The Impact of Inflation & Deflation, Yield Curves, and Duration on Interest Rates and Asset Prices

1. 7 The Impact of Inflation & Deflation, Yield Curves, and Duration on Interest Rates and Asset Prices C h a p t e r Money and Capital Markets Financial Institutions and Instruments in a Global Marketplace Eighth Edition Peter S. Rose McGraw Hill / Irwin Slides by Yee-Tien (Ted) Fu

2.  Learning Objectives  • To learn what inflation is and how it can impact interest rates and asset prices. • To understand the greater concern today over deflation and how deflation may affect the economy and financial system. • To see how yield curves arise and explore the ideas about what determines the shape of the yield curve at any point in time.

3.  Learning Objectives  • To discover how yield curves can be a useful tool for those interested in investing their money and in tracking the health of the economy. • To look at the concept of duration and see how it can assist in the making of investment choices and in protecting against the risk of changing interest rates.

4. 7 Inflation and Interest Rates • Inflation refers to the rise in the average level of prices for all goods and services.

5. Rate of Inflation (% D) CPI GDP Deflator 6-month T-bill Rate (secondary market) Year 1960 1.7 % 1.4 % 3.2 % 1970 5.7 5.3 6.5 1980 13.5 9.2 11.4 1990 5.4 3.9 7.5 2000 3.4 2.3 5.9 2001 2.8 2.2 3.3 Inflation and Interest Rates • In recent years, the U.S. inflation and interest rates appear to be fairly strongly correlated.

6. Inflation and Interest Rates Nominal and Real Interest Rates • In general, lenders will attempt to charge nominal rates of interest that give them their desired real rates of return on their loanable funds based upon their expectations regarding inflation. • nominal rate = published or quoted rate • real rate = rate measured in terms of the actual purchasing power

7. Inflation and Interest Rates The Fisher Effect • In a 1896 classic article, economist Irving Fisher argued that expected nominal interest rate = expected real rate + inflation premium + (expected real rate  inflation premium)  expected real rate + inflation premium • The inflation premium measures the rate of inflation expected by investors in the marketplace during the life of a particular financial instrument.

8. Inflation and Interest Rates The Harrod-Keynes Effect of Inflation • Building upon the Keynesian liquidity preference theory, Harrod argued that unless inflation affects money demand or supply, the expected nominal interest rate must be the same regardless of inflationary expectations. • So, a rise in inflationary expectations will lower the real rate of interest.

9. Inflation and Interest Rates • The simple Fisher effect was the majority view for decades until problems began to surface: • Partial anticipation of inflation • Inflation-caused wealth effect • Inflation-caused income effect • Inflation-caused depreciation effect • Inflation-caused income tax effect

10. Inflation and Interest Rates • The bulk of recent research suggests that nominal rates rise by less than any given increase in the expected inflation rate and decline by less than any given decrease in the expected inflation rate. • However, note that the topic of inflation and interest rates is plagued by numerous measurement problems.

11. Inflation and Interest Rates Impact of Price Deflation • There is growing concern that deflation – a fall in the average level of prices – may soon replace inflation as one of the key problems that nations may face in the future. • Past experiences indicate that price deflation can result in lower output (production) of goods and services, and force real interest rates upward.

12. Inflation and Interest Rates Inflation and Stock Prices • Common stock is widely viewed as a hedge against inflation. • However, research evidence seem to support the view that the impact of inflation on stock prices varies from firm to firm and from industry to industry depending on the actual rate of inflation and the terms of existing nominal contracts.

13. Inflation-Adjusted Securities • The U.S. Treasury offers TIPS (Treasury Inflation Protected Securities) and “I bonds” for investors who want some protection against inflation. • Annual nominal interest payment from a TIPS = inflation-adjusted  promised nominal value coupon rate • When the public expects higher inflation, inflation-adjusted securities rise in value.

14. Inflation-Adjusted Securities Source: Economic Trends, Federal Reserve Bank of Cleveland, June & July 2001

15. The Maturity of a Loan • One important factor causing interest rates to differ from one another is differences in the maturity (or term) of securities and loans. • The relationship between the rates of return on financial instruments and their maturity is called the term structure of interest rates. • This term structure may be represented visually by drawing a yield curve for all securities having the same credit quality.

16. The Maturity of a Loan • Yield curves may be upward sloping, downward sloping, or horizontal (flat). Source: Economic Trends, Federal Reserve Bank of Cleveland, June 2001

17. The Maturity of a Loan • The unbiased expectations hypothesis argues that investor expectations regarding future changes in short-term interest rates determine the shape of the curve. • Thus, changes in the relative amounts of long-term and short-term securities will not affect the shape of the yield curve unless investor expectations are also affected.

18. The Maturity of a Loan • The liquidity premium view of the yield curve suggests that there is a bias toward positively-sloped yield curves. • Longer-term securities tend to have more volatile market prices and hence, greater risk of capital loss. • So, investors must be paid an interest rate premium (the liquidity premium) to encourage them to purchase long-term securities.

19. The Maturity of a Loan • The market segmentation argument of the yield curve separates the financial markets into several distinct markets according to the maturity preferences of the investors. • The implication is that governments can alter the shape of the yield curve by shifting the available supplies of securities relative to the demand for those securities in each distinct market.

20. The Maturity of a Loan • The preferred habitat or composite theory of the yield curve argues that investors seek out their preferred habitat – they choose securities that match their risk preferences, tax exposure, liquidity needs, regulatory requirements, and planned holding periods. • An investor will not normally stray from his or her preferred habitat unless the rates of return on some other securities are high enough to overcome his or her preferences.

21. The Maturity of a Loan • Empirical studies on the various yield curve theories have produced mixed results. • As such, the traditional models are giving way today to newer models that are being created in response to recent theoretical developments – in particular, the Black-Scholes option pricing formula and the rational expectations theory.

22. The Maturity of a Loan • The yield curve is a useful tool for … • forecasting interest rates – a downward-sloping yield curve suggests near-term declines in rates • identifying portfolio management strategies – a rising yield curve favors short-term borrowing and long-term lending • detecting overpriced and underpriced securities • indicating trade-offs between maturity and yield • “riding” the yield curve – active investors may gain by timely portfolio switching

23. % D in a security’s price over time % D in a security’s yield over time Duration: A Different Approach to Maturity • A popular measure of how responsive a debt security’s price is to changes in interest rates is its price elasticity (E). • Greater price elasticity means that an asset goes through a greater price change for a given change in market rates of interest.

24. Duration: A Different Approach to Maturity • Longer-term debt securities generally have a larger price elasticity than shorter-term securities. • Debt securities with lower coupon rates also tend to have a larger price elasticity than those with higher coupon rates, since a greater proportion of the lower-coupon security’s total return lies in the final payment at maturity. This is called the coupon effect.

25. Duration: A Different Approach to Maturity • To enable financial analysts to construct a linear relationship between maturity and security price elasticity, regardless of differing coupon rates, a maturity measure called duration (D) was introduced.

26. Duration: A Different Approach to Maturity • Duration is thus a weighted average of the time required for the investor to receive the promised payments. The weights are the present values of those payments. Ct = the expected principal/interest payment in time period t y = the security’s yield to maturity, with maturity reached at the end of n periods

27. Duration: A Different Approach to Maturity • The relationship between an asset’s change in market price and its change in yield or interest rate is called convexity. • Research shows that convexity increases with an asset’s duration. • Moreover, an asset’s change in price is greater at lower market interest rates than it is at higher market interest rates in general.

28. Duration: A Different Approach to Maturity Uses of Duration • Estimating asset price changes • % D in asset price  • Portfolio immunization against interest rate changes • This can be achieved by acquiring a portfolio of assets whose average duration equals the length of the investor’s desired holding period.

29. Duration: A Different Approach to Maturity Limitations of Duration • In practice, it is often difficult to find a group of assets with a certain average duration. • As time passes, constant adjustments are also needed to ensure that the average duration decreases at the same pace. • There is some risk associated with the use of conventional measures of duration due to uncertain future interest rate movements.

30. Money and Capital Markets in Cyberspace • Websites that discuss the impact of inflation on interest rates include: • http://www.economist.com/ • http://www.clev.frb.org/research/index.htm • http://www.savingsbonds.gov/sav/sbiinvst.htm • For more on yield curves, visit: • http://www.mathematical-finance.com/ • http://www.pvlinton.com/securiti.htm • http://newrisk.ifci.ch/00011532.htm

31. Chapter Review • Inflation and Interest Rates • Correlation between Inflation and Interest Rates • Nominal and Real Interest Rates • The Fisher Effect • The Harrod-Keynes Effect of Inflation • Alternative Views on Inflation and Interest Rates • Impact of Price Deflation • Inflation and Stock Prices • Inflation-Adjusted Securities

32. Chapter Review • The Maturity of a Loan • The Yield Curve and the Term Structure of Interest Rates • Types of Yield Curves • The Unbiased Expectations Hypothesis • The Liquidity Premium View of the Yield Curve • The Segmented-Markets Argument • The Preferred Habitat or Composite Theory • Research Evidence on Yield-Curve Theories • Uses of the Yield Curve

33. Chapter Review • Duration: A Different Approach to Maturity • The Price Elasticity of a Debt Security • The Impact of Varying Coupon Rates • An Alternative Maturity Index for a Security: Duration • The Convexity Factor • Uses of Duration • Limitations of Duration