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AP/ECON 3430 3.0 A Money, Banking and Finance A Fall 2014

AP/ECON 3430 3.0 A Money, Banking and Finance A Fall 2014. Prof. Brenda Spotton Visano October 6, 2014. Agenda for Class #5. Review Bond Demand/Supply  Price of Bond Theories of Interest Rates What is “the” interest rate? Term Structure of Interest Rates

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AP/ECON 3430 3.0 A Money, Banking and Finance A Fall 2014

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  1. AP/ECON 3430 3.0 AMoney, Banking and Finance AFall 2014 Prof. Brenda SpottonVisano October 6, 2014

  2. Agenda for Class #5 • Review Bond Demand/Supply  Price of Bond • Theories of Interest Rates • What is “the” interest rate? • Term Structure of Interest Rates • What explains the different levels and variations of interest rates over time?

  3. Review of Bond Basics - Demand • Lenders demand bonds as a vehicle for storing value over time, as savings • Everything else equal, Bond Demand will be greater the… • lower the price of the bond • higher the rate of return on the bond • lower the risk of repayment • ??? real rate of return on the bond • ??? expected rate of inflation

  4. Review of Bond Basics - Supply • Borrowers supply bonds as a vehicle for financing economic investment • Everything else equal, Bond Supply will be greater the… • Higher the price of the bond • Lower the rate of return on the bond • Higher the rate of return on the economic investment being financed by the bond issue • ??? real rate of return on the bond • ??? expected rate of inflation

  5. Comparative Statics • What do you predict will happen to the Price of Bonds in the current period if • Business becomes more profitable? • We expect interest rates to rise in 1 year’s time? • Government of Canada pays off a large portion of the national debt? • Bank of Canada pursues expansionary monetary policy?

  6. Interest Rates What is “interest”? • = premium on present goods over future goods • = usury? • Is it a price of loanable funds? (I. Fisher) OR • Is it the opportunity cost of liquidity? (J.M. Keynes)

  7. Interest as the Price of Loanable Funds (Irving Fisher, 1930) • Demand for Loanable Funds (Uses): by whom? For what? • Marginal Efficiency of Capital (Investment) • Supply of Loanable Funds (Sources): by whom? Why? • Rate of time preference (psychological propensity to save)

  8. Interest as the Reward for Parting with Liquidity (J.M. Keynes, 1936) • Given a decision to save out of income, there is a second question: • Why hold wealth in liquid financial instruments? • Precautionary motive • Transactions motive • Speculative motive

  9. Variations in Interest Rates • Theories of Interest explain a levelof interest rates • But why are there so many different interest rates at any one time? • Stylized Facts of Interest Rates: • Short and Long rates tend to move together • Short rates are more volatile than Long rates • Long rates tend to be higher than Short rates

  10. What is that again? • Interest rate = real interest rate + expected inflation rate • Real rate of interest = Nominal interest rate – actual inflation • Interest rate = Yield • Yield = Benchmark GofC bond yield + Default-risk premium • Yield = Coupon rate + Capital gain/loss

  11. Yield • Yield includes both the Coupon (“interest”) rate and an adjustment to the rate of return for capital gain/loss in the difference between the Face Value and the Current market Price • Example: Risk free Bond with face value of $1000, Coupon Rate = 10%, term to maturity = 1 year, Market Price* = “109” • **Convention: Bond prices are quoted as a percentage of the bond's par or face value and exclude accrued interest; e.g. if a nominal fixed coupon bond is quoted as 109, then the price of that bond is 109% or 1.09 times the value of the bond at maturity. • What is the interest income? What is the total income? What is the net rate of return?

  12. Recent Government of Canada Bond Issue • Auction Date: 2014.09.10 • Term to Maturity: 2Y • Date of Maturity: 2016.11.01 • CouponRate*: 1.000 • Average Price**: 99.655 • AverageYield: 1.164 • *Fixed Coupon Rate paid semi-annually on a Face Value of $1000 • **Convention (again): Bond prices are quoted as a percentage of the bond's par or face value and exclude accrued interest; e.g. if a nominal fixed coupon bond is quoted as 99.655, then the price of that bond is 99.655% or 0.99655 times the value of the bond at maturity.

  13. Government of Canada Benchmark Bond Yields

  14. Consider… • Bond A: term to maturity = 1 year; yield = 5%; default-risk free • Bond B: term to maturity = 2 years; yield = 6%; default-risk free • You have funds available to lend out for 2 year period; which bond do you prefer to buy today?

  15. Term Structure of Interest Rates • With everything else (?) equal what explains the variation in interest rates on bonds that differ only in term to maturity? • Are debts of different maturities substitutable? • Market Segmentation (no substitution) • Liquidity Preference (limited substitution) • Expectations Theory (perfect substitution)

  16. Flip it Around… Recent Canadian yields on government debt • Overnight rate = 1.02% • 3-month T-Bills = 0.92% • 2-year GofCBonds = 1.00% • 10-year GofCBonds = 2.50% • What is the shape of the yield curve? • What might bond traders be expecting to happen to short term rates in 10 years time?

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