1. Copyright © 2004 by Thomson Southwestern All rights reserved. 8-1 Interest Rates, Exchange Rates and Inflation Theories and Forecasting Chapter 8

2. Copyright © 2004 by Thomson Southwestern All rights reserved. 8-2 Part A: Theories of Interest Rates Interest Rates A change causes an automatic market repricing of all fixed interest obligations Are altered as a major instrument of monetary policy by central banks to direct the economy Can be very volatile Foreign Exchange Rates A change alters international flows of both goods and capital Can be very volatile

3. Copyright © 2004 by Thomson Southwestern All rights reserved. 8-3 Theories Are Important to Managers Many decisions made on the basis of forecasts Need to understand assumptions underlying forecasts and data Need to understand the reasons why the assumptions are made

4. Copyright © 2004 by Thomson Southwestern All rights reserved. 8-4 A Historical Look at Interest Rates See Figures 8.1 and 8.2, pages 268-269 Interest Rates Are Constantly Changing and Have Been Particularly Volatile in Recent Decades. Interest Rates Generally Fall During Recessions Interest Rates Incorporate the Real Rate of Interest

5. Copyright © 2004 by Thomson Southwestern All rights reserved. 8-5 The General Level of Interest Rates Standard conventions 1.Models focus on the determination of the equilibrium interest rate ◦ Economy is rarely in equilibrium ◦ Assumption is made that economy is always moving toward equilibrium 2.Models use simplifying assumptions and hope that critical factors are not omitted 3.Focus is on the rate of interest not differences in rates among various securities

6. Copyright © 2004 by Thomson Southwestern All rights reserved. 8-6 Loanable Funds Theory Interest rates are determined by supply and demand of funds for investment Assumes open and competitive money and capital markets Useful for forecasting Market participant are borrowers and lenders Households or Consumers Businesses Governments The Central Bank The Foreign Sector

7. Copyright © 2004 by Thomson Southwestern All rights reserved. 8-7 Households as Suppliers Time preference for consumption Reward for saving is necessary Cash balances may be held due to Transactions demand Precautionary demand Speculative demand Savings necessary due to future needs (e.g. illness, college fund, retirement)

8. Copyright © 2004 by Thomson Southwestern All rights reserved. 8-8 Business as Suppliers More often demanders Supply from business affected by Available funds ◦ Depreciation ◦ Retained earnings Investment options (real and financial) Nature of the business Management philosophy

9. Copyright © 2004 by Thomson Southwestern All rights reserved. 8-9 Other Supply Factors The Money Supply Changed by Federal Reserve System policy An increase in the money supply increases funds available for investment The Foreign Sector Funds are also supplied from participants in other countries Supply is affected by interest rates & economic growth in the two countries and other factors Governments

10. Copyright © 2004 by Thomson Southwestern All rights reserved. 8-10 The Demand for Loanable Funds Businesses and households will demand less funds at higher interest rates Demand by governments is inelastic with respect to interest rates and due to budget deficits Demand by the foreign sector is due to Same factors affecting domestic units Differences in U.S. rates and rates abroad

11. Copyright © 2004 by Thomson Southwestern All rights reserved. 8-11 Loanable Funds ($) Interest Rate (%) 0 (Household + Business +  M + Foreign) S LF Loanable Funds ($) SUPPLY OF LOANABLE FUNDS The supply of loanable funds increases as the expected interest rate increases. 0 (Business +Government + Foreign) D LF Interest Rate (%) DEMAND FOR LOANABLE FUNDS The demand for loanable funds decreases as the expected interest rate increases.

12. Copyright © 2004 by Thomson Southwestern All rights reserved. 8-12 I* S LF D LF Q*Q* Loanable Funds ($) Interest Rate (%) 0 EQUILIBRIUM RATE OF INTEREST The equilibrium level of interest rates is the rate at which the quantity of loanable funds demanded equals the quantity of loanable funds supplied.

13. Copyright © 2004 by Thomson Southwestern All rights reserved. 8-13 Loanable Funds Theory and Interest Rate Forecasting Changes in Supply or Demand can be caused by Government Fiscal Policy (determined by Congress) ◦ Federal Budget Deficit ◦ Taxation Government Monetary Policy (determined by the Federal Reserve System Supply and demand determine the equilibrium interest rate (price) and equilibrium loanable funds (quantity)

14. Copyright © 2004 by Thomson Southwestern All rights reserved. 8-14 I'I' Interest Rate (%) I*I* Loanable Funds ($) 0 S LF D LF D LF' Higher D LF 0 Interest Rate (%) I*I* I'I' Loanable Funds ($) S LF D LF D LF' Lower D LF SHIFTS IN THE DEMAND CURVE AND CHANGES IN THE EQUILIBRIUM RATE OF INTEREST If the demand for loanable funds increases, the equilibrium interest rate will increase. If the demand for loanable funds decreases, the equilibrium interest rate will fall.

15. Copyright © 2004 by Thomson Southwestern All rights reserved. 8-15 Inflation and New Financial Innovations Due to Inflation Variable rate loans Variable rate deposits Adjustable-rate bonds and mortgages Zero-coupon bonds Interest rate swaps Inflation-adjusted Treasury securities Inflation futures contracts Other derivatives

16. Copyright © 2004 by Thomson Southwestern All rights reserved. 8-16 The Fisher Effect Explains the relationship between The nominal interest rate, The real interest rate, and Expected inflation Inflation affects real purchasing power. Investors will demand a higher interest rate (an inflation premium) for expected lost purchasing power over the period of an investment.

17. Copyright © 2004 by Thomson Southwestern All rights reserved. 8-17 The Fisher Effect (1 + i N ) = (1 + i R )(1 + Expected Inflation Rate) i N = [(1+i R ) )(1 + Expected Inflation Rate)] – 1 where i N is the nominal interest rate demanded i R is the real rate of return desired If the real rate of return desired is 2% and expected inflation is 12%, then the nominal rate demanded is: (1.02)(1.12) - 1 =.1424 or 14.24%

18. Copyright © 2004 by Thomson Southwestern All rights reserved. 8-18 The real ex post return that investors actually get is given by: i R = [( + i N )/(1 + Actual Inflation Rate)] – 1 If inflation turned out to be 12%, and the nominal rate was 14.2%, the real ex post return would be: (1.142)/(1.12) - 1 =.02 or 2% Real Ex Post Return

19. Copyright © 2004 by Thomson Southwestern All rights reserved. 8-19 The Fisher effect approximation formula eliminates the cross-products. i N = i R + Expected Inflation i R = i N – Expected Inflation or i N = 2% + 12% = 14% The Fisher effect assumes that the i R remains unchanged. Changes in nominal interest rates are driven by changes in expected inflation. Expected Inflation Drives Changes in Nominal Interest Rates

20. Copyright © 2004 by Thomson Southwestern All rights reserved. 8-20 Expected Inflation and the Loanable Funds Theory Loanable Funds ($) Q* 0 iRiR iNiN Interest Rate (%) E(INFL ) S LF S LF” D LF” Panel B: Inflationary Expectations and the Real Rate of Interest Panel A: Inflation and the Equilibrium Rate of Interest Q 0 i R’ iRiR Interest Rate (%) S LF S LF” D LF” Q’ Loanable Funds ($)

21. Copyright © 2004 by Thomson Southwestern All rights reserved. 8-21 Evaluation of the Fisher Effect The theory is based on ex ante real rates ex ante expected inflation These are not observable, resulting in measurement problems in testing the theory. Ex post real rates are not stable which suggests that inflationary expectations by investors were consistently incorrect.

22. Copyright © 2004 by Thomson Southwestern All rights reserved. 8-22 Further Evaluation of the Fisher Theory Historical Relationships Measurement Problems Historical Ex Post Analysis Interest Rate Behavior Adjustments for Deflation? Adjusting for the Tax Effect Accuracy of Interest Rate Forecasting Professional Forecasts Based on the Loanable Funds Theory

23. Copyright © 2004 by Thomson Southwestern All rights reserved. 8-23 Adjusting for the Tax Effect Income taxes are levied on nominal rather than on real returns. This suggests that changes in nominal yields will actually be greater than that predicted by Fisher to compensate for the tax on the inflation premiums. The nominal rate adjusting for tax effects is i N = [(1 + i R )(1 + Before-Tax Inflation Premium)] – 1 where i N = the nominal return before taxes i R = the real rate expected before taxes

24. Copyright © 2004 by Thomson Southwestern All rights reserved. 8-24 Calculating Effective Annual Yields on Money Market Securities Money Market Securities Maturity less than one year Generally sold at a discount Maximum maturity is 360 days If the yield is calculated in a 365 day year (to compare yields with capital market securities, it is the coupon equivalent yield If the yield is calculated in a 360 day year, it is the bank discount yield

25. Copyright © 2004 by Thomson Southwestern All rights reserved. 8-25 Coupon Equivalent Yield on Money Market Securities where: P 0 =the initial amount invested Par =the par value at maturity P 1 =price received if sold before maturity n =the number of days until maturity or sold

26. Copyright © 2004 by Thomson Southwestern All rights reserved. 8-26 Effective Annual Yield The equation implicitly assumes that any money received will be reinvested at the given annual rate during the year, resulting in a higher effective rate of return at the end of the year. Hence, y * will be greater than y.

27. Copyright © 2004 by Thomson Southwestern All rights reserved. 8-27 Bank Discount Yield The yield on money market securities is quoted as a percentage of par. Thus, discount yield (d) will always be lower than the annual yield (y) or the effective annual rate (y * ).

28. Copyright © 2004 by Thomson Southwestern All rights reserved. 8-28 The purchase price of money market securities is found by: Purchase Price of Money Market Securities

29. Copyright © 2004 by Thomson Southwestern All rights reserved. 8-29 Find the price, the coupon equivalent yield and the effective annual yield for a 91-day T-bill with a discount yield of 4.425%. Purchase price of the T-bill 98.8% of par The price that must be paid for the T-bill with a par value of $10,000 would be $9,888.10.

30. Copyright © 2004 by Thomson Southwestern All rights reserved. 8-30 Coupon equivalent (annual) yield for the T-bill 0.04539 or 4.539% The effective annual yield for the T-bill.04618 or 4.618% Yield Calculations

31. Copyright © 2004 by Thomson Southwestern All rights reserved. 8-31 Differences in Yields for Money Market Securities Calculating Yields for Negotiable CDs and Fed Funds where: P1 = the amount received at maturity, equal to interest earned at the quoted rate plus the principal or amount invested d = the quoted rate

32. Copyright © 2004 by Thomson Southwestern All rights reserved. 8-32 Find the effective annual yield on a 180-day CD with a face value of $1 million and a coupon rate of 3.5%. Amount received at maturity $1.0175 million The effective annual yield on the CD. 03581 or 3.581%

33. Copyright © 2004 by Thomson Southwestern All rights reserved. 8-33 Differences in Yields for Money Market Securities Default risk Liquidity Influenced by the size of the secondary market for the particular security. Denomination size Maturity

34. Copyright © 2004 by Thomson Southwestern All rights reserved. 8-34 Part B: Currency Exchange Rates Companies doing business in more than one country face exchange rate risk The risk that money will be lost solely through variations in the exchange rate of the two currencies Direct exchange rate – U.S. dollars per unit of foreign currency Indirect exchange rate – units of foreign currency per U.S. dollar Spot rate – rate for immediate currency exchange Forward rate – rate for an exchange on a future date agreed upon today

35. Copyright © 2004 by Thomson Southwestern All rights reserved. 8-35 Theories of Exchange Rate Determination Supply and Demand for Goods and Services Floating Exchange Rates as Adjusters for International Monetary Surpluses and Deficits Relative Inflation Rates Purchasing Power Parity Theorem Relative Interest Rates Interest Rate Parity Theorem

36. Copyright © 2004 by Thomson Southwestern All rights reserved. 8-36 Theories of Exchange Rate Determination Controlling Inflation for the Euro Politics Changing the Fiscal Rules Underpinning the Euro A Complex Puzzle The Role of Expectations