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6 September

6 September. FNCE 4070 Financial Markets and Institutions. Duration. How interest rates affect duration. For a single cashflow interest rates do not affect duration For multiple cashflows on different dates as interest rates rise duration decreases

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6 September

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  1. 6 September FNCE 4070Financial Markets and Institutions

  2. Duration

  3. How interest rates affect duration • For a single cashflow interest rates do not affect duration • For multiple cashflows on different dates • as interest rates rise duration decreases • as interest rates fall duration increases

  4. Risk and Duration

  5. Inflation • Inflation occurs when the prices of goods and services increase over time. • Inflation cannot be measured by an increase in the cost of one product or service, or even several products or services. Rather, inflation is a general increase in the overall price level of the goods and services in the economy(Fed Reserve comment) • The inflation rate is the percentage change in a price index. • General consensus is that an inflation rate of around 2% is reasonable… • Many countries have adopted an explicit inflation target of around 2%

  6. Related Terms • Deflation • A sustained decrease in the aggregate price level, which corresponds to a negative inflation rate • Hyperinflation • An extremely fast increase in the aggregate price level, which corresponds to an extremely high inflation rate • Disinflation • A decline in the inflation rate, such as from 10% to 5%. Note, inflation rates remain positive just reduces.

  7. Deflation • When deflation occurs the value of money increases. • Debt contracts are written in fixed amounts means that real liabilities are increasing. • Faced with increasing real debt costs a company that is short of cash will cut its spending, workforce etc. • Less spending and high unemployment exacerbate the situation • Occurred in Great Depression, briefly in US during 2008-9 and periodically in Japan since the late 1990’s

  8. Episodes of Hyperinflation • It is considered that the basic cause for hyperinflation is too much money in circulation. • Germany • In 1923-24 at the peak prices doubled every 3.7 days • Yugoslavia • In January 1994 the monthly inflation rate peaked at 313 million percent • Zimbabwe • In November 2008 the monthly inflation rate peaked at 79.6 billion percent

  9. Episode of Disinflation around the world

  10. Consumer Price Index (CPI) • It measures the relative cost of a basket of goods where the basket is changed infrequently • Problems with CPI • Three main biases • Substitution bias - As the price of one good or service rises it may be substituted with another. This will cause an upwards bias in the inflation rate • Quality bias - As the quality of the same product improves over time it may satisfy peoples needs and wants better. This will cause an upwards bias in the inflation rate • New Product Bias - New products are frequently introduced and these are not adequately reflected in the basket. This will cause an upwards bias in the inflation rate. • CPI-U (urban) is used to adjust the notional for TIPS

  11. Personal Consumption Expenditures (PCE) • This covers all personal consumption in the US • Done via business surveys. • This is the main index that the Fed uses for targeting inflation.

  12. Explaining Inflation • Supply-Demand • The supply of money goes up. • The supply of goods goes down. • Demand for money goes down. • Demand for goods goes up.

  13. Explaining Inflation • Cost-Push • Rising costs compel businesses to raise prices • Wages • Raw materials • Demand-Pull • Increasing demand raises prices which then feeds back into workers demands for higher wages to compensate for the rising cost of living • Increase in the money supply • Increases in government purchases • Increases in prices in the rest of the world

  14. Inflation Expectations • Once inflation becomes embedded in an economy, businesses, workers, consumers etc all begin to expect it and build those expectations into their actions. • This creates an inflation momentum of its own • Workers may demand larger wage increases to pay for expected increases in the cost of living which in turn cause goods to become more expensive. • Can try to identify expectation through the prices of TIPs • But it is viewed that Insurance Companies have used TIPS to match long-term liabilities and thus have depressed yields and thus TIPs might underestimate inflation rates.

  15. Distinction Between Real and Nominal Interest Rates • Real interest rate • Interest rate that is adjusted for expected changes in the price level ir = i – pe • Real interest rate more accurately reflects true cost of borrowing • When the real rate is low, there are greater incentives to borrow and less to lend

  16. Distinction Between Real and Nominal Interest Rates • Real interest rate ir = i – pe We usually refer to this rate as the ex ante real rate of interest because it is adjusted for the expected level of inflation. After the fact, we can calculate the ex post real rate based on the observed level of inflation.

  17. U.S. Real and Nominal Interest Rates

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