. Interest rates
. The determinants of interest rates
. Term structure of interest rates and yield curves
. What determines the shape of yield curves
. Other factors
. Interest rates
Cost of borrowing money
Factors that affect cost of money:
Production opportunities
Time preference for consumption
Risk
Inflation
. The determinants of interest rates
The quoted (nominal) interest rate on a debt security is composed of a real risk-free rate, r*, plus several risk premiums
Risk premium: additional return to compensate for additional risk
Quoted nominal return = r = r* + IP + DRP + MRP + LP
where, r = the quoted, or nominal rate on a given security
r* = real risk-free rate
IP = inflation premium (the average expected rate of inflation over the life
time of the security)
DRP = default risk premium
MRP = maturity risk premium
LP = liquidity premium
and r* + IP = rRF = nominal risk-free rate (T-bill rate)
. Term structure of interest rates and yield curves
Term structure of interest rates: the relationship between yields and maturities
Yield curve: a graph showing the relationship between yields and maturities
Normal yield curve (upward sloping)
Abnormal yield curve (downward sloping)
Humped yield curve (interest rates on medium-term maturities are higher than
both short-term and long-term maturities)
Term to maturity - Interest rate Interest rate (%)
1 year 0.4%
5 years 2.4%
10 years 3.7%
30 years 4.6%
. What determines the shape of yield curves?
Term structure theories
(1) Expectation theory: the shape of the yield curve depends on investor’s expectations about future interest rates (inflation rates)
Forward rate: a future interest rate implied in the current interest rates
For example, a one-year T-bond yields 5% and a two-year T-bond yields 5.5%, then the investors expect to yield 6% for the T-bond in the second year.
(1+5.5%)2 = (1+5%)(1+X), solve for X(forward rate) = 6.00238%
Approximation: (5.5%)*2 - 5% = 6%
(2) Liquidity preference theory: other things constant, investors prefer to make short-term loans, therefore, they would like to lend short-term funds at lower rates
Implication: keeping other things constant, we should observe normal yield curves
. Other factors
Fed policy: money supply and interest rates
Increase in money supply lowers short-term interest rates and stimulates the economy but may lead to inflation in the future
Government budget deficit or surpluses: if government runs a huge deficit and the debt must be covered by additional borrowing, which increases the demand for funds and thus pushes up interest rates
International perspective: trade deficit, country risk, exchange rate risk
Business activity: during recession, demand for funds decreases; during expansion, demand for funds rises
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