FACTORS DETERMINING THE LEVEL AND STRUCTURE OF INTEREST RATES

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FACTORS DETERMINING THE LEVEL AND STRUCTURE OF
INTEREST RATES
LECTURE 6
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• WHAT HAVE WE DONE AND WHERE ARE WE GOING ?

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WHAT WE HAVE DONE

• 1. DETERMINED THAT FUNDS MOVE
• FROM SURPLUS UNITS TO DEFICIT
• UNITS.
• PRIMARY SECURITIES MOVE FROM
• DEFICIT UNITS TO SURPLUS UNITS.
• SECONDARY SECURITIES MOVE
• FROM FINANCIAL INSTITUTIONS
• TO SURPLUS UNITS.

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WHAT WE HAVE DONE

• 2. DETERMINED THAT THE PRICE OF A SECURITY (BOND)
  IS THE PRESENT VALUE OF ITS FUTURE CASH FLOWS.
• MARKET YIELD (YIELD-TO-MATURITY) IS THAT RATE
  WHICH MAKES THE PRESENT VALUE OF A SECURITYS
  CASH FLOWS EQUAL TO ITS MARKET PRICE. MARKET
  YIELD IS THE RATE EMBEDDED IN A SECURITYS PRICE
  i.e., THE INTEREST RATE -- im .

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WHAT WE HAVE DONE

• 3. DETERMINED THAT INDIVIDUALS HOLD SECURITIES
  BASED ON WEALTH , EXPECTED RETURN ,RISK , AND
  LIQUIDITY.
• IF ONE OR MORE OF THESE FACTORS CHANGE , AN
  INDIVIDUALS DESIRED ASSET HOLDINGS WILL CHANGE.
• ASSET PRICES RESPOND TO NEW INFORMATION ABOUT THE
  FOUR DEMAND DETERMINANTS.

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WHERE ARE WE GOING ??

Loanable Funds Theory
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WE NEED TO DO

• 1. DESCRIBE HOW SECURITY PRICES AND YIELDS ARE
  DETERMINED.
• WHAT ARE THE MARKET FORCES THAT INTERACT TO
  DETERMINE THE LEVEL OF INTEREST RATES.
• 2. DESCRIBE HOW RISK PREMIUMS ARE DETERMINED.
• 3. DESCRIBE HOW INTEREST RATES AND EXCHANGE RATES
  ARE RELATED.

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Getting Started
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SECURITIES (BOND) AND LOANABLE FUNDS MARKETS
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SOURCES AND USES OF LOANABLE FUNDS

• SOURCE OR SUPPLY OF BONDS
• DEFICIT UNITS
• -- PRIVATE BUSINESS INVESTMENT
• -- GOVERNMENT SPENDING
• -- MONETARY SYSTEM SALE OF
• BONDS -- DECREASE IN MONEY
• SUPPLY

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SOURCES AND USES OF LOANABLE FUNDS

• SOURCE OR SUPPLY OF LOANABLE
• FUNDS
• -- NET SAVING BY HOUSEHOLDS
• -- DISHOARDING -- REDUCTION IN
• CASH BALANCES-- BY
• HOUSEHOLDS AND BUSINESSES
• -- INCREASE IN THE MONEY
• SUPPLY BY THE MONETARY
• SYSTEM

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SOURCES AND USES OF LOANABLE FUNDS

• DEMAND FOR BONDS
• -- PORTFOLIO HOLDINGS BY
• SURPLUS UNITS
• -- PURCHASES OF BONDS BY THE
• MONETARY SYSTEM -- INCREASE
• IN MONEY SUPPLY
• DEMAND FOR LOANABLE FUNDS
• -- INVESTMENT BY BUSINESSES
• -- GOVERNMENT SPENDING
• -- HOARDING -- INCREASE IN CASH
  BALANCES
• -- SALE OF BONDS- MON.SYSTEM

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Remainder
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EXAMPLE
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OVERVIEW OF LOANABLE FUNDS MARKET AND BOND
MARKET DIAGRAMS
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LOANABLE FUNDS MARKET

• SURPLUS MONETARY
  DEFICIT
• UNITS SYSTEM
  UNITS
• 
  SLF
• ilf
• 
  

SAVING

Ms
-MS
DISHOARHING
INVESTMENT HOARDING
DLF
Qlf
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BOND MARKET

• SURPLUS MONETARY DEFICIT
• SAVERS SYSTEM SAVERS

DEMAND FOR BONDS
SUPPLY OF BONDS
SB
MS
-MS
PB
Use Savings and Cash Balances to Purchase Bonds
DB
QB
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EQUILIBRIUM IN THE BOND / LOANABLE FUNDS MARKET
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BOND/LOANABLE FUNDS MARKET DIAGRAM

• DEMAND CURVE
• im RET (F-Pd ) / Pd 365/365
• (F-Pd ) / Pd
• HIGH PRICE / LOW YIELD
• (1000 - 950) / 950 .053 or 5.3
• LOW PRICE / HIGH YIELD
• (1000 - 750) / 750 .3333 or 33.3
• SUPPLY CURVE IS A FUNCTION OF MARKET YIELD

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BOND MARKET

EXCESS SUPPLY
SB
A
B
950 (5.3)
C
850 (17.6)
EXCESS DEMAND
D
E
750 (33.3)
DB
300
500
100
OF BONDS
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EQUILIBRIUM OR CLEARING IN THE BOND MARKET
EXCESS SUPPLY
SB
950
P850
AMOUNT OF LOANABLE FUNDS
DB
QUANTITY OF BONDS
0
500
100
300
Slf
EXCESS DEMAND
i 17.6
5.3
Dlf
QUANTITY OF LOANABLE FUNDS
255,000
95,000
475,000
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INCREASES IN THE DEMAND OF BONDS QB f ( W,
E(R), s , L )
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INCREASE IN THE DEMAND FOR BONDS
SLF1
SLF2
EXCESS DEMAND
SB

i1
EXCESS SUPPLY
P2
i2
P1
DB2
DB1
LF3
LF1
Q1
LF2
Q2
Q3
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INCREASE IN THE SUPPLY OF BONDS
DLF2
SLF

SB1
EXCESS SUPPLY
DLF1
SB2
EXCESS DEMAND
i2
P1
i1
P2
DB
Q1
Q2
LF1
LF2
Q3
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CROWDING-OUT IN THE LOANABLE FUNDS MARKET
Crowding-Out A reduction in private spending
caused by an increase in market interest rates
due to a rise in the Federal deficit financing.
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CROWDING-OUT EFFECT

SLF
i1
D (PRIVATE)
0
LF1
PRIVATE INVESTMENT
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CROWDING-OUT EFFECT

SLF
i1
D(PRIVATE PUBLIC)
D (PRIVATE)
0
LF1
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CROWDING-OUT EFFECT

SLF
GOVERNMENT DEFICIT
i1
D(PRIVATE PUBLIC)
D (PRIVATE)
0
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CROWDING-OUT EFFECT

SLF
GOVERNMENT DEFICIT
i2
i1
D(PRIVATE PUBLIC)
D (PRIVATE)
0
LF
LF1
LF0
NEW SAVINGS DISHOARDING
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CROWDING-OUT EFFECT

SLF
GOVERNMENT DEFICIT
i2
i1
?
D(PRIVATE PUBLIC)
D (PRIVATE)
0
LF
LF1
LF0
WHERE DOES THIS AMOUNT COME FROM ?
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CROWDING-OUT EFFECT

SLF
GOVERNMENT DEFICIT
i2
i1
D(PRIVATE PUBLIC)
D (PRIVATE)
0
LF
LF1
LF0
CROWDING-OUT OF PRIVATE INVESTMENT
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CROWDING-OUT EFFECT

SLF
GOVERNMENT DEFICIT
i2
i1
D(PRIVATE PUBLIC)
D (PRIVATE)
0
LF
LF1
LF0
CROWDING-OUT OF PRIVATE INVESTMENT
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CROWDING-OUT EFFECT

SLF
i2
i1
D (PRIVATE)
0
LF1
LF
NEW PRIVATE INVESTMENT
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CROWDING-OUT EFFECT

SLF
GOVERNMENT DEFICIT
i2
i1
D(PRIVATE PUBLIC)
D (PRIVATE)
0
LF3
LF1
LF2
NEW SAVINGS DISHOARDING
REDUCTION IN PRIVATE INVESTMENT
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ELASTICITY AND CROWDING-OUT EFFECT

SLF
i2
i1
D (PRIVATE)
0
LF1
LF
NEW PRIVATE INVESTMENT
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ELASTICITY AND CROWDING-OUT EFFECT

SLF
MORE INTEREST ELASTICITY
i2
i1
D (PRIVATE)
0
LF1
LF
NEW PRIVATE INVESTMENT
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FEDERAL DEFICIT AND MONETARY POLICY
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CROWDING-OUT AND FED INTERVENTION

(SAVINGS DISHOARDING)
SLF1
(SAVINGS DISHOARDING M)
SLF2
M
M CHANGE IN THE MONEY SUPPLY
EXCESS DEMAND FOR LOANABLE FUNDS
i
D( PRIVATE PUBLIC)
D(PRIVATE)
LF2
LF1
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Questions
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Questions
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Monetization of the Debt
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Small Open Economy
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INFLATION AND NOMINAL INTEREST RATES THE FISHER
EQUATION
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EXAMPLE

• ASSUME THAT INFLATIONARY EXPECTATIONS WERE ZERO
  TO START WITH-- AT PERIOD 1 -- THEN PEOPLE GET
  NEW INFORMATION WHICH CAUSES THEM TO EXPECT
  PRICES TO INCREASE.
• i r ( P / P) r
  ( P / P )

NOMINAL INTEREST RATE
REAL INTEREST RATE
COMMODITY PRICE LEVEL
ADJUSTMENT FOR THE LOSS OF THE REAL VALUE OF
INTEREST PAYMENTS
ADJUSTMENT FOR THE LOSS OF THE REAL VALUE OF
PRINCIPAL
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EXAMPLE

• EXAMPLE OF A CHANGE IN INFLATIONARY EXPECTATIONS
  ON BOND PRICES.
• ASSUME FIRST THAT ( P / P ) 0 ,
• i r
• LET THE REQUIRED REAL RATE r 10 ,
• SUPPOSE YOU PURCHASE A ONE YEAR ,
• 10 COUPON BOND FOR 1000 .
• BOND PRICE ( 100 1000)/ 1.10
• 1000

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EXAMPLE

• NOW SUPPOSE THAT YOU EXPECT INFLATION TO INCREASE
  OVER THE YEAR SO THAT ( P / P ) 5 . WHAT
  NOMINAL RATE MUST YOU EARN TO REALIZE A 10 REAL
  RATE ? WHAT PRICE WOULD YOU OFFER FOR THE BOND ?
• i r ( P / P ) r ( P /P )
• .10 .05 .10(.05) .155 or 15.5
• BOND PRICE ( 100 1000) / 1.155 952.38
• r .155 - .05 - .10(.05) .10 or 10

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INFLATIONARY EXPECTATION AND INTEREST RATES
DUE TO A REDUCTION IN THE REAL VALUE OF
PRINCIPAL AND INTEREST
SLF2
SLF1
i2 15.5
INFLATION PREMIUM
5.5
DUE TO A REDUCTION IN THE REAL BURDEN OF DEBT
DLF2
DLF1
r i1 10
LF
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NEWSPAPER HEADLINE
How Do You Interpret This Headline?
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THREE INTEREST RATE EFFECTS

• A CHANGE IN THE MONEY SUPPLY PRODUCES THREE
  INTEREST RATE EFFECTS
• 1. LIQUIDITY EFFECT -- IMMEDIATE
• IMPACT
• 2. INCOME EFFECT -- INTERMEDIATE
• IMPACT
• 3. PRICE EXPECTATIONS EFFECT--
• LONGER-RUN EFFECT

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THREE INTEREST RATE EFFECTS
i1
TIME
LIQUIDITY EFFECT
INCOME AND EXPECTATIONS EFFECTS
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THREE REMAINING ASPECTS OF THE INTEREST RATE
DISCUSSION

• 1. WHAT HAPPENS TO THE LEVEL OF
• INTEREST RATES OVER THE
• BUSINESS CYCLE ? CYCLICAL
• PATTERN ISSUE .
• 2. WHAT IS THE MATURITY
• STRUCTURE OF INTEREST RATES ?
• TERM STRUCTURE ISSUE
• 3. HOW IS THE DEFAULT RISK
• PREMIUM DETERMINED?

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CYCLICAL BEHAVIOR OF INTEREST RATES

• DURING PERIODS OF ECONOMIC OF EXPANSION
• 1. THE DEMAND FOR LOANBLE FUNDS
• GROWS RAPIDLY
• 2. INFLATIONARY PRESSURES TEND TO
• INCREASE AND
• 3. THE FED TRYS TO RESTRICT THE
• AVAILABILITY OF CREDIT.

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DURING A BUSINESS RECESSION
CYCLICAL BEHAVIOR OF INTEREST RATES

• 1. THE DEMAND FOR LOANABLE FUNDS
• FALLS
• 2. INFLATIONARY PRESSURES DIMINISH
• AND
• 3. THE FED TRYS TO INCREASE THE
• SUPPLY OF LOANBLE FUNDS .

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TERM STRUCTURE OF INTEREST RATES
Yield Curve
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TERM STRUCTURE OF INTEREST RATES
Yield Curve
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TYPES OF YIELD CURVES

SPOT RATE
im SPOT RATE
im
DESCENDING YIELD CURVE
ASCENDING YIELD CURVE
MATURITY
MATURITY
im SPOT RATE
HUMPED YIELD CURVE
im SPOT RATE
FLAT YIELD CURVE
MATURITY
MATURITY
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CONCEPT OF RISK ASSOCIATED WITH THE MATURITY
STRUCTURE OF INTEREST RATES

• ASSUME A HOLDING TIME OF
  TWO PERIODS t 2 .

HOLDING PERIOD
t 2
t 1
t 0
ROLL-OVER AT t 1
REINVESTMENT RISK
MATURITY OF BOND PURCHASED
t 1
t 2
t 0
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• 2

SELL AT THE END OF t 2
MARKET PRICE RISK
MATURITY OF BOND PURCHSED
t 3
t 1
t 0
t 2
PURCHASE BOND OF EXACT MATURITY
RISKLESS SITUATION -NO MATURITY RISK
t 2
t 0
t 1
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THEORIES OF THE TERM STRUCTURE

• 1. SEGMENTED MARKET APPROACH
• 2. UNBIASED EXPECTATIONS APPROACH
• 3. PRFERRED HABITAT /LIQUIDITY PREMIUM APPROACH

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RELATIONSHIP AMONG THE THREE APPROACH

• 1

SEGMENRED MARKET APPROACH
UNBIASED EXPECTATION APPROACH
PREFERRED HABITAT/ LIQUIDITY PREMIUM APPROACH
THEORETICAL APPROACH
MATURITY RISK AVERSION
INDIFFERENT TO RISK
SOME DEGREE OF RISK AVERSION
COMPLETELY RISK AVERSE
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RELATIONSHIP AMONG THE THREE APPROACH

• 2

MATURITY RISK PREMIUM

0
gt
gt
EXTREMELY RISKY
NO RISK PREMIUM
RISK PREMIUM POSITIVE
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UNBIASED EXPECTATIONS APPROACH

• 
  TERM ONE-YEAR
• EXPECTED
  STRUCTURE EXPECTED RATE
• YEAR ONE-YEAR (SPOT
  RATE) IN YEAR t
• 1 2.0 2.0
  2.0
• 2 3.0
  ------ ------
• 3 4.0
  ------ ------
• 4 5.0
  ------ ------
• 5 6.0
  ------ ------

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UNBIASED EXPECTATIONS APPROACH

• 
  TERM ONE-YEAR
• EXPECTED
  STRUCTURE EXPECTED
• YEAR ONE-YEAR (SPOT RATE)
  IN YEAR t
• 1 2.0
  2.0 2.0
• 2 3.0
  2.5 ------
• 3 4.0
  ------ ------
• 4 5.0
  ------ ------
• 5 6.0
  ------ ------

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UNBIASED EXPECTATIONS APPROACH

• 
  TERM ONE-YEAR
• EXPECTED
  STRUCTURE EXPECTED YEAR ONE-YEAR
  RATE (SPOT RATE) IN YEAR t
• 1 2.0
  2.0 2.0
• 2 3.0
  2.5 ------
• 3 4.0
  3.0 ------
• 4 5.0
  ------ ------
• 5 6.0
  ------ ------

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UNBIASED EXPECTATIONS APPROACH

• 
  TERM ONE-YEAR
• EXPECTED
  STRUCTURE EXPECTED
• YEAR ONE-YEAR RATE (SPOT RATE)
  IN YEAR t
• 1 2.0
  2.0 2.0
• 2 3.0
  2.5 ------
• 3 4.0
  3.0 ------
• 4 5.0
  3.5 ------
• 5 6.0
  ------
  ------

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UNBIASED EXPECTATIONS APPROACH

• 
  TERM ONE-
• EXPECTED
  STRUCTURE EXPECTED
• YEAR ONE-YEAR RATE (SPOT
  RATE) IN YEAR t
• 1 2.0
  2.0 2.0
• 2 3.0
  2.5 ------
• 3 4.0
  3.0 ------
• 4 5.0
  3.5 ------
• 5 6.0
  4.0 ------

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TERM STRUCTURE IS KNOWN

• 
  TERM ONE-YEAR
• EXPECTED
  STRUCTURE EXPECTED YEAR
  ONE-YEAR (SPOT RATE) IN YEAR
  t
• 1 2.0
  2.0 2.0
• 2 3.0
  2.5 ------
• 3 4.0
  3.0 ------
• 4 5.0
  3.5 ------
• 5 6.0
  4.0 ------

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HOW TO FIND THE EXPECTED ONE - YEAR RATE FROM THE
TERM STRUCTURE

• ( 2.0 X) / 2 2.5
• 2.0 X 2 ( 2.5 ) 5.0
• X 5.0 - 2.0
• X 3.0
• (2.0 3.0 X ) / 3 3.0
• X ?
  

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TERM STRUCTURE IS KNOWN

• 
  TERM ONE-YEAR
• EXPECTED
  STRUCTURE EXPECTED RATE
• YEAR ONE-YEAR (SPOT
  RATE) IN YEAR t
• 1 2.0 2.0
  2.0
• 2 3.0 2.5
  3.0
• 3 4.0 3.0
  ------
• 4 5.0 3.5
  ------
• 5 6.0 4.0
  ------

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TERM STRUCTURE IS KNOWN

• 
  TERM ONE-YEAR
• EXPECTED
  STRUCTURE EXPECTED RATE
• YEAR ONE-YEAR (SPOT
  RATE) IN YEAR t
• 1 2.0 2.0
  2.0
• 2 3.0 2.5
  3.0
• 3 4.0 3.0
  4.0
• 4 5.0 3.5
  ------
• 5 6.0 4.0
  ------

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TERM STRUCTURE IS KNOWN

• 
  TERM ONE-YEAR
• EXPECTED
  STRUCTURE EXPECTED RATE
• YEAR ONE-YEAR (SPOT
  RATE) IN YEAR t
• 1 2.0 2.0
  2.0
• 2 3.0 2.5
  3.0
• 3 4.0 3.0
  4.0
• 4 5.0 3.5
  ---?---
• 5 6.0 4.0
  ---?---

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EXPECTATION THEORY EXAMPLE 1

• ASSUME A FLAT YIELD CURVE. THEN SUPPOSE INVESTORS
  GET NEW INFORMATION THAT MAKES THEM ANTICIPATE A
  RISE IN MARKET RATES IN THE FUTURE. BASED ON THIS
  NEW INFORMATION BORROWERS AND LENDERS WILL CHANGE
  THEIR PORTFOLIO CHOICES BETWEEN SHORT-TERM AND
  LONG-TERM BONDS.

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EXPECTATION THEORY EXAMPLE 1

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EXPECTATION THEORY EXAMPLE 1

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EXPECTATION THEORY EXAMPLE 1

SHORT-TERM MARKET
LONG-TERM MARKET
SL
SL
SS
SPOT RATE
SPOT RATE
SS
IL2
IS1
IL1
IS2
DL
DL
DS
DS
LFL2
LFL1
LFS1
LFS2
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EXPECTATION THEORY EXAMPLE 1

I1
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EXPECTATION THEORY EXAMPLE 1

I1
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EXPECTATIONS THEORY EXAMPLE 2

• ASSUME A FLAT YIELD CURVE. THEN SUPPOSE
  INVESTORS, DUE TO NEW INFORMATION, COME TO
  ANTICIPATE A DECLINE IN INTEREST RATES IN THE
  FUTURE. THIS CHANGE IN EXPECTATION S CAUSES
  INVESTORS TO CHANGE THE COMPOSITION OF THEIR
  PORTFOLIOS BETWEEN SHORT -TERM AND LONG -TERM
  SECURITIES.

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EXPECTATIONS THEORY EXAMPLE 2

SHORT-TERM MARKET
LONG-TERM MARKET
SL
SS
SPOT RATE
SPOT RATE
IS1
IL1
DL
DS
LFL1
LFS1
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EXPECTATIONS THEORY EXAMPLE 2

SHORT-TERM MARKET
LONG-TERM MARKET
SS
SL
SS
SL
SPOT RATE
SPOT RATE
IS1
IL1
DL
DS
LFL1
LFS1
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EXPECTATIONS THEORY EXAMPLE 2

SHORT-TERM MARKET
LONG-TERM MARKET
SPOT RATE
SS
SL
SS
SPOT RATE
SL
IS2
IS1
IL1
IL2
DS
DL
DS
DL
LFL1
LFS1
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EXPECTATIONS THEORY EXAMPLE 2

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EXPECTATIONS THEORY EXAMPLE 2

SPOT RATES
FLAT YIELD CURVE
TIME TO MATURITY
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PREFERRED HABITAT THEORY LIQUIDITY PREMIUM

• THIS APPROACH IS REFERRED TO AS
  THE BIASED FORWARD
• RATE THEORY.

SPOT RATE
EXPECTATIONS YIELD CURVE
TIME TO MATURITY
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PREFERRED HABITAT THEORY LIQUIDITY PREMIUM

• THIS APPROACH IS REFERRED TO AS THE BIASED
  FORWARD RATE THEORY.

SPOT RATE
LIQUIDITY PREMIUM
EXPECTATIONS YIELD CURVE
TIME TO MATURITY
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PREFERRED HABITAT THEORY LIQUIDITY PREMIUM

• THIS APPROACH IS REFERRED TO AS THE BIASED
  FORWARD RATE THEORY.

Actual or Unbiased Yield Curve
SPOT RATE
LIQUIDITY PREMIUM
EXPECTATIONS YIELD CURVE
TIME TO MATURITY
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PREFERRED HABITAT THEORY LIQUIDITY PREMIUM
SPOT RATE
DESCENDING YIELD CURVE
ACTUAL YIELD CURVE
UNBIASED EXPECTED RATES
LIQUIDITY PREMIUM
TIME TO MATURITY
ASCENDING YIELD CURVE
SPOT RATE
ACTUAL YIELD CURVE
UNBIASED EXPECTED RATES
LIQUIDITY PREMIUM
TIME TO MATURITY
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SEGMENTED MARKET APPROACH AN EXAMPLE

• UNDER THE SEGMENTED MARKET APPROACH , WHAT
  HAPPENS IF THE TREASURY RETIRES 10 BILLION OF
  SHORT-TERM DEBT BY ISSUING LONG-TERM DEBT.
• THE SEGMENTED MARKET APPROACH WOULD PREDICT AN
  INCREASE IN LONG-TERM RATES RELATIVE TO
  SHORT-TERM RATES --THE EXPECTATIONS APPROACH
  WOULD PREDICT NO CHANGE .

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SEGMENTED MARKET APPROACH AN EXAMPLE
LONG-TERM MARKET
SHORT-TERM MARKET
SS
SHORT SPOT RATES
LONG SPOT RATES
SL
IS1
IL1
DS
DL
LFL1
LFS1
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SEGMENTED MARKET APPROACH AN EXAMPLE
LONG-TERM MARKET
SHORT-TERM MARKET
SHORT SPOT RATES
SS
LONG SPOT RATES
SL
DS
IL2
IS1
IL1
IS2
DS
DL
LF2
LFL1
LFS1
LFS2
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DEFAULT RISK PREMIUM
Default Risk Premium Risky Rate minus Riskless
Rate
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DEFAULT RISK PREMIUM
RISKY MARKET
DEFAULT-FREE MARKET
Sd1
Sr1
Ir1
Id1
Dd1
Dr1
LF1
LF1
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DEFAULT RISK PREMIUM
RISKY MARKET
DEFAULT-FREE MARKET
Sd1
Sr1
Ir1
Id1
Dd1
Dr1
LF1
LF1
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DEFAULT RISK PREMIUM
RISKY MARKET
DEFAULT-FREE MARKET
Sd1
Sr1
Ir1
DEFAULT RISK PREMIUM
Id1
Dd1
Dr1
LF1
LF1
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NEW INFORMATION FLOWS INTO THE MARKET A SUMMARY

• 1. INITIAL RISK PREMIUM IS EQUAL TO
  Ir1 - Id1 .
• 2. SUPPOSE THAT THERE IS AN ANNOUNCEMENT OF
  ADVERSE INFORMATION --NEW , UNANTICIPATED
  INFORMATION.
• 3.THEN THE RISK PREMIUM WILL CHANGE TO Ir2 - Id2
  .

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DEFAULT RISK PREMIUM
Sr2
RISKY MARKET
DEFAULT-FREE MARKET
Sd1
Sr1
Ir2
Sd2
Ir1
Id1
Id2
LF2
LF1
Dd1
Dr1
LF2
LF1
LF1
LF2
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DEFAULT RISK PREMIUM
101
DEFAULT RISK PREMIUM
RISKY MARKET
DEFAULT-FREE MARKET
Sr2
Sd1
Sr1
Ir2
Sd2
Ir1
DEFAULT RISK PREMIUM
Id1
Id2
Dd1
Dr1
LF2
LF2
LF1
LF1
102
SUMMARY OF INTEREST RATE COMPONENTS

• RISKLESS RATE RATE ON A DEFAULT -
• FREE BOND / U.S. GOVT BOND
• Id r ( P/ P ) r ( P/ P )
• RISKY RATE RATE ON CORPORATE
• ISSUES / BONDS OF PRIVATE
• CORPORATIONS.

REAL RATE
INFLATION PREMIUM
103
SUMMARY OF INTEREST RATE COMPONENTS

• RISKY RATE
• ??????r??? r ( ?P/ P ) r ( ?P/ P ) ?

INDUSTRIAL PRODUCTION
RISK PREMIUM
CYCLICAL BEHAVIOR OF THE DEFAULT RISK PREMIUM
TIME
t1
t2
?
TIME
t2
t1
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We Made It !
LOANABLE FUNDS THEORY
105
Quiz
106
According to the unbiased expectations approach
to the term structure, if the expected one period
rates for the next four years are 4, 5, 3, and
2, then the current four year spot rate is
4.50
4.75
3.50
2
107
INCORRECT!!!
Try Again
108
CORRECT
Next Question
109
Surplus savers are _______ of bonds.
suppliers
demanders
Neither suppliers or demanders
110
INCORRECT!!!
Try Again
111
CORRECT
Next Question
112
Deficit savers are _______ of loanable funds.
suppliers
demanders
Neither suppliers or demanders
113
INCORRECT!!!
Try Again
114
CORRECT
Next Question
115
According to the Fisher Equation, if the real
rate is 4 and the expected rate of inflation is
6, the nominal interest rate should be
2.0
4.6
6.4
10.24
116
INCORRECT!!!
Try Again
117
CORRECT
Next Question
118
According to the expectations approach to the
term structure of the interest rates, at the peak
of the rate cycle, the yield curve is likely to
be
ascending.
descending
flat.
backward bending.
119
INCORRECT!!!
Try Again
120
CORRECT
Next Question
121
The bond demand curve slopes down because
interest rates decline as bond prices decline.
when bond prices are low, inflation is low.
the lender is willing and able to purchase more
bonds when the price of the bond is low.
the borrower is willing and able to purchase more
bonds when the price of the bond is low.
122
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123
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124
Loanable funds refers to
only those funds loaned from one bank to another.
only those funds loaned to banks by the Federal
Reserve.
only those funds loaned by banks to private
individuals.
all those funds changing hands between lenders
and borrowers in the bond market.
125
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126
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127
The supply curve of loanable funds slopes up
because
at higher bond prices more loanable funds will be
supplied.
a decrease in the interest rate makes lenders
more willing and able to supply more funds.
an increase in the interest rate makes lenders
more willing and able to supply more funds.
higher interest rates reduce the inflation rate.
128
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129
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130
If the equilibrium price in the bond market for a
one-year discount bond is 9200, then the
equilibrium interest rate in the loanable funds
market must be
8.0
8.7.
9.2.
10.0
131
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132
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133
If there is an excess supply of loanable funds at
a given interest rate, then
the price of bonds will fall.
the price of bonds will rise.
the interest rate will rise.
the price of bonds may rise or fall depending
upon the reasons for the excess supply of
loanable funds.
134
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135
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136
As wealth increases in the economy, we would
expect to observe
bond prices and interest rates both rise.
bond prices and interest rates both fall.
bond prices rise and interest rates fall.
bond prices fall and interest rates rise.
137
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138
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139
In an effort to increase government revenue,
Congress and the president decide to increase the
corporate profits tax. The likely result will be
the supply curve for bonds shifts to the right.
the demand curve for loanable funds shifts to the
left.
the equilibrium interest rate rises.
the equilibrium price of bonds falls.
140
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141
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142
If the federal government decreases its purchases
and doesnt decrease taxes, the bond supply
schedule shifts to the
left and the equilibrium interest rate rises.
left and the equilibrium interest rate falls.
right and the equilibrium interest rate rises.
right and the equilibrium interest rate falls.
143
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144
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145
In an open economy, desired domestic lending
must equal desired domestic borrowing.
is always greater than desired domestic borrowing.
is always less than desired domestic borrowing.
must equal desired domestic borrowing plus the
amount of international lending.
146
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147
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148
The world real interest rate is
set annually by a special commission at the
United Nations.
set annually by a special commission at the
International Monetary Fund.
determined in the international capital market.
determined daily on the New York Stock Exchange.
149
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150
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151
Default risk
is the probability that a borrower will not pay
in full the promised interest and/or principal.
exists only for the bonds of small corporations.
is also known as market risk.
is zero for bonds issued by cities and states.
152
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153
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154
The term structure is usually defined with to
yields on which securities?
Corporate bonds
Commercial paper
U.S. Treasury securities
Municipal bonds
155
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156
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157
The segmented markets theory
explains upward-sloping yield curves as resulting
from the demand for long-term bonds being high
relative to the demand for short-term bonds.
explains upward-sloping yield curves as resulting
from the demand for long-term bonds being low
relative to the demand for short-term bonds.
explains upward-sloping yield curves as resulting
from the favorable tax treatment of long-term
bonds.
is unable to account for upward-sloping yield
curves.
158
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159
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160
The expectations theory suggests that
the yield curve should normally be upward sloping.
the yield curve should normally be downward
sloping.
the slope of the yield curve depends on the
expected future path of short-term rates.
the slope of the yield curve reflects the risk
premium incorporated into the yields on
long-term bonds.
161
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162
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163
The key assumption of the preferred habitat
theory is that investors
investors prefer longer to shorter maturities.
investors prefer shorter to longer maturities.
investors are indifferent between short and long
maturities.
investors are more interested in the tax
treatment of bonds than they are in the liquidity
of bonds.
164
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165
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166
If a one-year bond currently yields 5 and is
expected to yield 7 next year, the preferred
habitattheory predicts that the yield today on a
two-year bond will be
5
less than 6 but more than 5
6.
more than 6.
167
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168
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