Transcript Rate influences ppt

BA 580-Interest Rates
Breaking Down Market
Influences on Rates
Influences on Rates
Factors that influence all rates as well as
account for differences in rates
– Inflation
– Market forces on supply and demand for loans
(price of borrowing-lending)
Income growth & expectations (consumption;
business investment decisions)
Risk
Time
Inflation & Rates: Why Connected?
Inflation = change in purchasing power of $
– With 5% inflation for 1 year, lender receives dollars
worth $9500 on a 1-year $10,000 note
Nominal rates made up of price for borrowing
(real rate) plus premium for expected inflation
–
–
–
–
–
R = r + Pe
Implies 1:1 relationship between R and Pe
“Money Center” banks estimate Pe
Bond buyers/sellers incorporate formal & informal
Estimates by surveys of experts, guesses based on
recent history, or stat models e.g.
PI = 1 + 0.4*infl(-1 month) + 0.2*(-2 months) + 0.15*(-3
months)
Evidence on Inflation & Rates
Regression Evidence
R-Square indicates the % of the
changes in the given rate that
can be attributed to predicted
inflation
Slope indicates whether the
relationship is 1:1 – e.g.
0.95 means that the T-bill rate
goes up about .95% for each
1% increase in predicted
inflation
Rate= constant + slope*Predicted Inflation
Rate
Slope
R-Square
RFFUNDS
1.17
0.51
RTB3m
0.95
0.49
RCPR1M
1.01
0.41
RTB1Y
1.00
0.48
RTB10Y
0.77
0.37
RAAA
0.71
0.33
RBBB
0.80
0.33
Differences in Rates Due to Inflation
Predicted inflation more closely
related to and closer to 1:1 for short
term rates
Predicted Monthly Inflation & Rates (Fed Funds; 30-year Mortagage) 1960-2004
Market Influences on Real Rates
(Economy-Wide Level)
Analytics: risk; income growth; time
– Income growth influences demand & supply
– Timing of income growth influence a key
– Measuring economy wide risk
Bbb Rate – Aaa Rate
Risk Premium (Moody's Aaa - Bbb Rates) & Real GDP Growth
3.0
7
6
2.5
5
2.0
4
1.5
3
2
1.0
1
0.5
0
0.0
-1
60
65
70
75
Risk Premium
80
85
90
95
00
Real GDP Growth (smoothed)
Real Rate Movements
Real 10-year T-Bond Rate Movements
– Monthly data 1960-2004
TB10 Rate = 0.03* above avg. (3.1%) growth
+ 0.5*(Bbb – Aaa rate)
Implies 1% additional growth raises TB10 by 3 basis pts
Implies 1% additional risk premium raises TB10 by 5 basis pts
Market Influences on Real Rates
(Individual Business Loan Level)
Analytics: income potential (profitability) and risk
measures
– Profitability (Past-expected Return on Assets)
– Risk
Default-Credit (Debt/Equity, …)
Liquidity (ST assets/ST liabilities, …)
Term (length of loan)
Methods
– Simple: use thresholds
– Complex: use “scoring” or “likelihood” producing
statistical methods such as regression, discriminant
analysis, …
Why Rates Differ
Law of One Price
– Resale not limited by law or product
– Price Market A = Price Market B + cost difference
– Implies demand differences are not sufficient to sustain price
differences; cost difference (transport; storage; … and risk)
SF Fed Article link explains non-risk cost differentials
Loans of similar nature (risk) and time are very, very
closely related (see irates.xls)
Because Time (term of loan) is closely intertwined with
risk, it is a key reason that rates differ
Time & Rate Differences
R(short) = R(long) + cost differences
What costs/risks differ or may differ depending
on length of the loan?
– Inflation
– Income growth
Yield Curve – graph of rates over time
– Typically graphing loans that are similar except with
regard to length such as Treasury Yield Curve,
Corporate Aaa Yield Curve, …
Yield Curve Shape Changes with changes in
views about future inflation & income growth
Digging Into the Yield Curve
“Normal” Yield Curve – about a 2%
difference in 3-month & 10-year T-rates
Higher Inflation Expected Near Term?
– Flatter or even negative Yield Curve
Lower Income growth expected near
term?
– Flatter or even negative Yield curve
See website links (Living Yield Curve; NY
Fed for examples and current situation)
Digging into Yield Curve (con’t)
Difficulties in Interpreting Yield Curve
– Separating Inflation from other Influences
– Expectations are not always correct
Inflation-Indexed Treasury Securities
(TIPS) as way to separate out inflation part
of Yield Curve
– See forwardyields.xls for example