Changing Times for Financial Institutions Chapter 1
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Transcript Changing Times for Financial Institutions Chapter 1
8-1
Interest Rates, Exchange Rates and
Inflation Theories and Forecasting
Chapter 8
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8-2
Part A: Theories of Interest
Rates
Interest Rates
•
•
•
A change causes an automatic market repricing of
all fixed interest obligations
Are altered as a major instrument of monetary policy
by central banks to direct the economy
Can be very volatile
Foreign Exchange Rates
•
•
A change alters international flows of both goods
and capital
Can be very volatile
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8-3
Theories Are Important to
Managers
Many decisions made on the basis of forecasts
Need to understand assumptions underlying
forecasts and data
Need to understand the reasons why the
assumptions are made
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8-4
A Historical Look at Interest
Rates
See Figures 8.1 and 8.2, pages 268-269
Interest Rates Are Constantly Changing and Have
Been Particularly Volatile in Recent Decades.
Interest Rates Generally Fall During Recessions
Interest Rates Incorporate the Real Rate of
Interest
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8-5
The General Level of
Interest Rates
Standard conventions
1. Models focus on the determination of the equilibrium
interest rate
◦ Economy is rarely in equilibrium
◦ Assumption is made that economy is always
moving toward equilibrium
2. Models use simplifying assumptions and hope that
critical factors are not omitted
3. Focus is on the rate of interest not differences in
rates among various securities
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8-6
Loanable Funds Theory
Interest rates are determined by supply and
demand of funds for investment
Assumes open and competitive money and capital
markets
Useful for forecasting
Market participant are borrowers and lenders
• Households or Consumers
• Businesses
• Governments
• The Central Bank
• The Foreign Sector
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8-7
Households as Suppliers
Time preference for consumption
Reward for saving is necessary
Cash balances may be held due to
• Transactions demand
• Precautionary demand
• Speculative demand
Savings necessary due to future needs
(e.g. illness, college fund, retirement)
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8-8
Business as Suppliers
More often demanders
Supply from business affected by
•
•
•
•
Available funds
◦ Depreciation
◦ Retained earnings
Investment options (real and financial)
Nature of the business
Management philosophy
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8-9
Other Supply Factors
The Money Supply
•
•
Changed by Federal Reserve System policy
An increase in the money supply increases funds
available for investment
The Foreign Sector
•
•
Funds are also supplied from participants in other
countries
Supply is affected by interest rates & economic
growth in the two countries and other factors
Governments
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8-10
The Demand for Loanable
Funds
Businesses and households will demand less
funds at higher interest rates
Demand by governments is inelastic with respect
to interest rates and due to budget deficits
Demand by the foreign sector is due to
• Same factors affecting domestic units
• Differences in U.S. rates and rates abroad
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8-11
SUPPLY OF LOANABLE FUNDS DEMAND FOR LOANABLE FUNDS
The supply of loanable funds
increases as the expected
interest rate increases.
The demand for loanable funds
decreases as the expected interest
rate increases.
0
SLF
Loanable Funds ($)
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(Business +Government + Foreign)
Interest Rate (%)
Interest Rate (%)
(Household + Business +M +
Foreign)
0
DLF
Loanable Funds ($)
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8-12
EQUILIBRIUM RATE OF INTEREST
The equilibrium level of interest rates is the rate at which the
quantity of loanable funds demanded equals the quantity of
loanable funds supplied.
Interest Rate (%)
SLF
I*
DLF
0
Q*
Loanable Funds ($)
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8-13
Loanable Funds Theory and
Interest Rate Forecasting
Changes in Supply or Demand can be caused by
•
•
Government Fiscal Policy (determined by Congress)
◦ Federal Budget Deficit
◦ Taxation
Government Monetary Policy (determined by the
Federal Reserve System
Supply and demand determine the equilibrium
interest rate (price) and equilibrium loanable
funds (quantity)
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8-14
SHIFTS IN THE DEMAND CURVE AND CHANGES
IN THE EQUILIBRIUM RATE OF INTEREST
If the demand for loanable funds increases, the equilibrium interest rate will increase.
If the demand for loanable funds decreases, the equilibrium interest rate will fall.
Lower DLF
SLF
I'
I*
DLF'
DLF
0
Loanable Funds ($)
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Interest Rate (%)
Interest Rate (%)
Higher DLF
SLF
I*
I'
DLF
DLF'
0
Loanable Funds ($)
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8-15
Inflation and New Financial
Innovations Due to Inflation
Variable rate loans
Variable rate deposits
Adjustable-rate bonds and mortgages
Zero-coupon bonds
Interest rate swaps
Inflation-adjusted Treasury securities
Inflation futures contracts
Other derivatives
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8-16
The Fisher Effect
Explains the relationship between
•
•
•
The nominal interest rate,
The real interest rate, and
Expected inflation
Inflation affects real purchasing power.
Investors will demand a higher interest rate (an
inflation premium) for expected lost purchasing
power over the period of an investment.
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8-17
The Fisher Effect
(1 + iN) = (1 + iR)(1 + Expected Inflation Rate)
iN = [(1+iR) )(1 + Expected Inflation Rate)] – 1
where
iN is the nominal interest rate demanded
iR is the real rate of return desired
If the real rate of return desired is 2% and
expected inflation is 12%, then the nominal rate
demanded is:
(1.02)(1.12) - 1 = .1424 or 14.24%
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8-18
Real Ex Post Return
The real ex post return that investors actually get is
given by:
iR = [( + iN)/(1 + Actual Inflation Rate)] – 1
If inflation turned out to be 12%, and the nominal
rate was 14.2%, the real ex post return would be:
(1.142)/(1.12) - 1 = .02 or 2%
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8-19
Expected Inflation Drives Changes
in Nominal Interest Rates
The Fisher effect approximation formula
eliminates the cross-products.
iN = iR + Expected Inflation
iR = iN – Expected Inflation
or iN = 2% + 12% = 14%
The Fisher effect assumes that the iR remains
unchanged.
Changes in nominal interest rates are driven by
changes in expected inflation.
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8-20
Expected Inflation and the
Loanable Funds Theory
Panel B: Inflationary
Expectations and the Real
Rate of Interest
Panel A: Inflation and the
Equilibrium Rate of Interest
SLF”
SLF
iN
E(INFL)
iR
DLF”
Interest Rate (%)
Interest Rate (%)
SLF”
SLF
iR
iR’
DLF”
DLF”
0
Q*
Loanable Funds ($)
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0
Q
Loanable Funds ($)
Q’
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8-21
Evaluation of the Fisher Effect
The theory is based on
• ex ante real rates
• ex ante expected inflation
These are not observable, resulting in
measurement problems in testing the theory.
Ex post real rates are not stable which suggests
that inflationary expectations by investors were
consistently incorrect.
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8-22
Further Evaluation of the Fisher
Theory
Historical Relationships
Measurement Problems
•
•
Historical Ex Post Analysis
Interest Rate Behavior Adjustments for Deflation?
Adjusting for the Tax Effect
Accuracy of Interest Rate Forecasting
Professional Forecasts Based on the Loanable
Funds Theory
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8-23
Adjusting for the Tax Effect
Income taxes are levied on nominal rather than on
real returns.
•
This suggests that changes in nominal yields will
actually be greater than that predicted by Fisher to
compensate for the tax on the inflation premiums.
The nominal rate adjusting for tax effects is
iN = [(1 + iR)(1 + Before-Tax Inflation Premium)] – 1
where
iN= the nominal return before taxes
iR = the real rate expected before taxes
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8-24
Calculating Effective Annual
Yields on Money Market Securities
Money Market Securities
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•
•
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Maturity less than one year
Generally sold at a discount
Maximum maturity is 360 days
If the yield is calculated in a 365 day year (to
compare yields with capital market securities, it is
the coupon equivalent yield
If the yield is calculated in a 360 day year, it is the
bank discount yield
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8-25
Coupon Equivalent Yield on
Money Market Securities
Par or (P1) - P0 365
y
P0
n
where:
P0 = the initial amount invested
Par = the par value at maturity
P1 = price received if sold before maturity
n = the number of days until maturity or sold
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8-26
Effective Annual Yield
365
Par (or P1) n
y
*
P0
1
The equation implicitly assumes that any money
received will be reinvested at the given annual
rate during the year, resulting in a higher
effective rate of return at the end of the year.
Hence, y* will be greater than y.
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8-27
Bank Discount Yield
Par - P0 360
d
P0
n
The yield on money market securities is quoted
as a percentage of par. Thus, discount yield (d)
will always be lower than the annual yield (y) or
the effective annual rate (y*).
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8-28
Purchase Price of Money
Market Securities
The purchase price of money market
securities is found by:
1- (d n)
P0 Par
360
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8-29
Find the price, the coupon equivalent yield
and the effective annual yield for a 91-day
T-bill with a discount yield of 4.425%.
Purchase price of the T-bill
(.04425)(9 1)
P0 100%1
98.8% of par
360
The price that must be paid for the T-bill with a
par value of $10,000 would be $9,888.10.
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8-30
Yield Calculations
Coupon equivalent (annual) yield for the T-bill
100% 98.881% 365
y
0.04539 or 4.539%
98.881%
91
The effective annual yield for the T-bill
100%
y
98.881%
*
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36591
1 .04618 or 4.618%
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8-31
Differences in Yields for Money
Market Securities
Calculating Yields for Negotiable CDs and Fed Funds
dn
P1 Amount Invested 1
360
where:
P1 = the amount received at maturity, equal to
interest earned at the quoted rate plus the
principal or amount invested
d = the quoted rate
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8-32
Find the effective annual yield on a 180-day
CD with a face value of $1 million and a
coupon rate of 3.5%.
Amount received at maturity
(.035)(180)
P1 $1 million 1
$1.0175 million
360
The effective annual yield on the CD
365
180
*
y 1.0175
.03581 or 3.581%
1
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8-33
Differences in Yields for Money
Market Securities
Default risk
Liquidity
Influenced by the size of the secondary
market for the particular security.
Denomination size
Maturity
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8-34
Part B: Currency Exchange Rates
Companies doing business in more than one
country face exchange rate risk
The risk that money will be lost solely through variations
in the exchange rate of the two currencies
Direct exchange rate – U.S. dollars per unit of
foreign currency
Indirect exchange rate – units of foreign currency
per U.S. dollar
Spot rate – rate for immediate currency exchange
Forward rate – rate for an exchange on a future
date agreed upon today
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8-35
Theories of Exchange Rate
Determination
Supply and Demand for Goods and Services
Floating Exchange Rates as Adjusters for
International Monetary Surpluses and Deficits
Relative Inflation Rates
Purchasing Power Parity Theorem
Relative Interest Rates
Interest Rate Parity Theorem
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8-36
Theories of Exchange Rate
Determination
Controlling Inflation for the Euro
•
•
•
Politics Changing the Fiscal Rules Underpinning the
Euro
A Complex Puzzle
The Role of Expectations
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