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Economics, Money Markets and Banking Lecture 5 Yield Curves and Interest Forecasts

Economics, Money Markets and Banking Lecture 5 Yield Curves and Interest Forecasts. Yield Curve (Term Structure of Interest Rates) Basics 1. What is the Yield Curve? • Interest rates on financial instruments vary because of default risk, liquidity risk, call provisions, etc.

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Economics, Money Markets and Banking Lecture 5 Yield Curves and Interest Forecasts

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  1. Economics, Money Markets and Banking Lecture 5 Yield Curves and Interest Forecasts

  2. Yield Curve (Term Structure of Interest Rates) Basics • 1. What is the Yield Curve? • • Interest rates on financial instruments vary because of default risk, liquidity risk, call provisions, etc. • • Holding all the above constant, it also appears rates vary because of maturity. The relationship between interest rates and maturity, all else fixed, is called the term structure of interest rates or the yield curve. • • Where do we find the yield curve? • • Typical yield curve.

  3. Note: downward sloping when rates high Flatter when rates moderate Upward sloping when rates low

  4. Determinants of the Yield Curve Shape • A. Segmented Markets View: independent markets • i S i S • .10 • D D Short-term funds Long-term funds • Players: Fed Banks Insurance/pension companies • Instruments: T-bills, commercial paper Mortgages, bonds, note

  5. • Implied Yield Curve i .10 • • 1 30 maturity • Operation Twist (early 1960’s) To raise short rates and lower long rates Fed was to sell bills and buy bonds. .12

  6. • Implied Yield Curve i .10 1 30 maturity • Operation Twist (early 1960’s) To raise short rates and lower long rates Fed was to sell bills and buy bonds. Fed sold T-bills from its portfolio. This should lower T-bill prices and raise short term rates. Fed then purchased long term Treasury Securities, trying to drive long term debt prices up, and long rates down. .12 • • • .08 •

  7. Pure Expectations View (sometimes called the Rational Expectations View) • Example: Suppose an investor has a two-year time horizon (holding period). Suppose further that 1-year and 2-year deposits exist. Suppose further that the current 1-year rates is 4% and the depositor thinks the 1-year rate one year from now will be 10%. What rate would you have to offer to get this depositor to put money in a 2-year deposit. • • What does the depositor expect to make on two 1-year deposits? (Let’s ignore compounding). • First year return + expected second year return • .04 + .10 = .14 = 14%

  8. • What would seller of 2-year deposit have to offer to attract a buyer? R2 + R2 = .14 2 R2 = .14 R2 = .07 = 7%

  9. Implications for Yield Curve • • Example shows that the 2-year rate will end up being roughly the average of the current 1-year rate and the expected 1-year rate, i.e., • • This implies that the yield curve is drawn for some market expectation of short-term rates in the future. • i • Yield curve given the • .07 • Market thinks the 1-year • rate next year is going to be • .04 • 10% • 1 2 maturity * • * What if This Doesn’t Hold ? • If R2 < 7, nobody will buy 2yr Bonds. Price will fall, rate will increase • If R2 > 7, everybody will buy 2yr Bonds. Price will Rise, rate will fall

  10. • This implies that the “expected” future direction of rates is embedded in the yield curve. To see this, what if the market thinks the 1-year rate next year will be 4% or 20%? I .12 • If 1-year rate next year expected to be 20% .07 • If 1-year rate next year expected to be 10% .04 •• If 1-year rate next year expected to be 4% .03 •If 1-year rate next year expected to be 2% 1 2 maturity

  11. Conclusion (compare to picture of typical yield curve)

  12.  Formal yield curve forecasts Let Ri = current known rate from the WSJ on i period Investments tFi = forward rates = markets’ guess of rate on i period investments, t periods from now  Then, 2R2 = R1 + 1F1 (invest in a 2 yr, or two 1 yrs) 3R3 = R1 + 21F2 (invest in a 3 yr, or a one and a two) 3R3 = 2R2 + 2F1 (invest in a 3 yr, or a two and a one) Solutions

  13. Example Yield Curve on June 28, 2005 R1 = .0346 R2 = .0366 R3 = .0369 What does the market think the 1-year rate will be in July 2006? 2 R2 = R1 + 1F1 1F1 = 2 R2 - R1 = 2(.0366) - .0346 = .0386 Last year 1F1 = .0304 What does the market think the 1-year rate will be in July 2007? 3R3 = 2R2 + 2F1 2F1 = 3(.0369) - 2(.0366) = .0375

  14. Two Applications in Banking • Riding the yield curve • Loan interest swaps

  15. Yield Curve Games • A. Riding the Yield Curve for Fun and Profit • • Basic idea: Assuming a positively sloped yield curve, purchase a security with a maturity longer than your expected holding period. • • Rationale: You will make money because 1) longer maturities pay higher rates, 2) when you sell it in the security will have a shorter maturity, hence lower rates, hence a capital gain. • Yield • .07 • .04 • 1 2 maturity (years)

  16. • Example: You want to invest for 1 year. Current 1-year rate is 4%, 2-year rate is 7%. -- If you buy 1-year security make 4% -- If “ride,” price per dollar of face of 2-year security is .8734. If sell in one year when 1-year rate is 4%, get .9615

  17. • Will this work in an “efficient market”? -- What will you be able to sell the security at next year? The market expects the rate on 1- year securities to be 10%. This implies the price will be .9090. • NOTE: You will make money riding the yield curve as long as the 1-year rate next year turns out to be less than the market forecast. If the rate turns out to be more than the market forecast, you will lose money. The market forecast is a “breakeven” rate.

  18. What if 1 year rate next year ends up 14% !

  19. If positive, market overestimated what rates would be, i.e. rate ended up less than the market expected. Rates went up more than the market thought ! i.e got burned is you rode (markets underestimated inflation) Article recom -mands riding !

  20. LIBOR SWAPS Suppose the banker wants to receive variable rate interest, but the customer wants to pay fixed. Impasse! No Deal? Solution: Let the customer pay fixed, then swap the fixed for Libor (variable) in the interest swap market. The curve on the next page says the market will trade about 4% fixed for two years (4% fixed each year) for 3 month Libor each quarter for two years.

  21. How does the market come up with this tradeoff? (Let’s use annual Libor for simplicity) Then market will add a risk premium in case customer defaults.

  22. Real World Suppose a customer knows that the market typically overestimates short-term rates. In our example, suppose customer thinks rate next year on 1 year stuff is going to be 8%, not 10%. Then, they will prefer the variable to the fixed, because 4% + 8% < 7% + 7%. This is what is happening a lot in our local banks even though fixed rates are so low.

  23. Interest Forecasting • There are three ways to forecast interest rates. • Roll your own • Nominal rate = real rate + expected inflation • Forecast Real GDP Forecast inflation • Use implied forward rates • Look at the futures market • Suppose you (I) think a bushel of corn will sell for $100 a year from now. Would you agree now to sell it to me then for less than $100? Would I agree to pay more than $100 ? • So, the price will end up being close to our “best” guess of the price. • Same is true for the t-bills, fed funds, bonds.

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