BUS 2203 - Chapter 5 & Chapter 6 Notes PDF

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Chapter 5 and Chapter 6 Notes for Principles of Finance 1....

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Chapter 5: The Economics of Interest-Rate Fluctuations 5.1: Interest Rate Fluctuations As a first approximation, what causes the interest rate to change?

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Interest rates change monthly, weekly, daily, and even, in some markets, by the nanosecond.

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Why “the” interest rate changes over time: o Simple price theory (supply and demand) o Theory of asset demand o The liquidity preference framework The above is all part of John Maynard Keynes work. ▪ Renowned early twentieth-century British economist The demand curve for bonds = slopes downward The supply curve = slopes upward

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The supply curve for bonds slopes upward because: o Price of bonds increases → Yield decreases → borrowers increase supply o Price of bonds decrease (fall) → Yield increases → borrowers decrease supply

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The demand curve for bonds slopes downward because: o Bond prices increase → Yield decreases → Demand decreases o Bond prices decrease → Yield increases → Demand increases

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The market price of a bond and the quantity that will be traded is determined by the equilibrium. o

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If the market price were temporarily greater than p* (equilibrium) → the quantity of bonds supplied would exceed the quantity demanded → Sellers of bonds would lower their asking price to the equilibrium point. Market price temporarily dipped below p* → the quantity demanded would exceed the quantity supplied → Investors would bid up the price of the bonds to the equilibrium point.

Bond market:  Supply increases → Supply curve shifts right → Prices decrease → Quantity increases → Interest rate increases  Supply decreases → Supply curve shifts left → Prices increase → Quantity decreases → Interest rate decreases  Demand decreases → Demand curve shifts left → Prices decrease → Quantity decreases → Interest rate increases  Demand increases → Demand curve shifts right → Prices increase → Quantity increases → Interest rate decreases

5.2: Shifts in Supply and Demand for Bonds What causes the supply and demand for bonds to shift?

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Wealth determines the overall demand for assets.

❖ Asset: Something owned; is any store of value. o Financial assets ▪ Money ▪ loans (for the lender) ▪ bonds ▪ equities (stocks) ▪ a potpourri of derivatives o Non-financial assets ▪ Real estate → Land, buildings ▪ Precious metals → Gold, silver, platinum ▪ Gems → Diamonds, rubies, emeralds ▪ Hydrocarbons → Oil, natural gas ▪ All other physical goods (to a greater or lesser extent, depending on their qualities) •

As wealth increases → Quantity demand increases (though to different degrees)

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When determining which assets to hold, investors take the following 3 variables into account: o Expected relative return o Risk o Liquidity

❖ Expected relative return: The belief that the return on one asset will be higher than the returns of other comparable (in terms of risk and liquidity) assets. o Return is a good thing, of course, so as expected relative return increases, the quantity demanded of an asset also increases. o Two major factors will affect return expectations and the demand for certain financial assets, like bonds: ▪ expected interest rates ▪ expected inflation. Interest rate is expected to increase for any reason (including expected increases in inflation) → bond prices are expected to fall → Quantity demanded will decrease Interest rate is expected to decrease for any reason (including the expected decrease in inflation) → bond prices are expected to rise → Quantity demanded will increase

❖ Risk: The uncertainty of an asset’s returns. Risk increases → Asset quantity demanded decreases.

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Default risk (aka credit risk): The chance that a financial contract will not be honored. Interest rate risk: The chance that the interest rate will rise and hence decrease a bond or loan’s price. Reinvestment risk (aka Offsetting risk): When the interest rate decreases because coupon or other interest payments have to be reinvested at a lower yield to maturity. Liquidity risk: Occurs when an asset cannot be sold as quickly or cheaply as expected. ▪ This is a serious risk because liquidity relative to other assets is the third major determinant of asset demand.

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Risks can be idiosyncratic o They can be pertinent to: ▪ A particular company ▪ Sectoral → An entire industry (Like trucking or restaurants) ▪ Systemic → Economy-wide

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The more liquid an asset is, the higher the quantity demanded.

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The demand curve for bonds shifts due to changes in: o Wealth o Expected relative returns Positively related to demand o Liquidity o Risk Inversely related to demand

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Wealth sets the general level of demand → Investors then trade off risk for returns and liquidity.

 Expansions → Increase demand for bonds → Demand curve shifts right → Increases bond prices → Decreases bond yields

Supply Three main variables that cause the supply to shift: •

Government budgets o Budget deficits - They borrow by selling their bonds. ▪ Budget Deficits → Shift supply curve right → Bond Prices decrease → Yield increases o

Budget Surpluses – Redeem and/or buy back their bonds on net. ▪ Budget Surplus → Shift supply curve left → Bond Prices increase → Yield decreases

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Inflation expectations o Expectations of higher inflation – Borrowers will issue more bonds ▪ Higher Inflation Expected → Supply Curve shifts right → Bond prices decrease → Yield increases. o

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Expectations of lower inflation ▪ Lower inflation expected → Supply curve shifts left → Bond prices increase → Yield decreases

General business conditions o Favorable Business conditions: Tax reduction, regulatory costs decrease or economy expansion. o Most economic entities borrow out of strength to finance expansion or engage in projects they believe will be profitable. o Favorable business conditions = Increased borrowing. ▪ Increased borrowing (sell/issue bonds) → Shift the supply curve right → Bond prices decrease → Yield increases. o Less favorable business conditions – Higher taxes, increased regulation costs, & recessions ▪ Decreased Borrowing (buy bonds) → Shift supply curve left → Bond prices increase → Yield decreases

 An expansion → Bond supply curve shifts right → Bond prices decrease → Interest rate increases •

The bond supply curve typically shifts much further than the bond demand curve. o Expansions = Interest rate rises o Recessions = Interest rates fall

5.3: Liquidity Preference In Keynes’s liquidity preference framework, what effects do inflation expectations and business expansions and recessions have on interest rates and why?

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In the model below: o There are two assets ▪ Money – Earns no interest. ▪ Bonds – Earns some interest greater than 0. o o o

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The markets for bonds and money are both in equilibrium. Vertical axis = Interest rate (not price) Vertical line = Money supply ▪ Slides left or right if monetary authority decreases or increases the money supply. ▪ Quantity supplied does not vary with changes in the interest rate. The supply of money is perfectly inelastic.

 Interest rate increases → Money/Quantity demand decreases → Money demand curve slopes down  Interest rate decreases → Money /Quantity demand increases → Money demand curve slopes up o Opportunity cost of holding bonds decreases. •

Intersection of the money supply and demand curves = The market rate of interest (Equilibrium rate)

 Interest rate exceeds the equilibrium rate → Quantity of money demanded < Quantity of money supplied → People use excess money to buy bonds → Bond prices increase → Bond Yield decreases → Move back to equilibrium

 Interest rates fall below the equilibrium rate → Quantity of money demanded > Quantity of money supplied → People sell bonds for money → Bond prices decrease → Bond yields increase → Moves back to equilib. •

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The equilibrium interest rate changes with movements of either curve. o

Money supply increases → Supply curve shifts rights → Interest rate decreases → More money to lend

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Money supply decreases → Supply curve shifts left → Interest rate increases → Less money to lend + Demand stays the same

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Money demand increases → Demand curve shifts right (money supply stays constant) → Interest rate increases

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Money demand decreases → Demand curve shifts left → Interest rate decreases

Money demand curve shifts for two major reasons: Income & Price level o Both are positively related to demand. ▪ Income/Price levels increase → Money demand increases → Money demand curve shifts right → Interest rates increase. o

Demand increases with income because: ▪ Money is an asset & demand for it increases with wealth. ▪ Economic entities transact more as income rises so more money is needed for payments. ▪ Inflation increases demand because people care about real balances.

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Price Level ▪ As price levels increase, the same amount of money cannot buy as much so more money is demanded. The money demand curve shifts right, and the interest rate increases. • Price levels increase → Money demand increases → Demand curve shifts right → Interest rate increases

5.4: Predictions and Effects How does the interest rate react to changes in the money supply?

❖ Liquidity Preference Framework: Predicts that increasing the money supply will decrease the interest rate. o This liquidity effect holds if all other factors remain the same. ▪ Factors include: • Income • Actual inflation • Expected inflation

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As the money supply increases = Interest rate falls

Government entities regulate the money supply. o They expand the money supply because it increases economic growth, employment, and incomes. o Expanding the money supply also causes prices to rise with no reversion to earlier levels.

Each of these three effects causes the interest rate to rise: o Income effect o Price level effect o Expected inflation effect  Money supply increases → Interest rates decrease → Liquidity effect battles the 3 countervailing effects.

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When the money supply increases (or increases faster than usual) = The liquidity effect wins out = The interest rate declines and stays below the previous level.

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In modern industrial economies with independent central banks: o The liquidity effect wins at first and the interest rate declines, but then incomes rise, inflation expectations increase, and the price level rises = The interest rate increases above the original level.

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In modern undeveloped countries with weak central banking institutions: o The expectation of inflation is so strong and so quick that it overwhelms the liquidity effect, driving up the interest rate immediately. o After incomes and the price level increases = The interest rate soars higher

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Under a commodity money system: o Such as the gold standard o Increase in the money supply → Decreases the interest rate o Decrease in the money supply → Increases the interest rate

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Under a floating or fiat money system (like we have today) o Increase in the money supply might induce interest rates to rise immediately if inflation expectations were strong or to rise with a lag as actual inflation took place.

Chapter 6: The Economics of Interest-Rate Spreads and Yield Curves 6.1: A Short History of Interest Rates How and why has the interest rate changed in the United States over time?

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Interest rate movements are highly correlated.

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Interest rates generally trended: o Downward from 1920 to 1945 ▪ 1920s: General business conditions were favorable → demand for bonds increased → demand curve shifted right → Increased prices → YTM decreased. ▪ 1930s: The Great Depression which dried up profit opportunities → shifted supply curve left → Bond prices increased → YTM decreased. ▪ Early 1940s: WW2; Govt used monetary policy to keep interest rates low. o

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Upward from 1946 until the early 1980s ▪ After WW2: America had its first ever inflation (“creeping inflation”). - Prices increased → Upward pressure on interest rates. ▪ 1970s: Unprecedented increase in prices (Creepy/Great inflation) → Nominal interest rates increased even higher. ▪ Early 1980s: The Federal Reserve mended its ways and brought inflation under control → interest rates started decreasing. Downward again from the early 1980s through to 2005 ▪ Late 1980s & Early 1990s: Positive geopolitical events (End of Cold War & Globalization) rendered the business climate more favorable → Interest rates decreased. • Demand curve shifts right → Bond prices increase → YTM decreases

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General business conditions were favorable → Bond Demand increased → Demand curve shifted right → Bond prices increased → YTM decreased.

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General business conditions were unfavorable → Profit opportunities for businesses dried up → Supply curve shifted left → Bond prices increased → YTM decreased.

6.2: Interest-Rate Determinants I: The Risk Structure What is the risk structure of interest rates and flight to quality, and what do they explain?

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Yields on Baa corporate bonds are always higher than the yields on Aaa corporate bonds, which in turn are higher than those on Treasury bonds (issued by the federal government), which for a long time have been higher still than those on munis (bonds issued by municipalities, like state and local governments).

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Bonds issued by the same economic entity (the U.S. government) with different maturities generally have different yields and the rank ordering changes over time.

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Investors know that bonds issued by different economic entities have very different probabilities of defaulting:

1. The U.S. government has never defaulted on its bonds and is extremely unlikely to do so because even if its political stability and efficient tax administration (IRS) were to shatter, it could always meet its nominal obligations by creating money. - Might create inflation. 2. Municipalities have defaulted on their bonds in the past and could do so again in the future because, although they have the power to tax, they do not have the power to create money at will. - The risk of default on municipal bonds (aka munis) is often low, especially for revenue bonds, upon which specific taxes and fees are pledged for interest payments. 3. Municipal bonds are exempt from most forms of income taxation. 4. Corporations are more likely to default on their bonds because they must rely on business conditions and management acumen. They have no power to tax and only a limited ability to create the less-liquid forms of money. - Some corporations are more likely to default on their bonds than others. - Credit-rating agencies, including Moody’s and Standard and Poor’s, assess the probability of default and assign grades to each bond. There’s grade inflation built in with the highest grade being Aaa not A+. - Corporate bonds are fully taxable. 5. The most liquid bond markets are usually those for Treasuries. - The liquidity of corporate and municipal bonds is a function of the size of the issuer and the amount of bonds outstanding. •

Investors place a positive risk premium on corporate bonds.

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Risk, after-tax returns, and liquidity also help to explain changes in spreads. o Spreads: The difference between yields of bonds of different types.

❖ Flight to quality: During crises, investors sell risky assets and buy safer ones. o This drives down the prices of the risky assets and drives up the prices of the safer assets. •

The three major risks (aka the Risk Structure) are: o Default o Liquidity o After-tax return

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By concentrating on the three major risks, you can ascertain why some bonds are more (less) valuable than others, holding their term (repayment date) constant.

6.3: The Determinants of Interest Rates II: The Term Structure What is the term structure of interest rates and the yield curve, and what do they explain?

❖ Term structure of interest rates: The variability of returns due to differing maturities. o Bonds from the same issuer can have yields that vary according to the length of time they have to run before their principals are repaid. •

Sometimes: o Short-term treasuries have lower yields than long-term treasuries. o Short-term treasuries have about the same yield as long-term treasuries. o Short-term treasuries have higher yields than long-term treasuries.

❖ Yield Curve: A snapshot of yields of bonds of different maturities at a given moment which reveals the market’s prediction of future short-term interest rates. o Created by plotting the yield against the maturity for a single class of bonds. o Can be used to make inferences about inflation and business cycle expectations. o Used to study the above phenomenon. •

What observers have discovered using the Yield Curve is that: o The yields of bonds of different maturities (but identical risk structures) tend to move in tandem. ▪ Yield curves usually slope upward. ▪ Short-term rates are usually lower than long-term rates. o

The yield “curve” can actually be flat. ▪ Yields for bonds of different maturities are identical.

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When short-term rates are higher than normal, the curve inverts or slopes downward. ▪ The yield on short-term bonds is higher than that on long-term bonds.

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Sometimes the curve goes up and down, resembling a sideways S or Z.

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Bonds of different maturities are partial substitutes for each other but not completely segmented either.

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Investors prefer short-term bonds to long-term ones, but they reverse their preference if the interest rate goes unusually high. o Investors are willing to pay more for short-term bonds because longer-term bonds are more subject to interest rate risk. o Investors need a premium (in the form of a lower price or higher yield) to hold longterm bonds. ▪ The yield curve usually slopes upward.

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The one thing that can induce investors to give up their liquidity preference: The expectation of a high interest rate for a short term. o Liquidity Preference: their preferred habitat of short-term bonds. o Investors think of a long-term bond yield as the average of the yields on shorterterm obligations. ▪ When the interest rate is high by historical norms but expected after a year to revert to long-term mean, they will begin to prefer long-term bonds. ▪ They will buy them at much higher prices (lower yields) than short-term bonds.

in=[(ie0+ie1+ie2+ie3+.... ie(n−1))/n]+ρn where: 𝑖𝑛 = interest rate today on a bond that matures in n years 𝑖𝑥𝑒 = expected interest rate at time x (0, 1, 2, 3, . . . through n) ρ = the liquidity or term premium for an n-period bond (it is always positive and increases with n)

Example: The yield today of a bond with 5 years to maturity, if the liquidity premium is 0.5% and the expected interest rate each year is 4% is: i5 = (4 + 4 + 4 + 4 + 4)/5 + 0.5 = 20/5 + 0.5 = 4.5 Implying an upward sloping yield curve because 4 < 4.5

If interest rates are expected to fall over the next 5 years, the yield curve will slope downward: i5 = (12 + 10 + 8 + 5 + 5)/5 + .5 = 40/5 + .5 = 8.5 Implying an inverted yield curve because 12 > 8.5

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