1. Why Do Interest Rates Change?
Chapter 4
Why Do Interest Rates Change?

2. Chapter Preview
Interest rates might fluctuate time and time and affect business activities. We will examine the forces that move interest rates and the theories behind those movements. Topics include:
Determining Asset Demand
Supply and Demand in the Bond Market
Changes in Equilibrium Interest Rates

3. 4.1 Determinants of Asset Demand
An asset is a piece of property that is a store of value.
Facing the question of whether to buy and hold an asset or whether to buy one asset rather than another, an individual must consider the following factors:
Wealth, expected return, risk and liquidity

4. The effect of changes in wealth:
Wealth, the total resources owned by the individual, including all assets;
The effect of changes in wealth:
Other things being equal, an increase in wealth raises the quantity demanded of an asset.

5. 4.1.2 Expected Return (预期收益)
Expected return: the return expected over the next period, on one asset relative to alternative assets;
The expected return on an asset is the weighted average of all possible returns, where the weights are the probabilities of occurrence (发生事件) of that return:
Re = p1R1 + p2R2, Where
p1 = probability of occurrence of return 1; R1 = return in state 1
p2 = probability of occurrence return 2; R2 = return in state 2

6. 4.1.2.1 EXAMPLE 1: Expected Return (P72)
What is the expected return on the Mobil Oil bond if the return is 12% two-thirds of the time and 8% one-third of the time?
Solution
The expected return is 10.68%.
Re = p1R1 + p2R2， where
p1 = probability of occurrence of return 1 = 2/3 = .67
R1 = return in state 1 = 12% = 0.12
p2 = probability of occurrence return 2 = 1/3 = .33
R2 = return in state 2 = 8% = 0.08
Thus
Re = (.67)(0.12) + (.33)(0.08) = = 10.68%

7. 4.1.2.2 Effect of changes in expected return
An increase in an asset’s expected return relative to that of an alternative asset, holding everything else unchanged, raises the quantity demanded of the asset.

8. 4.1.3 Risk
Risk: the degree of uncertainty associated with the return on one asset relative to alternative assets;
In finance, we use standard deviation of return as a measure of risk;
The formula for the standard deviation is shown as on P73

9. 4.1.3.1 EXAMPLE 2: Standard Deviation (a)
What is the standard deviation of the returns on the Fly-by-Night Airlines stock and Feet-on-the Ground Bus Company, with the same return outcomes and probabilities described as on P73?
Of these two stocks, which is riskier?

10. 4.1.3.2 EXAMPLE 2: Standard Deviation (b)
Solution
Fly-by-Night Airlines has a standard deviation of returns of 5%.

11. 4.1.3.3 EXAMPLE 2: Standard Deviation (c)
Feet-on-the-Ground Bus Company has a standard deviation of returns of 0%.

12. 4.1.3.4 EXAMPLE 2: Standard Deviation (d)
Fly-by-Night Airlines has a standard deviation of returns of 5%; Feet-on-the-Ground Bus Company has a standard deviation of returns of 0%
Clearly, Fly-by-Night Airlines is a riskier stock because its standard deviation of returns of 5% is higher than the zero standard deviation of returns for Feet-on-the-Ground Bus Company, which has a certain return.

13. 4.1.3.5 Conclusion on the above example
A risk-averse （厌恶风险） person prefers stock in the Feet-on-the-Ground (the sure thing) to Fly-by-Night stock (the riskier asset), even though the stocks have the same expected return, 10%.
By contrast, a person who prefers risk is a risk lover.
Most people are risk-averse, especially in their financial decisions.

14. 4.1.3.6 Effect of changes in risk
Holding everything else constant, if an asset’s risk rises relative to that of alternative assets, its quantity demanded will fall.

15. 4.1.4 Liquidity
Liquidity: the ease and speed with which an asset can be turned into cash, relative to alternative assets;
Effect of changes in liquidity: The more liquid an asset is relative to alternative assets, holding everything else unchanged, the more desirable it is, and the greater will be the quantity demanded.
Government bond VS company bond

16. 4.1.5 Determinants of Asset Demand

17. 4.2 Supply and demand in the bond market
We want to study the interest-rate determination by examining the supply of and demand for bonds;
Since interest rates on different markets tend to move together, we first of all study by supposing that there is only one type of securities and a single interest rate in the entire economy.
In next chapter, we will discuss why interest rates on different securities differ.

18. 4.2.1 Derivation of Demand Curve (look at Figure 1 on P77)
For one-year discount bonds (no coupon, face value $1000):
Point A:
Point B:

19. 4.2.1.1 Derivation of Demand Curve
Point C: P = $850 i = 17.6% Bd = 300
Point D: P = $800 i = 25.0% Bd = 400
Point E: P = $750 i = 33.0% Bd = 500
Demand Curve is Bd in Figure 1 which connects points A, B, C, D, E.
Has usual downward slope

20. 4.2.1.2 Supply and Demand Analysis of the Bond Market
Figure 4.1 Supply and Demand for Bonds

21. 4.2.2 Derivation of Supply Curve
Point F: P = $750 i = 33.0% Bs = 100
Point G: P = $800 i = 25.0% Bs = 200
Point C: P = $850 i = 17.6% Bs = 300
Point H: P = $900 i = 11.1% Bs = 400
Point I: P = $950 i = 5.3% Bs = 500
Supply Curve is Bs that connects points F, G, C, H, I, and has upward slope: the higher the interest rate, the less willingness to issue new bonds.

22. 4.2.3 Market Equilibrium Occurs when Bd = Bs, at P* = 850, i* = 17.6%
When P = $950, i = 5.3%, Bs > Bd (excess supply): P  to P*, i  to i*
When P = $750, i = 33.0, Bd > Bs (excess demand): P  to P*, i  to i*

23. 4.2.4 Market Demand Conditions
Market equilibrium occurs when the amount that people are willing to buy (demand) equals the amount that people are willing to sell (supply) at a given price
Excess supply occurs when the amount that people are willing to sell (supply) is greater than the amount people are willing to buy (demand) at a given price
Excess demand occurs when the amount that people are willing to buy (demand) is greater than the amount that people are willing to sell (supply) at a given price.

24. 4.2.5 Loanable (可贷出的)Funds Terminology
Demand for bonds = supply of loanable funds
Supply of bonds = demand for loanable funds
Therefore we can use the Figure 4.2 to express interest rates value in the usual direction.
Figure 4.2 A Comparison of Terminology: Loanable Funds and Supply and Demand for Bonds

25. 4.3 Changes in Equilibrium Interest Rates
It is important to distinct between movements along a demand (or supply) curve and a shifts in a demand (or supply) curve.

26. 4.3.1 Movement along the demand curve
When quantity demanded changes as a result of a change in the price of the bond, we have a movement along the demand curve, e.g., from Point A to B;

27. 4.3.2 Shift in the demand curve
When quantity demanded changes at each given price of the bond in response to a change in some other factor besides the bond’s price or interest rate, we have a shift in the demand curve, e.g. B1d to B2d .

28. 4.3.3 Shifts in the Demand Curve
Figure 4.3 Shifts in the Demand Curve for Bonds

29. 4.3.4.1 How Factors Shift the Demand Curve - Wealth
Economy , wealth , Bd , Bd shifts out to right, and the vice versa.

30. 4.3.4.2 How Factors Shift the Demand Curve – Expected return
i  in future, Re for long-term bonds , Bd shifts out to right
πe , relative Re , Bd shifts out to right

31. 4.3.4.3 How Factors Shift the Demand Curve - Risk
Risk of bonds , Bd , Bd shifts out to right
Risk of other assets , Bd , Bd shifts out to right

32. 4.3.4.4 How Factors Shift the Demand Curve - Liquidity
Liquidity of bonds , Bd , Bd shifts out to right
Liquidity of other assets , Bd ,Bd shifts out to right

33. 4.3.4.5 Factors That Shift Demand Curve

34. 4.3.5.1 Summary of Shifts in the Demand for Bonds (1)
Wealth: in a business cycle expansion with growing wealth, the demand for bonds rises, conversely, in a recession, when income and wealth are falling, the demand for bonds falls
Expected returns: higher expected interest rates in the future decrease the demand for long-term bonds, conversely, lower expected interest rates in the future increase the demand for long-term bonds

35. 4.3.5.1 Summary of Shifts in the Demand for Bonds (1)
Risk: an increase in the riskiness of bonds causes the demand for bonds to fall, conversely, an increase in the riskiness of alternative assets (like stocks) causes the demand for bonds to rise
Liquidity: increased liquidity of the bond market results in an increased demand for bonds, conversely, increased liquidity of alternative asset markets (like the stock market) lowers the demand for bonds

36. 4.3.6 Changes in Supply
Certain factors can cause the supply curve for bonds to shift:
Expected profitability of investment opportunities;
Expected inflation;
Government activities.

37. 4.3.6.1 Shifts in the Supply Curve
Figure 4.4 Shift in the Supply Curve for Bonds

38. 4.3.6.2.1 Factors that shift supply curve- Profitability
Profitability of Investment Opportunities
Business cycle expansion, investment opportunities , Bs , Bs shifts out to right
In a business cycle expansion, the supply of bonds increases, conversely, in a recession, when there are far fewer expected profitable investment opportunities, the supply of bonds falls

39. 4.3.6.2.2 Factors that shift supply curve- Expected Inflation
πe , Bs , Bs shifts out to right
An increase in expected inflation causes the supply of bonds to increase

40. 4.3.6.2.3 Factors that shift supply curve- Government Activity
Government Activities
Deficits , Bs , Bs shifts out to right
Higher government deficits increase the supply of bonds, conversely, government surpluses decrease the supply of bonds

41. 4.3.6.2.4 Factors That Shift Supply Curve (Table 3)

42. 4.4 Fisher Effect and Business cycle

43. 4.4.1 Changes in expected inflationπe
If πe 
Relative Re , Bd shifts in to left
Bs , Bs shifts out to right
P , i 
Figure 4.5 Response to a Change in Expected Inflation

44. 4.4.2 Fisher Effect
Our analysis on demand and supply has brought an important observation: when expected inflation rises, interest rates will rise.
This observation was firstly pointed out by Irving Fisher, and therefore called Fisher Effect.
Irving Fisher, famous economist( ( )

45. 4.4.3 Evidence on the Fisher Effect in the United States
Figure 4.6 Expected Inflation and Interest Rates (Three-Month Treasury Bills), 1953–2004

46. 4.4.4 Summary of the Fisher Effect
If expected inflation rises from 5% to 10%, the expected return on bonds relative to real assets falls and, as a result, the demand for bonds falls
The rise in expected inflation also means that the real cost of borrowing has declined, causing the quantity of bonds supplied to increase
When the demand for bonds falls and the quantity of bonds supplied increases, the equilibrium bond price falls
Since the bond price is negatively related to the interest rate, this means that the interest rate will rise

47. 4.4.5 Business Cycle Expansion
Wealth , Bd , Bd shifts out to right
Investment , Bs , Bs shifts right
If Bs shifts more than Bd then P , i 
Figure 4.7 Response to a Business Cycle Expansion

48. 4.4.6 Evidence on Business Cycles and Interest Rates
Figure 4.8 Business Cycle and Interest Rates (Three-Month Treasury Bills), 1951–2004

49. 4.4.7 Business cycle and Interest rates
Interest rates rise during business expansions;
Interest rates fall during contractions (as shown in the shaded areas indicating periods of recession in Figure 4.8)

50. 4.5 Profiting from Interest-Rate Forecasts
Methods for forecasting
Supply and demand for bonds: use Flow of Funds Accounts and judgment
Econometric Models: large in scale, use interlocking equations that assume past financial relationships will hold in the future

51. 4.6 Profiting from Interest-Rate Forecasts
Make decisions about assets to hold
Forecast i , buy long bonds
Forecast i , buy short bonds
Make decisions about how to borrow
Forecast i , borrow short
Forecast i , borrow long

52. Chapter Summary
Determining Asset Demand: We examined the forces that affect the demand and supply of assets.
Supply and Demand in the Bond Market: We examine those forces in the context of bonds, and examined the impact on interest rates.

53. Chapter Summary (cont.)
Changes in Equilibrium Interest Rates: We further examined the dynamics of changes in supply and demand in the bond market, and the corresponding effect on bond prices and interest rates.