Chp 6: Interest Rates

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Production Opportunities

Back 1

The investment opportunities in productive(cash generating) assets.

Front 2

Time Preference for Consumption

Back 2

The preferences of consumers for current consumption as opposed to saving for future consumption.

Is dependent on:

1. Rate of return that producers expect to earn on invested capital

2. Savers time preferences for current versus future consumption

3. Riskiness of a loan

4. expected future rate of inflation

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Risk

Back 3

In a financial market context, the chance that an investment will provide a low or negative return

Front 4

Inflation

Back 4

The amount by which prices increase over time.

Front 5

Interest rate paid to savers depends on:

Back 5

1. Rate of return that producers expect to earn on invested capital

2. Savers' time preferences for current versus future consumption

3. Riskiness of loan

4. Expected future rate of inflation

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r*("r-star)

Back 6

The real risk-free rate of interest; rate that would exist on a riskless security in a world where no inflation was expected.

Is not static, changes based on:

1. the rate of return that corporations and other borrowers expect to earn on productive assets

2. people's time preferences for current versus future consumption

3. Best forecast for its future value is its current value because it changes in response to things that change randomly, such as changes in demographics and the economy.

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IP

Back 7

Inflation premium; average expected rate of inflation over the life of the security; expected future inflation rate not necessarily equal to current inflation rate

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DRP

Back 8

Default Risk premium; reflects the possibility that the issuer will not pay the promised interest or principal at the state time; difference between the interest rate on a U.S. Treasury bond and a corporate bond of equal maturity and marketability.

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LP

Back 9

Liquidity(or marketability) premium; Charged by lenders to reflect the fact that some securities cannot be converted to cash on short notice at a reasonable price.

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MRP

Back 10

Maturity risk premium; longer-term bonds are exposed to a significant risk of price declines due to increases in inflation and interest rates.

A premium that reflects interest rate risk.

1. varies somewhat over time, rising when interest rates are more volatile and uncertain, and then falling when interest rates are more stable

2. Long-term bonds heavily exposed to interest rate risk, while short-term bonds exposed to reinvestment risk.

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Nominal, (Quoted) Risk-Free Rate(rRF)

Back 11

The rate of interest on a security that is free of all risk; proxied by the T-bill rate or the T-bond rate; includes an inflation premium.

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Bond Ratings

Back 12

A grade(AAA to C) given to bonds that reflects their credit quality.

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Real Assets

Back 13

Physical or tangible assets(such as precious, commodities, real estate, agricultural land and oil) have value due to their substance and properties.

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Financial Assets

Back 14

An asset that derives value from contractual claims, such as stock, bonds, and bank deposits.

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Volume of Trade

Back 15

Total quantity of future contracts bought and sold during a trading day.

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Future Contracts

Back 16

A contract made on the trading floor of a futures exchange, to buy or sell a particular commodity or financial instrument at pre-determined price in the future.

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Futures Exchange

Back 17

A central financial exchange where people can trade standardized future contracts.

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Financial Instruments

Back 18

Are tradable assets of any kind; Can be cash, evidence of ownership interest of an entity, or a contractual right to receive or deliver cash or another financial instrument.

Ex: Stocks and bonds

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Active market

Back 19

A market for a security with a high trading volume.

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Interest Rate Risk

Back 20

The risk of capital losses to which investors are exposed because of changing interest rates.

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Reinvestment Rate Risk

Back 21

The risk that a decline in interest rates will lead to lower income when bonds mature and funds are reinvested.

Front 22

Term structure of interest rates

Back 22

Relationship between bond yields and maturities; Relationship between long- and short-term rates.

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Yield Curve

Back 23

Graph showing the relationship between bond yields and maturities

Corporate yield curves generally higher than treasury security curves because they include DRP and higher LRP.

Riskier corporations have bonds with higher yield curves.

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Humped

Back 24

Intermediate term rates were higher than either short- or long-term rates.

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Normal yield curve

Back 25

An upward-sloping yield curve; historically long-term rates are generally above short-term rates because of maturity risk premium

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Abnormal yield curve

Back 26

A downward-sloping yield curve

When short-term rates are higher than long-term rates

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Humped yield curve

Back 27

A yield curve where interest rates on intermediate-term maturities are higher than rates on both short- and long-term maturities.

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Pure Expectations Theory

Back 28

A theory that states that the shape of the yield curve depends on investor's expectations about future interest rates.

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Interest Rate levels

Back 29

1. Borrowers bid for available debt capital using interest rates

2. Most profitable firms pay the most capital and attract it away from inefficient firms with products not in demand

3. Government policy can also influence the allocation of capitals and the level of interest rates.

4. Most capital is allocated through the price system, where the interest rate is the price.

5. Supply curve is upward sloping, indicating that investors are willing to supply more capital at higher interest rates.

6. Demand curve is downward sloping, indicating that borrowers are willing to borrow more at lower interest rates.

7. Interest rate of market is where demand and supply curve intersect.

8. Investors are willing to accept relatively higher risk in another market for a risk premium.

9. If supply of funds is increased in a market, supply curve will shift to the right, and market interest rate will decrease.

10. If supply of funds decrease, interest rates will increase.

11. There are many interconnected capital markets in the U.S.

12. There is a price for each type of capital, and these prices changes as supply and demand conditions change.

13. When economy is expanding, firms demand more capital, thus increasing interest rates.

14. Inflationary pressures exert upward pressure on rates.

15. Interest rates will vary in the future and increase with an increase in inflation and decrease with a decrease in inflation.

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Corporate Bond Yield Spread

Back 30

Corporate bond yield-treasury bond yield= DRPt

+LPt

Corporate bonds' default and liquidity risks are affected by their maturities.

Short-term bonds are more liquid than long-term bonds, which means their LP is lower.

spread between corporate bonds and treasury bonds is larger the longer the maturity, which occurs because longer-term corporate bonds have more default and liquidity risk than shorter-term bonds and both of these premiums are absent in treasury bonds.

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Macroeconomic factors that influence interest rate levels

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1. Federal reserve policy

2. The federal budget deficit or surplus

3. international factors, including the foreign trade balance and interest rates in other countries

4. level of business activity

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Federal Reserve policy

Back 32

1. Fed controls money supply, which has a significant effect on the level of economic activity, inflation, and interest rates

2. Fed stimulates the economy by increasing money supply; buys and sells short-term securities

3. Larger money initially leads to lower short-term rates, but might lead to an increase in expected future inflation, which would cause long-term rates to rise even as short-term rates fell.

4. Fed has delicate balancing act of promoting economic growth while controlling inflation

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Federal Budget deficits or surpluses

Back 33

1. When federal government spends more than it takes in, it runs a deficit, which is covered by additional borrowing

2. When the government borrows, this increases the demand for funds, which pushes up interest rates.

3. The larger the federal deficit, the higher the level of interest rates.

4. Government printing money increases inflation, which increases interest rates.

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Foreign trade deficit

Back 34

The situation that exists when a country imports more than it exports; generally means borrowing from nations with export surpluses

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International factors

Back 35

1. The larger the trade deficit, the higher the tendency to borrow.

2. U.S. rates dependent on other rates in the world

3. Interdependence makes it harder for the fed to control the U.S. economy through monetary policy

4. Higher or lower interest rates abroad lead to higher or lower U.S. rates.

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Business Activity

Back 36

Short term rates decline more sharply than long-term rates during a recession because:

1. Fed mainly operates in the short-term, so its intervention has the strongest effect there.

2. Long-term rates reflect the average expected inflation over the next 20 to 30 years.