Chapter 2 Money, Credit, and the Determination of Interest Rates © OnCourse Learning

Chapter 2 Learning Objectives  Understand how the supply and demand for money and credit affect (and are affected by) the economy and the general level of interest rates  Understand how yields on individual debt instruments are determined  Understand why securities of different maturities may have different yields © OnCourse Learning 2

The General Level of Interest Rates  Assume that only one type of credit instrument exists (e.g. a bond)  The bond is riskless  No inflation expectation  The price of the bond is inversely related to and determined by the market-required yield  Market value of the bonds can be defined in terms of either their price or their yield. 3 © OnCourse Learning

The General Level of Interest Rates  Interest rate on an instrument reflects general market rates and the risk of the specific instrument  Transition mechanism of money and interest rates:  Money supply → economy → inflation → inflationary expectations → credit markets → interest rates © OnCourse Learning 4

The General Level of Interest Rates  Equation of ExchangeMV = PT  M = money supply  V = velocity of circulation (the average number of time$1 turns over in 1 year)  P = general price level  T = the volume of trade  Monetary theory of inflation  The greater the rate of growth in money, the grater the rate of inflation 5 © OnCourse Learning

The Fisher Equation  The inflation rate plays an important role in the determination of market rates  Fisher equation: I = r + p  I – the equilibrium nominal rate of interest observed in the credit market  r – the real interest rate  P – the expected inflation over the maturity of the instrument 6 © OnCourse Learning

The Relationship between Inflation and T- Bill Yield 7 © OnCourse Learning

The Gibson Paradox  An increase in money supply leads to increases in demand for bonds and goods and services, resulting in upward pressure on bond prices, forcing interest rates down. 8 © OnCourse Learning

Liquidity, Income and Price-Anticipation Effects  Liquidity effect (short-run)  Money supply goes up  Demand for bonds goes up  Interest rates go down  Income effect  Income goes up  Demand for credit goes up  Interest rates go up  Price anticipation effect  Future expected inflation  Decrease in supply of credit 9 © OnCourse Learning

Liquidity, Income and Price-Anticipation Effects 10 © OnCourse Learning

Risks In Real Estate Finance  Default risk  Risk that the borrower will not repay the mortgage per the contract  Callability risk  Borrower may repay the debt before maturity  Maturity risk  Other things held constant, the longer the maturity the greater the change in value for a given change in interest rates 11 © OnCourse Learning

Risks In Real Estate Finance  Marketability risk  Risk that the asset doesn’t trade in a large, organized market  I = r + p + k, where k is risk premium associated with noninflationary risks  Inflation risk  Risk in loss of purchasing power  Interest rate risk  Risk of loss due to changes in market interest rates  Fixed-income assets are most susceptible 12 © OnCourse Learning

Description of Agency Ratings 13 © OnCourse Learning

Income Tax Considerations  Municipal bonds – issued by government jurisdictions other than the federal government  Interest from municipal bonds is tax free  The tax-free nature of these instruments implies that investors will receive lower return on these bonds  MY = TY(1 – T) where MY is the yield on a municipal bond, TY is the taxable yield on a comparable non-municipal bond, T is the investor’s tax rate. 14 © OnCourse Learning

The Yield Curve  Relates maturity and yield at the same point in time  Theories explaining the structure of the yield curve:  Liquidity Premium Theory Long-term rates tend to be higher that short-term rates  Market Segmentation Theory There are two (or more) markets for securities of different maturities Assumes that investors will not change their preferences as a result of yield discrepancies  Expectations Theory The long-term rate for some period is the average of the short-term rates over that period Upward-sloping (downward-sloping) curves indicate that market participants expect rates to rise (fall) in the future. 15 © OnCourse Learning

Yield Curve 16 © OnCourse Learning

Explaining the Yield Curve  Liquidity premium  Premium paid for liquidity  Segmented markets  Market divided into distinct segments  Expectations theory  Current rates are the average of expected future rates  The current two-year rate is the average of the current one- year rate and the one-year rate a year from now 17 © OnCourse Learning

Examples of Yield Curves 18 © OnCourse Learning