FInance
Chapter 3 Structure of interest rates
Structure of interest rates:
- Debt security yields
- Modeling the yield
- Term structure
Why debt security yields vary:
1) Credit (default) risk
a. Use of credit rating agencies to assess credit risk.
b. Credit rating and risk premiums over time.
c. Accuracy of credit ratings (opinions not guarantees).
d. Oversight of credit rating agencies.
2) Liquidity – securities with less liquidity must offer a higher yield
a. Debt securities with a short-term maturity or an act of secondary market have greater liquidity which is attractive.
3) Tax status
a. Investors are more concerned with after-tax income than with before-tax income carried on securities.
b. Taxable securities must offer a higher before-tax yield and due tax exempt securities.
c. Extra compensation required for taxable securities depends on the tax rates of individual and institutional investors.
i. Investors in higher tax brackets benefit most from tax exempt securities.
d. After tax yield: Yab = Ybt (1-T)
e. Before tax yield: Ybt = Yat / (1-T)
4) Term to maturity
Modeling the yield offered on a debt security
Determining the appropriate yield: Yn = Rf,n + CP + LP + TA
Term Structure
Term to maturity – three major theories
1) Pure expectation theory
a. Term structure of interest rates is determined solely by expectations of interest rates.
b. Assume investors are willing to invest in either short-term or long-term risk-free securities.
i. If investors believe that interest rates will rise in the near future, they’ll invest their funds mostly in the short-term securities, so that they can soon reinvest their funds and securities that offer higher yield after interest rates increase.
1. As the investor money moves into the short-term market, the supply curve of funds shifts to the right.
2. In the long-term market, the supply curve shifts to the left.
ii. Borrowers side: demand investor funds
1. Borrowers who plan to issue securities, and also expect the interest rates to increase, will want to lock in the present interest rate over a long period of time. (borrowers prefer to issue long-term securities, thus shifting the demand curve for investor funds to the left). also putting downward pressure on the yield of short-term funds.
2. The upward pressure on the yield of long-term funds causes the yield to increase.
a. SO, yields in long-term increase and yield in short-term decrease.
iii. Consider the impact of an expected decline in interest rates.
1. If investors expect interest rates to decrease in future, they’ll prefer to invest in long-term funds because they can lock into these higher rates before the interest rates fall.
a. Supply of funds into long-term market increases, shifting supply curve in long-term market to the right.
i. Take money out of short-term market, supply curve shifts right.
2. Borrowers on the other hand, will prefer to borrow short term funds so they can refinance at lower interest rates once they decline.
a. This increases the demand for lower rate financing and shifts the demand curve to the right (short-term)
i. The result of this is decreased demand for long-term.
b. SO, yield rates in short-term increase and yield rates in long-term decrease.
2) Liquidity premium theory
a. Shorter maturity represents greater liquidity.
i. So willing to hold long-term securities places an upward pressure on slope of yield curve.
3) Segmented market theory
Investors and borrowers choose securities with maturities that satisfy their forecasted cash needs.
a. Pension funds and life-insurance companies may generally prefer long-term investments that coincide with their long-term liabilities.
b. Commercial banks may prefers more short-term investments.
Overall:
1) Interest rates are expected to rise (expectations theory) suggest upward sloping yield curve “E.”
2) Borrowers need long-term funds; investors invest in short term (segmented markets) upward sloping yield “S.”
3) Investors prefer more liquidity (liquidity) “L”
The term structure of interest rates is used to:
1) Forecast interest rates.
2) Forecast recessions.
3) Make investment and finance decisions.
Chapter 5 Monetary Policy
Supply of money effects the economy.
Monetary policy
1) Inputs to determine monetary policy
2) Implementing a stimulative monetary policy
3) Implementing a restrictive monetary policy
4) Trade-offs in monetary policy
5) Monitoring the impact of monetary policy
6) Global monetary policy
Inputs to determine monetary policy:
Indicators of economic growth:
Because high economic growth rates creates a more prosperous economy and can result in lower unemployment.
1) GDP
2) National income
3) Unemployment rate
4) Index of leading economic indicators
Indicators of inflation:
1) Wage rates
2) Oil prices
3) Gold prices
4) Produce and consumer indexes
Stimulative monetary policy:
How a stimulative monetary policy reduces interest rates:
- If supply of loanable funds increase by 5 billion, the supply curve shifts outward (right), and equilibrium interest rate will decrease
- Once the interest rate declines, the level of business investments in new projects increases.
o This is because the lower interest rates results in a lower cost so more projects are possible.
- How lower interest rates increase business investments:
o Cost of financing is lower.
o The increase in business investment represents new business spending that can stimulate the economy.
- How lower interest rates lower the business cost of equity:
o Cost of equity is based on the risk-free rate plus a risk-free premium that reflects the sensitivity of the firm’s stock price movement to general market movements.
In summary, the Fed’s ability to stimulate the economy is due to its effects on the treasury, or risk-free rate, which reduces the cost of debt (borrowing) and the cost of equity.
therefore, reduces overall cost of capital. When cost of capital is reduced, its required return on its business investment is reduced. In turn, more of the possible projects that a firm considers will become feasible and will be implemented.
Why stimulative monetary policy might fail:
1) Not always possible to control long-term interest rates.
2) Limited credit provided by banks.
3) Low return on savings.
4) Adverse effects on inflation.
5) Lagged effects of monetary policy.
Restrictive monetary policy:
When Excessive inflation is the main concern, the Fed implements a restrictive monetary policy. results in a decrease of loanable funds and an increase of the market interest rates
- If loanable funds decrease by 5 billion dollars, this reflects an inward shift of the supply curve (left). In turn, the interest rate will increase.
- The higher interest rate level increases the corporate cost of financing new projects, and therefore, causes a decrease in the level of business investment.
- As economic growth is slowed by this reduction in business investment, inflationary pressure may be reduced.
Trade-off in monetary policy:
Ideally the fed would like to achieve both a low level of unemployment and a low level of inflation.
- The US unemployment rate should be low in a period when economic conditions are strong. Inflation will likely be relatively high at this time, because wages and price levels tend to increase when economic conditions are strong.
- Inflation may be lower when economic conditions are weak, but employment will be relatively high.
*** difficult to cure problems simultaneously.
The Fed’s assessment of the tradeoff between redeciding unemployment versus inflation becomes more complicated when fiscal policy is created.
Fiscal Policy:
Monetary policy is commonly influenced by the administrations fiscal policies.
- If fiscal policies create large budget deficits, this may place upward pressure on interest rates.
o These higher interest rates caused by the fiscal policy could dampen the economy. therefore they may feel pressure to use stimulative monetary policy to reduce interest rates.
- Fiscal policy typically shifts the demand and monetary policy has a larger impact on the supply of loanable funds.
Monitoring the effects of monetary policy:
- Households monitor the Fed because their loan rates and car mortgages will be affected.
- Firms monitor the fed because their cost of borrowing from loans and from issuing new bonds will be affected.
- The treasury monitors the Fed because its cost of financing the budget deficit will be affected.
Global monetary policy
- A weak dollar can stimulate US exports because it reduces the amount of foreign currency needed by foreign companies to obtain dollars to purchase US exports.
- A weak dollar also discourages US imports because it increases the dollars needed to obtain foreign currency to purchase imports. As a consequence, a weak dollar can stimulate the US economy.
- A strong dollar tends to reduce inflationary pressure, but also dampens the US economy.
- The Fed recognizes that economic conditions are integrated across countries so it considers prevailing global economic conditions when conducting monetary policy.
- When global economic conditions are strong, foreign countries purchase more US products and can stimulate the US economy.
- When global economic conditions are weak, the foreign demand for US products weakens.
- Each country has its own currency and its own interest rate, which is based on the supply and demand for loanable funds in that currency. Investors in one country may attempt to capitalize on high interest rates in another country.
- If an upward pressure on US interest rates could be offset by foreign inflows of funds, then the fed may not feel compelled to use a stimulative policy.
- However, if foreign investors reduce their investment in US securities, the Fed may be forced to intervene to prevent interest rates from rising.
- A governments budget deficit can affect interest rates in various countries. This concept is referred to as global crowding out.
- An increase in the US budget deficit causes an outward shift in the federal governments demand for US funds, and therefore in the aggregate demands for US.
- This crowding out effect forces the US interest rates to move up and as they rise they attract funds from investors in other countries. As foreign investors use more of their funds to invest in US securities, the supply of available funds in their repective countries declines.
o Consequently, there’s upward pressure on non-US interest rates as well.
DAD:
When interest rates goes down more people can borrow money and invest in their businesses that acts as a stimulus to the economy which leads to higher earnings and sales so the value of the stock will go up.
Supply and demand = inverse
Government demands loanable funds
Interest rates are higher in the US so they’ll invest in US to make more interest on their money.
Consequently, supply of funds goes down, when there’s less money in the country the rates goes up.
Unemployment rate increases because companies are hiring/investing less when the interest rates go up. People aren’t working and don’t have
Chapter 4