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Determinants of Interest Rates

Determinants of Interest Rates LOANABLE FUNDS THEORY RATES OVER TIME RATES FOR INDIVIDUAL SECURITIES TERM STRUCTURE OF RATES Supply Demand = borrowers, issuers of securities, deficit spending unit Supply = lenders, financial investors, buyers

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Determinants of Interest Rates

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  1. Determinants of Interest Rates LOANABLE FUNDS THEORY RATES OVER TIME RATES FOR INDIVIDUAL SECURITIES TERM STRUCTURE OF RATES Supply Demand = borrowers, issuers of securities, deficit spending unit Supply = lenders, financial investors, buyers of securities, surplus spending unit Slope of demand/supply curves related to elasticity or sensitivity of interest rates Demand Shifts

  2. Supply of Loanable Funds • Quantity supplied directly related to interest rates • Households are major suppliers of loanable funds • Businesses and governments may invest (loan) funds temporarily • Foreign sector a net supplier of funds in last twenty years • Federal Reserve’s monetary policy impacts supply of loanable funds • Sector cash receipts in period greaterthan outlays—lender

  3. Demand for Loanable Funds • Quantity demanded inversely related to interest rates • Household demand (mortgages, cars, appliances,..) • Business demand (working capital, profitable investments: Net present value NPV>0,..) • Governments (temporary imbalances, budget deficits, general economic conditions,…) • Foreign demand (differential interest rates,…)

  4. Equilibrium Interest Rate • Aggregate Demand DA = Dh + Db + Dg + Df • Aggregate Supply SA = Sh + Sb + Sg + Sf In equilibrium, DA = SA

  5. Shifts in the Supply and Demand • Supply • Wealth • Risk • Near-term spending needs • Monetary expansion • Economic conditions • Demand • Utility derived from asset purchases with borrowed funds • Restrictiveness on nonprice conditions on borrowed funds • Economic conditions

  6. Movement of Interest Rates Over Time • Key interest rates: 1970 -1999 • Interpret the patterns • www.stls.frb.org/fred/index.html

  7. Rates for Individual Securities= i • i = IP + RIR +DRP LRP +MP +SCP • Inflation premium (IP) • Real interest rates (RIR) • Default risk premium (DRP) • Liquidity risk premium (LRP) • Maturity premium (MP) • Special covenant premium (SCP)

  8. Rates for Individual Securities= i • Fisher effect: Inflation and Real Interest rates • RIR = I – Expected IR • http://www.bls.gov/cpi/ • Default risk: DRP= i – i(gov) • ..www.moodys.com and www.standardpoors.com • Liquidity risk: ability to sell at predictable price with low transaction cots • Maturity risk • In general, rates rise with maturity. (Upward sloping yield curve) • Special provisions • Call premium • Conversion premium • Tax exemption of municipal bonds

  9. Yield Curves at Various Points in Time 17 16 15 February 17, 1982 14 13 January 2, 1985 12 1 1 10 Annualized Treasury Security Yields 9 August 2, 1989 8 October 22, 1996 7 October 15, 2000 6 5 September 18, 2001 4 3 2 0 5 10 15 20 25 30 Number of Years to Maturity

  10. Term Structure of Interest Rates The relationship between maturity and yield. • The Yield Curve is the plot of current interest yields versus time to maturity. • Unbiased expectation theory • Forward rate calculations • Forward rate = Expected short rates • Different maturities are perfect substitutes • Liquidity premium theory • Market segmentation theory

  11. Upward and Downward Sloping Yield Curve • Upward • Expected higher interest rate levels • Expansive monetary policy • Expanding economy • Downward • Expected lower interest rate levels • Tight monetary policy • Recession soon?

  12. Uses of The Term Structure • Forecast interest rates • The market provides a consensus forecast of expected future interest rates • Expectations theory dominates the shape of the yield curve • Forecast recessions • Flat or inverted yield curves have been a good predictor of recessions. • Investment and financing decisions • Lenders/borrowers attempt to time investment/financing based on expectations shown by the yield curve • Riding the yield curve • Timing of bond issuance

  13. Treasury Debt Management • U.S. Treasury attempts to finance federal debt at the lowest overall cost • Treasury uses a mixture of Bills, Notes, and Bonds to finance periodic deficits and refinance outstanding securities • Treasury focuses on short-term issuance, phasing out 30-year bonds • Treasury 10-year bond now the standard issue • Leave the long-term issuance to private issuers

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