IFM Chapter 4: Why Do Interest Rates Change?

Flashcards covering key concepts from IFM Chapter 4, including determinants of asset demand, supply and demand in the bond market, and changes in equilibrium interest rates.

Asset

A piece of property that is a store of value.

Wealth

The total resources owned by the individual, including all assets.

Expected Return

The return expected over the next period on one asset relative to alternative assets.

Risk

The degree of uncertainty associated with the return on one asset relative to alternative assets.

Liquidity

The ease and speed with which an asset can be turned into cash.

Impact of Increased Wealth on Asset Demand

When wealth increases, the quantity of assets demanded increases.

Expected Return on an Asset

Weighted average of all possible returns, where the weights are the probabilities of occurrence of that return

Rate of return on an asset

How much we gain (or lose) from holding that asset.

Change in Expected Returns Impact

If expected return on one asset increases relative to expected return on alternative assets, the quantity demanded increases.

Standard Deviation Formula for Risk

√(p1(R1 − Re)2 + p2(R2 − Re)2 + … + pn(Rn − Re)2)

Diversification

Holding of many risky assets in a portfolio, reduces the overall risk an investor faces.

Independent Securities

When one earns the high 15% return, the other earns the low 5% return and vice versa, giving the investor a return of 10% (equal to the expected return).

Liquidity Impact on Asset Demand

The more liquid an asset is relative to alternative assets, the more desirable it is, and the greater will be the quantity demanded.

Theory of Portfolio Choice

How much of an asset people want to hold in their portfolio.

Supply and Demand in the Bond Market

Examine how interest rates are determined from a demand and supply perspective.

Demand Curve

Shows the relationship between the quantity demanded and the price when all other economic variables are held constant.

YTM Formula

F - P / P

Supply Curve

Shows the relationship between the quantity supplied and the price when all other economic variables are held constant.

Market Equilibrium

The amount that people are willing to buy (demand) equals the amount that people are willing to sell (supply) at a given price.

Excess Supply

A situation in which the quantity of bonds supplied exceeds the quantity of bonds demanded.

Excess Demand

A situation in which the quantity of bonds demanded exceeds the quantity of bonds supplied.

Important Feature of Asset Market Approach

Supply and demand are always in terms of stocks (amounts at a given point in time) of assets, not in terms of flows (amounts per a given unit of time).

Movements Along a Demand (or Supply) Curve

Due to changes in price.

Shifts in a Demand (or Supply) Curve

Quantity demanded changes at each given price (or interest rate).

Fisher Effect

When expected inflation rises, interest rates will rise.

Practicing Manager

Many firms have economists or hire consultants to forecast interest rates.

Methods for forecasting

Use Flow of Funds Accounts and judgment or Econometric Models: large in scale, use interlocking equations that assume past financial relationships will hold in the future.

In making decisions about assets to hold (= to invest)

Forecast interest rates decreasing ⇒ buy long-term bonds or Forecast interest rates increasing ⇒ buy short-term bonds

In making decisions about how to borrow

Forecast interest rates decreasing ⇒ borrow on the short-term or Forecast interest rates increasing ⇒ borrow on the long-term