Transcript Chapter 2

Chapter 2
Money, Credit, and
the Determination
of Interest Rates
2-1
Chapter 2
Learning Objectives
Understand how the supply and
demand for money and credit affect
(and are affected by) the economy and
the general level of interest rates
 Understand how yields on individual
debt instruments are determined
 Understand why securities of different
maturities may have different yields
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Determining Interest
Rates
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LIQUIDITY EFFECT
Money supply goes up
 Demand for bonds goes up
 Interest rates go down
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INCOME EFFECT
Income goes up
 Demand for credit goes up
 Interest rates go up
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2-3
Yield Curves
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LIQUIDITY PREMIUM
 Premium paid for liquidity
SEGMENTED MARKETS
 Market divided into distinct segments
EXPECTATIONS THEORY
 Current rates are the average of expected future
rates
 The current two-year rate is the average of the
current one-year rate and the one-year rate a year
from now
The General Level of
Interest Rates
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Interest rate on an instrument reflects
general market rates and the risk of the
specific instrument
 Equation of Exchange
MV = PT
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M = money supply
V = stable velocity of circulation
P = passive price level
T = stable volume of trade
Fisher Equation
i=r+p
Risks In Real Estate
Finance
2-5
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DEFAULT RISK
 Risk that the borrower will not repay the mortgage
per the contract
CALLABILITY RISK
 Borrower may repay the debt before maturity
MATURITY RISK
 Other things held constant, the longer the
maturity the greater the change in value for a
given change in interest rates
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Risks In Real Estate
Finance
MARKETABILITY RISK
 Risk that the asset doesn’t trade in a large,
organized market
 INFLATION RISK
 Risk in loss of purchasing power
 INTEREST RATE RISK
 Risk of loss due to changes in market
interest rates
 Fixed-income assets are most susceptible
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The Yield Curve
Relates maturity and yield at the same point
in time
 Explaining the structure of the yield curve:
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Liquidity Premium Theory
Market Segmentation Theory
Expectations Theory – the long-term rate for some
period is the average of the short-term rates over
that period