Money Banking Exam 1

The term structure of interest rates is used to:

1) To forecast interest rates: The yield curve can be used to determine the market's expectations of future interest rates. An upward-sloping yield curve means there is an expectation of higher interest rates, while a downward-sloping yield curve means there is an expectation of lower interest rates. 2) To forecast recessions: Some analysts believe that flat or inverted yield curves indicate a recession in the near future. This is because of decrease in loanable funds which suggests expectations of a weak economy. 3) To make investment and financing decisions: Market participants can compare their own expectations to the market's expectations in order to determine their borrowing or investing decisions. If the yield curve is upward sloping, some investors may attempt to benefit from the higher yields on longer-term securities even though they have funds to invest for only a short period of time. The secondary market allows investors to implement this strategy, which is known as riding the yield curve.

Explain why interest rates tend to decrease during recessionary periods.

During a recession, firms and consumers reduce their amount of borrowing. The demand for loanable funds decreases and interest rates decrease as a result.

Loanable Funds Theory

Suggests that the market interest rate is determined by the factors that control supply of and demand for loanable funds

Nominal interest payments help savers in 2 ways:

1) They compensate for a saver's reduced purchasing power 2) They provide an additional premium to savers for declining present consumption. Savers are willing to forgo consumption only if they receive a premium on their savings above the anticipated rate of inflation.

Segmented Markets Theory:

A theory that long and short-term interest rates are not related to each other. Interest rates for short, intermediate, and long-term bonds should be viewed separately like items in different markets for debt securities. This is because investors and borrowers choose securities maturities that satisfy their future cash needs. Ex. commercial banks want more short term(for their short term liabilities), pension funds and life insurance companies may want long term (for their long term liabilities) Consequently, since investors and borrowers participate only in the maturity market that satisfies their particular needs, then markets are segmented. The choice of long-term versus short-term maturities is determined more by investors' needs than by their expectations of future interest rates. Ex: 1) Most investors have funds available to invest for only a short period of time and therefore desire to invest primarily in short-term securities. Also assume that most borrowers need funds for a long period of time and therefore desire to issue mostly long-term securities. The result will be downward pressure on the yield of short-term securities and upward pressure on the yield of long-term securities. Overall, the scenario described would create an upward- sloping yield curve. 2) Now consider the opposite scenario in which most investors wish to invest their funds for a long period of time while most borrowers need funds for only a short period of time. According to segmented markets theory, this situation will cause upward pressure on the yield of short- term securities and downward pressure on the yield of long-term securities. If the supply of funds provided by investors and the demand for funds by borrowers were better balanced between the short-term and long-term markets, the yields of short-and long-term securities would be more similar. So : The yields of securities with various maturities should be influenced in part by the desires of investors and borrowers to participate in the maturity market that best satisfies their needs.

Identify the relevant characteristics of any security that can affect the security's yield:

Credit (Default) Risk: The yield of a security can depend on the extent of it's risk measured by the creditworthiness of it's issuers. Creditworthiness of an issuer can be measured by the investor or by a credit rating company. The higher the risk or the lower a security is rated, a higher yield will need to be added on to entice investors. An investor may take on a higher risk security because it's yield could ultimately compensate for it. Liquidity: The yield of a security can also depend on the extent of it's liquidity. Investors want to know that they can turn their security into cash as quickly and as easily as possible, with no loss in value. Securities with less liquidity will have to offer higher yields to entice investors. Some investors who may not need so much liquidity, may take on less liquid securities of receive a slightly higher return. Tax Status: The yield of a security can also depend on whether the the different tax regulation associated with them. Investors are more concerned with after tax income. They may calculate their after tax yield by subtracting the investors marginal tax rate from the before tax yield times 1. Taxable securities will offer higher before-tax yields than tax-exempt securities. Term Maturity: The yield of a security will also depend on the length of time it takes the security to mature. The longer it takes for the security to reach maturity, the higher the yield will need to be to entice investors. This is because investors may feel they can better predict what will occur in one year rather than ten. Consequently, the security with the nearest maturity date holds the least amount of risk.

Forecasting Interest Rates. Why do forecasts of interest rates differ among experts?

Forecasts of interest rates differ among experts because it is almost impossible to accurately predict the direction of unpredictable interest rates. Various factors may influence interest rates, and changes in these factors will affect interest rate movements. Experts disagree about how various factors will change. They also disagree about the specific influence these factors have on interest rates. Some analysts believe that when the net demand is either positive or negative, a disequilibrium will occur. When the net demand is positive interest rates will adjust upward, and when the net demand is negative, interest rates will adjust downward. Alternatively, other analysts choose to forecast by studying the changes in aggregate demand and supply. Despite the different methods used by analysts to forecast interest rates, there are a large number of economic variables that ultimately influence the net demand for loanable funds. This makes it very difficult to give a truly accurate prediction.

Nominal versus Real Interest Rate. What is the difference between the nominal interest rate and real interest rate? What is the logic behind the implied positive relationship between expected inflation and nominal interest rates?

Generally, interest rates refer to the cost that a borrower pays to be able to borrow money from a credit. In other words it is the rate of return that a creditor receives when lending money and the rate that a borrower pays when borrowing money. There are however two key types of interest rates. The nominal interest rate is the stated or quoted interest rate of a bond/coupon that does not account for inflation. For example if a bond/coupon's interest rate is 6%, then the nominal interest rate would also be 6%. Alternatively, the real interest rate considers the impact of inflation. This is because fluctuations of the inflation rate significantly change the cost of borrowing money (as mentioned in the previous answer.) The real interest rate ultimately reflects the accurate cost of borrowing money and the actual yield for lenders. According to Fisher's theory, the real interest rate is found by subtracting the inflation rate from the nominal rate. So: Real interest rate = Nominal interest rate - inflation rate. Real interest rates will fall as inflation increases unless the nominal rate increases the same as the inflation rate. When the real interest rate is positive, an investor knows he's beating inflation. Alternatively if the rate is negative then the nominal rate being charged on a loan or paid on a savings account is not beating inflation and loosing money.

Should increasing money supply growth place upward or downward pressure on interest rates?

If one believes that higher money supply growth will not cause inflationary expectations, the additional supply of funds places downward pressure on interest rates. However, if one believes that inflation expectations do erupt as a result, demand for loanable funds will also increase, and interest rates could increase (if the increase in demand more than offsets the increase in supply).

Liquidity Premium Theory. Explain the liquidity premium theory.

Investors prefer to keep their money liquid as cash. They demand interest payments in return for giving out their money. They will pay more for short term debt because it is more liquid. They will also demand higher interest rates for longer term debts. They will demand higher premiums on medium term and long term securities rather than short securities. For example, they may choose between a between a 3 year treasury note at 1% interest (most liquidity), a 10 year treasury note at 3% interest, and a 30 year bond at 4% interest (least liquidity.) The longer of a term a security has, the less liquid it is, and the most sensitive to insert rates it becomes. The preference for short term liquid securities puts upward pressure on the slope of a yield curve. Liquidity may be more desirable to investors at some times more than others. This means the liquidity premium will change over time and cause the yield curve to change too.

Explain the loanable funds theory by deriving demand and supply schedules for loanable funds.

Savings provides a supply of loanable funds and demand is provided by the desire of individuals and businesses who invest through borrowing. The loanable funds market follows the general law of supply and demand, where an increase in supply leads to lower interest rates and demand remains unchanged. An increase in demand leads to increased interest rates and supply remains unchanged. The market price for interest rates will reach equilibrium and stabilize, where supply of loanable funds equals the demand for them.

Pure Expectations Theory

The term structure of interest rates (as reflected in the shape of the yield curve) is determined solely by expectations of interest rates. Impact of an Expected Increase in Interest Rates: When investors believe interest rates will rise, they buy up as much short term securities so they can later reinvest their funds at higher yields once interest rates increase. Flooding the short term market and avoiding the log term market means the large supply of funds i short term markets will push annualized yields down, while the reduced supply of long term funds will push yields up. While his makes short term yields lower than long term yields, investors are still satisfied because they expect interest rates to rise. They will make up for the lower short-term yield when the short-term securities mature, and they reinvest at a higher rate (if interest rates rise) at maturity. Supply of funds by INVESTORS: downward pressure on short term yields, upward pressure on long term yields. Borrowers planning to issue securities are also expecting interest rates to increase. They would rather issue long term securities than short term to lock in the present interest rate. This gives a downward pressure on the yield of short term funds. There is a corresponding increase in the demand for long term funds by borrowers which places upward pressure on long term funds. Demand for bunds by borrowers: upward pressure on short term yields, downward pressure on long term yields. Overall: The expectation of higher interest rates changes the demand for funds and the supply of funds in different maturity markets, which forces the original flat yield curve (labeled YC1 in the two rightmost graphs) to pivot upward (counterclockwise) and become upward sloping (YC2). Impact of an Expected Decrease in Interest Rates: If investors expect interest rates to decrease in the future, they will prefer to invest in long-term funds rather than short-term funds because they could lock in today's interest rate before interest rates fall. Borrowers will prefer to borrow short-term funds so that they can refinance at a lower interest rate once interest rates decline The supply of funds provided by investors will be low for short-term funds and high for long-term funds. Supply of funds by INVESTORS: Upward pressure on short term yields, long term markets, downward pressure on yields. Demand for funds by borrowers: downward pressure on short term yields, upward pressure on long term yields.

3 Key Theories to explain Term structure:

Pure Expectations Theory Liquidity Premium theory Segmented Markets Theory

Explain the Fischer Effect, and tie it in with the Loanable Funds Theory by explaining how inflation affects the demand and supply schedules for loanable funds.

The Fisher Effect is a theory of interest rate determination, that describes the relationship between the inflation rate, and the nominal interest rate. For example, lets say I lend someone $100 with a 10% interest rate, however the inflation rate is also 10%. At the end of the year, I get paid back $110, however because of inflation money has become less valuable, and a good that had cost $100 last year, costs $110 this year. So technically, my real return is 0. The Fisher Effect states that the real interest rate =nominal rate - inflation rate. So if I had expected the inflation rate to be 10%, then in order to get a real return of 5%, I should have charged a 15% nominal rate. The Fisher Effect observes that nominal interest rates will ultimately rise with expected inflation rates. Interest rates and expected inflation rates move together. Inflation affects the demand and supply schedule for loanable funds because it puts upward pressure on interest rates by shifting supply of funds inward and demand for funds outward.

Impact of Government Spending. If the federal government planned to expand the space program, how might this affect interest rates?

The impact that increased spending for the space program would have on interest rates can be related to the crowding out effect. According to the textbook, the U.S. government is a major demander for loanable funds, despite the fact that their spending exceeds tax revenue. If the federal government planned to expand the space program, it would need to increase it's budget which would require more borrowing. The loanable funds theory indicates that the market interest rate is determined by factors controlling the supply and demand for loanable funds. The increase in demand for loanable funds would ultimately cause interest rates to rise. Since the federal government is interest inelastic, it is more willing to borrow despite interest rates. Alternatively, the private sector, which is interest elastic would not be as willing to demand loanable funds.

Impact of the Economy. Explain how the expected interest rate in one year depends on your expectation of economic growth and inflation.

The interest rate in the future should increase if economic growth and inflation are expected to rise, or decrease if economic growth and inflation are expected to decline. There are two key factors that can impact the expected interest rate in one year. First is the impact of economic growth. When changes in economic conditions occur, they can either increase or decrease the demand for loanable funds. When businesses think that economic conditions will improve, they both increase their budgets for future projects, and plan more projects. With such a high outlook on the future, these companies are willing to demand more loanable funds and take on more interest payments. According to the loanable funds theory, this will cause demand to exceed equilibrium and cause interest rates to rise. Alternatively, during economic slow downs, the demand for loanable funds will be under the equilibrium and cause interest rates to also decrease. The second key factor that can impact the expected interest rate in one year is inflation. When inflation is low, suppliers or lenders of lovable funds know that the money they get back in installments will be as valuable as the money they lend out. Consequently, interest rates remain low. Alternatively, in times of high inflation suppliers or lenders must charge more for their loans because they fear increasing inflation will mean the money they get back will be less valuable. They must increase interest rates to protect themselves so they may continue to supply funds.

What factors influence the Yield Curve?

The yield curve is influenced by the demand and supply for securities. The demand and supply is impacted by the expectation of future interest rates, the desire for liquidity, and the desire for segments of securities.

Describe how financial market participants use the yield curve.

Financial market participants can use the yield curve in three key ways: To forecast interest rates: The yield curve can be used to determine the market's expectations of future interest rates. An upward-sloping yield curve means there is an expectation of higher interest rates, while a downward-sloping yield curve means there is an expectation of lower interest rates. To forecast recessions: Some analysts believe that flat or inverted yield curves indicate a recession in the near future. This is because of decrease in loanable funds which suggests expectations of a weak economy. To make investment and financing decisions: Market participants can compare their own expectations to the market's expectations in order to determine their borrowing or investing decisions. If the yield curve is upward sloping, some investors may attempt to benefit from the higher yields on longer-term securities even though they have funds to invest for only a short period of time. The secondary market allows investors to implement this strategy, which is known as riding the yield curve.

Interest Elasticity. Explain what is meant by interest elasticity. Would you expect federal government demand for loanable funds to be more or less interest-elastic than household demand for loanable funds? Why?

Interest elasticity is the kind of response that demanders for loanable funds may have to a change in interest rates. The response would be elastic if a fall in the interest rate caused the demand for loanable funds to rise (the demand is inverse to the interest rate.) Alternatively, the response would be interest inelastic if fall in the interest rate caused the demand to also increase. The level of sensitivity that these loanable fund demanders have, determines the extent of interest elasticity. It is expected that the federal government's demand for loanable funds would be less interest elastic than the household sector. According to the textbook, The federal government's expenditure and tax policies are generally thought to be independent of interest rates aka interest inelastic. Further, the federal government will likely maintain it's long term planned projects regardless of an increased interest rate. Alternatively, the household sector should be much more interest elastic, as they may choose to postpone until interest rates decrease. The household sector ultimately maintains an inverse relationship between interest rates and the demand for loanable funds and there will be a higher demand for loanable funds at lower interest rates.

Provide additional application (especially current events) one at a time to help illustrate how events can affect the demand and supply schedules, and therefore influence interest rates.

There are a number of events that can affect the demand and supply schedules and thus influence interest rates. Economic growth: Puts upward pressure on interest rates by shifting demand for loanable funds outward. Economic Slowdown:A slowdown in the economy will cause the demand curve to shift inward (to the left), reflecting less demand for loanable funds at any given interest rate. Inflation: Puts upward pressure on interest rates by shifting supply of funds inward and demand for funds outward. Monetary Policy/money supply: When the Fed reduces the money supply, it reduces the supply of loanable funds, putting upward pressure on interest rates. Alternatively when the Fed increases the money supply, it increases the supply of loanable funds, putting downward pressure on interest rates. Budget deficit: The government is a major demander for laoandcble funds despite the fact that they have a budget deficit (their spending exceeds tax revenue.) A new project would require more spending and mean an increase in budget deficit, and more borrowing. An increase in demand for loanable funds would cause interest rates to rise. However, since the federal government is interest inelastic, it is more willing to borrow despite interest rates. Alternatively, the private sector, which is interest elastic would not be as willing to demand loanable funds. This is called crowding out. Given a certain amount of loanable funds supplied to the market, excessive government demand for funds tends to "crowd out" the private demand for funds Foreign interest rates: The interest rate for a certain currency is determined by the demand for funds in that currency and the supply of funds available in that currency. Economic conditions are the primary forces behind a change in the supply and demand schedules. The demand for funds in the United States is indirectly affected by U.S. monetary and fiscal policies because these policies influence economic growth and inflation, which in turn affect business demand for funds. Fiscal policy determines the budget deficit and therefore determines the federal government demand for funds. In conclusion: These factors can have a strong impact on the aggregate supply of funds and/or the aggregate demand for funds and can thereby affect the equilibrium interest rate. In particular, economic growth has a strong influence on the demand for loanable funds, and changes in the money supply have a strong impact on the supply of loanable funds.

Explain how forecasts of interest rates are needed to make financial decisions, which require forecasts of shifts in the demand and supply schedules for loanable funds.

To forecast future interest rates, the net demand for funds (ND) should be forecast: ND= Da-Ds (demand of: household+businesses+municipal gov+federal gov+foreign minus supply of household+businesses+municipal gov+federal gov+foreign) If the forecasted level of ND is positive or negative, then a disequilibrium will exist temporarily. If ND is positive, the disequilibrium will be corrected by an upward adjustment in interest rates; if ND is negative, the disequilibrium will be corrected by a downward adjustment. The larger the forecasted magnitude of ND, the larger the adjustment in interest rates.