , B d shifts in to left 2. B s , B s shifts out to right 3. P , i 

Copyright © 2000 Addison Wesley Longman Slide #4-16 Evidence on the Fisher Effect in the United States

Copyright © 2000 Addison Wesley Longman Slide #4-17 Business Cycle Expansion 1. Wealth , B d , B d shifts out to right 2. Investment , B s , B s shifts right 3. If B s shifts more than B d then P , i 

Copyright © 2000 Addison Wesley Longman Slide #4-19 Relation of Liquidity Preference Framework to Loanable Funds Keynes’s Major Assumption Two categories of assets in wealth 1. money 2. bonds 1.Thus: M s + B s = Wealth 2.Budget constraint: B d + M d = Wealth 3.Therefore: M s + B s = B d + M d 4.Subtracting M d and B s from both sides: M s - M d = B d - B s

Copyright © 2000 Addison Wesley Longman Slide #4-20 Money Market Equilibrium 5. Occurs when M d = M s 6. Then M d - M s = 0 which implies that B d - B s = 0, so that B d = B s and bond market is also in equilibrium Relation of Liquidity Preference Framework to Loanable Funds

Copyright © 2000 Addison Wesley Longman Slide #4-21 Relation of Liquidity Preference Framework to Loanable Funds 1. Equating supply and demand for bonds in loanable funds framework is equivalent to equating supply and demand for money in liquidity preference framework 2. Two frameworks are closely linked, but differ in practice because liquidity preference assumes only two assets, money and bonds, and ignores effects from changes in expected returns on real assets

Copyright © 2000 Addison Wesley Longman Slide #4-22 Liquidity Preference Analysis Derivation of Demand Curve 1. Keynes assumed money has i = 0 2. As i , relative RET e on money  (equivalently, opportunity cost of money  )  M d  3. Demand curve for money has usual downward slope Derivation of Supply curve 1. Assume that central bank controls M s and is a fixed amount 2. M s curve is vertical line

Copyright © 2000 Addison Wesley Longman Slide #4-23 Liquidity Preference Analysis Market Equilibrium 1. Occurs when M d = M s, at i* = 15% 2. If i = 25%, M s > M d (excess supply): Price of bonds , i  to i* = 15% 3. If i =5%, M d > M s (excess demand): Price of bonds , i  to i* = 15%

Copyright © 2000 Addison Wesley Longman Slide #4-25 Rise in Income 1. Income , M d , M d shifts out to right 2. M s unchanged 3. i* rises from i 1 to i 2

Copyright © 2000 Addison Wesley Longman Slide #4-26 Rise in Price Level 1. Price level , M d , M d shifts to right 2. M s unchanged 3. i* rises from i 1 to i 2

Copyright © 2000 Addison Wesley Longman Slide #4-27 Rise in Money Supply 1. M s , M s shifts out to right 2. M d unchanged 3. i* falls from i 1 to i 2

Copyright © 2000 Addison Wesley Longman Slide #4-29 Money and Interest Rates Effects of money on interest rates 1. Liquidity Effect M s , M s shifts right, i  2. Income Effect M s , Income , M d , M d shifts right, i  3. Price Level Effect M s , Price level , M d , M d shifts right, i  4. Expected Inflation Effect M s , π e , B d , B s , Fisher effect, i 

Copyright © 2000 Addison Wesley Longman Slide #4-30 Effect of higher rate of money growth on interest rates is ambiguous - Because income, price level and expected inflation effects work in opposite direction of liquidity effect Money and Interest Rates

Copyright © 2000 Addison Wesley Longman Slide #4-33 Profiting from Interest-Rate Forecasts Methods for Forecasting 1. Loanable funds: use Flow of Funds Accounts and judgement 2. Econometric Models: large in scale, use liquidity preference Make decisions about assets to hold 1. Forecast i , buy long bonds 2. Forecast i , buy short bonds Make decisions about how to borrow 1. Forecast i , borrow short 2. Forecast i , borrow long

Copyright © 2000 Addison Wesley Longman Slide #4-34 Supply and Demand in Gold Market Deriving Demand Curve 1. P e t+1 is held constant 2. P t , g e , RET e   G d  3. Demand curve is downward sloping Deriving Supply Curve 1. P t , more production, G s  2. Supply curve is upward sloping

Copyright © 2000 Addison Wesley Longman Slide #4-35 Supply and Demand in Gold Market Market Equilibrium 1. G d = G s 2. If P t > P* = P 1, G s > G d, P t  to P* 3. If P t < P* = P 1, G s < G d, P t  to P*

Copyright © 2000 Addison Wesley Longman Slide #4-36 Changes in Equilibrium Factors that Shift Demand Curve for Gold 1. Wealth 2. Expected return on gold relative to alternative assets 3. Riskiness of gold relative to alternative assets 4. Liquidity of gold relative to alternative assets Factors that Shift Supply Curve for Gold 1. Technology of mining 2. Government sales of gold

Copyright © 2000 Addison Wesley Longman Slide #4-37 Response of Gold Market to a Change in π e If π e  1. π e , P e t+1  ; at given P t, g e   G d   G d shifts right 2. Go to point 2; P t  3. Price of gold positively related to π e 4. Gold price is barometer of π-pressure