FNCE 3020 Financial Markets and Institutions Fall Semester 2005 Lecture 3 The Behavior of Interest Rates.
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FNCE 3020 Financial Markets and Institutions Fall Semester 2005 Lecture 3 The Behavior of Interest Rates
How Might We Examine How Interest Rates Behave? Examine interest rates in two stages: First, through the Bond Market Model: i.e., demand and supply analysis of bonds in the bond market! What happens to the quantity demand and quantity supplied of bonds as we varying the price! Second, from the Bond Market Model to Loanable Funds Model, where: The Demand for bonds = supply of loanable funds The Supply of bonds = demand for loanable funds
Determinants of Financial Asset Demand When anyone is faced with the question of whether to buy and hold an asset or whether to buy one asset rather than another, the following factors are likely to enter into the decision: Wealth, i.e., the total resources currently owned by the individual, including all financial assets held Expected return, i.e., the return expected over the next investment period on an asset relative to alternative assets. Risk, i.e., the degree of uncertainty associated with the return on an asset relative to alternative assets. Liquidity, i.e., the ease and speed with which an asset can be turned into cash relative to alternative assets.
What Changes the Quantity of an Asset Demanded The (quantity) demanded of a particular financial asset varies according to: Wealth: An increase in wealth raises the quantity demanded of an asset. Expected return: An increase in an asset’s expected return, relative to that of alternative assets, raises the quantity demanded of the asset. Risk: An increase in an asset’s risk, rises relative to that of alternative assets, reduces the quantity demanded of the asset. Liquidity: The more liquid an asset, relative to alternative assets, the more desirable it is, and thus the greater will be the quantity demanded of the asset.
Summary Table: Response of Demand to Changes in Four Factors
The Derivation of the Economy’s Demand Curve for Bonds Bond Demand Curve: Plots the relationship between the quantity demanded for bonds and the price of a bond, when all other factors are held constant. Thus, we are only looking at the relationship between prices and quantity demanded. This is important!!!
Conceptualizing the Demand for Bonds Begin, by examining the demand for a 1 year discount bond. Question: What is the expected return on this bond? We can calculate the expected return as the investment yield on a 1 year discount bond as follows (see investment yield formula, Lecture 2): Where: i = investment yield Re = “expected return” F = face value P = market price
Plotting Appropriate Points Along the Bond Demand Curve Demand for 1 year bond, for a given price of $950. i = Re = (1,000-950/950) = 5.3% Assume at this price (and yield) 100 bonds will be demanded. this will be point A on the demand schedule (see second slide). Demand for the 1 year bond at a given price of $900 i = Re = (1,000-900/900) = 11.1% Assume at this price (and yield) 200 bonds will be demanded This will be point B on the demand schedule (see second slide). Important: We assume the market will hold more (demand more) of the bond as its price decreases. Why: At a lower price, the expected yield increases.
Determining Additional Points Along the Bond Demand Curve Point C:P = $850i = 17.6%B d = 300 Point D:P = $800i = 25.0%B d = 400 Point E:P = $750i = 33.0%B d = 500 Demand Curve is B d in Figure 1 which connects points A, B, C, D, E Demand Curve has a downward slope! As the price of the bond decreases, demand for the bond will increase (see movement along the x axis; next slide). Why: As the price decreases, the yield (expected return) increases!
Figure 1: Demand Curve (Bd) Demand Curve is Bd connecting points A, B, C, D, E. Demand Curve has a downward slope. As the price of the bond decreases (and the yield increases), the demand for bonds will increase (along the x axis). Reason: The expected yield has increased.
Derivation of the Supply Curve Supply Curve: shows the relationship between the quantity of a bond supplied and its price, when all other factors are held constant. Again, we are only looking at the relationship between price and quality supplied Assume the following supply conditions: Point F:P = $750i = 33.0%B s = 100 Point G:P = $800i = 25.0%B s = 200 Point C:P = $850i = 17.6%B s = 300 Point H:P = $900i = 11.1%B s = 400 Point I:P = $950i = 5.3%B s = 500 Important: As the price of the bond increases, supply will increase. Why: The cost to borrow funds decreases and thus more bonds will be supplied by borrowers (e.g., corporations).
Figure 2: Supply Curve (Bs) Supply Curve is Bs connecting points F, G, C, H, and I. Supply Curve has upward slope. As the price of the bond increases (and the yield decreases), the supply of bonds will increase (along the x axis). Reason: The cost of borrowing has decreased.
Point of Bond Market Equilibrium Bond Market Equilibrium: This occurs when the amount of bonds an economy is willing to buy (i.e., demand) equals the amount of bonds an economy is willing to sell (i.e., supply). This point is called the “market-clearing price.” In the previous slide, this is point C. Any Bond Market disequilibrium (i.e., excess demand or excess supply) is corrected through price changes!
Restoring Market Equilibrium Equilibrium occurs when B d = B s, or at P* = 850, i* = 17.6% (Point C) However, when P = $950, i = 5.3%, B s > B d There is excess supply, To restore equilibrium: P to P*, i to i* And, when P = $750, i = 33.0, B d > B s There is excess demand, to restore equilibrium: P to P*, i to i*
Shifts in the Bond Demand and Supply Schedules Up to this point, we have examined what will cause a movement along (up or down) a bond demand and bond supply curve. There is only one factor: Changes in the price of the bond. Now we need to examine, what will cause either schedule to shift (inward or outward) These will occur in response to all factors other than a change in the price of the bond. Important: When one of the schedules changes, this produces a change in the economy’s equilibrium (i.e., market) interest rate.
Shifts in the Demand and Supply Curves The analysis of interest rate behavior (i.e., changes in the market equilibrium interest rate) needs to explore why the curves shift in or out!
Factors Causing the Demand Schedule to Shift Outward Wealth: When the economy grows, wealth increases. Increased wealth will result in a higher demand for bonds (in investor portfolios). During a business expansion, as incomes (and wealth) increase, the demand for bonds will also increase. Risk: As prices in the bond market become less volatile (i.e., as the risk decreases), bonds will become more attractive and thus the demand for bonds will rise. Additionally, as alternative financial assets (e.g., on stocks) become more risky, the demand for bonds will rise.
Factors Causing the Demand Schedule to Shift Outward Expected Future Returns on Bonds: If the interest rate is “expected” to be lower in the future than it is now, the demand for bonds will increase now: Why: Because if interest rates do fall in the future, the prices of currently held bonds will rise. Recall the inverse relationship between bond prices and yield. Additionally, if expected returns on alternative financial assets falls (e.g., on stocks), the demand for bonds will increase
Factors Causing the Demand Schedule to Shift Liquidity: Increases in the liquidity of bonds (i.e., their marketability in secondary markets) will cause bonds to be more attractive, and increase their demand. Additionally, decreases in the liquidity of alternative financial assets (e.g., stocks), causes the demand for bonds to increase Expected Rate of Inflation: Decreases in the expected rate of inflation, will result in an increase in the real return on bonds, and cause the demand for bonds to increase. The real return is the interest rate minus the rate of inflation.
Summary of Demand Factors 1. Wealth Wealth , B d shifts out to right 2. Expected Return R e for bonds (in the future) , B d shifts out to the right. 3. Risk Risk of bonds , B d shifts out to right Risk of other assets , B d shifts out to right 4. Liquidity Liquidity of bonds , B d shifts out to right Liquidity of other assets , B d shifts out to right 5. Expected Inflation π e , real return , B d shifts out to right
Factors that Cause the Supply Schedule to Shift Outward Expected Profitability of Business Investment Opportunities: As businesses anticipate higher profits on their potential investments, they will be more willing to borrow to fund those investments. Increase business borrowing results in an increase in the supply of bonds in the market. This generally occurs during a business expansion as demand for products increases and businesses become more optimistic about the future.
Factors that Cause the Supply Schedule to Shift Outward Expected Inflation: When expected inflation increases, the real cost of borrowing decreases. As the real cost of borrowing falls, businesses increase their borrowing. Increase borrowing results in an increase in the supply of bonds in the market. Government Policies: Higher government deficits increases the need for government borrowing. Deficits result from a shortfall of tax receipts over spending. Increase government borrowing results in an increase in the supply of bonds in the market.
Summary of Supply Factors 1. Expected Profitability of Business Investment Profitability , Bs shifts out to right 2. Expected Inflation π e , real cost of borrowing , Bs shifts out to right 3. Government Policies Government deficits , B s shifts out to right
Adding the Rest of the World to the Model. Foreign sector activity can result in shifts in another country’s demand and supply curves. Assume the U.S. financial market: Inward investment from overseas investors will shift the demand schedule (for bonds) out. Inward borrowing from overseas businesses will shift the supply schedule (for bonds) out. Thus, we need to consider the impact of a global financial market on changes in a country’s equilibrium (i.e., market) interest rate. This is important…
And What About the Central Bank? We can introduce the central bank into this model through its impact on actions on the debt markets. One of the major policy instruments used by the Federal Reserve is open market operations. Buying and selling government securities to influence the amount of reserves in the banking system. As the central bank buys securities, this will increase the demand. Push up the price and bring down the interest rate. As the central bank sells securities, this will increase supply. Lower the price, and increase the interest rate.
The Loanable Funds Model of Interest Rates Now that we have developed the bond market model, we need to move to the loanable funds model of interest rates. Loanable Funds Model Defined: Changes in the quantity of “loans” demanded and supplied in an economy explains interest rate changes. Loans refers to the amount of funds supplied or demanded in an economy. Thus, the demand for bonds is equal to the supply of loanable funds (Bd = Ls on the next slide). And the supply of bonds is equal to the demand for loanable funds (Bs = Ld on the next slide)
The Loanable Fund Model Illustrated Note: The model has as the price the interest rate on the Y-axis.
Changes in the Market’s Equilibrium Interest Rate Decreasing interest rate results from either: Increase in the demand for bonds (increase in the supply of loanable funds) Decrease in the supply of bonds (decrease in the demand for loanable funds) Increasing interest rate results from either: Decrease in the demand for bonds (decrease in the supply of loanable funds) Increase in the supply of bonds (increase in the demand for loanable funds)
Additional Interest Rate Considerations: The Fisher Interest Rate Effect This is another possible explanation of the market rate of interest. Fisher Effect states that the market rate of interest is the sum of (1) the real interest rate plus (2) the market’s expected rate of inflation. The real rate of interest reflects the rate of real economic growth (i.e., the amount of reward that should accrue to the lender for lending to a productive economy). Then, an inflation premium is added to the real rate, to produce a market interest rates that protects investors against this loss of purchasing power. So: interest rate = real rate + inflation expectations.
Changes in Market Interest Rates with the Fisher Model According to the Fisher Model, over time, changes in market interest rates may be attributed to changes either in the real interest rate, or to changes in inflationary expectations. Changes in the real rate reflects the behavior in the market for loanable funds in response to changing long term economic activity (real economic activity). Explaining changes in inflationary expectations tends to be a more complicated matter. One hypotheses is that current inflationary expectations are based on the history of past actual rates of inflation. Called Adaptive Expectations model.
Expected Inflation and Interest Rates (Three-Month Treasury Bills), 1953–2004 Evidence on the Fisher Effect in the United States: 1953-2004
Additional Consideration in Using the Fisher Interest Rate Model At the time the debt contract (i.e., bond) is priced the inflation premium is based on expected rates of future inflation. If these expectations differ from actual inflation rates during the life of the debt instrument (i.e., bond) either the lender (investor) or borrower can be adversely affected. For example, the lender (investor) can end up with a negative return if actual inflation is greater than yield on the purchased debt instrument. Or the borrower can end up paying much more in real terms if the actual rate of inflation falls short of the expected at the time the bond was issued.
Final Consideration: Impact of the Business Cycle on Interest Rates Historically, interest rates have moved in a “pro-cyclical” manner. Generally we have observed that: Rates moving down during a business recession. Rates moving up in during a business expansion. Why? Business cycle impacts, especially business demand for funds. Central bank impacts, i.e., the central bank responding to changes in economic activity. However, the inflationary environment can affect (and offset or dominate) this cyclical move. 1970s: High and rising inflationary expectations in economy. 1990 - present: Falling and eventually low inflationary expectations in the economy.