FIM Lecture V VI

Why Do Interest Rates Change?

Forces that impact interest rates

There have been times that interest rates have been relatively stable and other times that the rates have been rather volatile Let us examine the forces that move interest rates and the theories behind those movements Let us look at the following
Determinants of Asset Demand Supply and Demand in the Bond Market Changes in Equilibrium Interest Rates

Determinants of Asset Demand

An asset is a piece of property that is a store of value Facing the question of whether to buy and hold an asset or whether to buy one asset rather than another, an individual must consider the following factors: 1. Wealth: the total resources owned by the individual, including all assets

2. Expected return: the return expected over the next period on one asset relative to alternative assets
3. Risk: the degree of uncertainty associated with the return, on one asset relative to alternative assets 4. Liquidity: the ease and speed with which an asset can be turned into cash relative to alternative assets

Benefit of Diversification
Diversification is holding of more than one asset It benefits investors because it reduces the risk they face The benefit is greater, the less the returns on securities move together

Calculation of Expected Return An Example

What is the expected return on the Mobil Oil bond if the return is 12% two-thirds of the time and 8% one-third of the time? Solution The expected return is 10.68%. Re = p1R1 + p2R2 where p1 = probability of occurrence of return 1 = 2/3 = 1/3 = 8% = = = .67

R1 = return in state 1
p2 = probability of occurrence of return 2 R2 = return in state 2 Thus

= 12% =

0.12
.33 0.08

Re = (.67)(0.12) + (.33)(0.08) = 0.1068 = 10.68%

Example of Varying risk

Feet-on-the-Ground Bus Company has an expected return of 10%, with a probability of 1 On the other hand, Fly-by-Night Airlines has expected return of 10%, based on likely return of 15% with probability of 0.5 and likely return of 5% with probability of 0.5 Thus, Fly-by-Night Airlines has standard deviation of returns of 5%; Feet-on-the-Ground Bus Company on the other hand has a standard deviation of returns of 0% Clearly, Fly-by-Night Airlines is a riskier stock because its standard deviation of returns of 5% is higher than the zero standard deviation of returns for Feet-on-the-Ground Bus Company, which has a certain return A risk-averse person would prefer stock in the Feet-on-the-Ground (the sure thing) to Fly-by-Night stock (the riskier asset), even though both stocks have the same expected return, 10%. By contrast, a person who prefers risk, would like the other stock more. Most people are risk-averse, especially in financial decisions

Determinants of Asset Demand

Analysis of Demand & Supply of Bonds In Loanable Funds Framework

A firm supplying a bond is in fact taking a loan from the person buying the bond Thus supplying the bond is like demanding a loan Similarly, buying a bond is equivalent to supplying a loan With Loanable funds on the X axis and interest rate on the Y axis (see next slide), we have the usual downward sloping demand curve and upward sloping supply curve for Loanable Funds Within this framework, our analysis is easier as we are dealing with the usual demand and supply curves Remember that price of bonds and interest rates in bond markets are inversely related

Loanable Funds Terminology

1. Demand for bonds = supply of loanable funds 2. Supply of bonds = demand for loanable funds

A Comparison of Terminology: Loanable Funds and Supply and Demand for Bonds

Shifts in the Demand Curve

Shifts in the Demand Curve for Bonds

Shifts in the Demand for Bonds

1. Wealth: in a business cycle expansion with growing wealth, the demand for bonds rises; conversely, in a recession, when income and wealth are falling, the demand for bonds falls

2. Expected returns: higher expected interest rates in the future decrease the demand for long-term bonds; conversely, lower expected interest rates in the future increase the demand for long-term bonds

Shifts in the Demand for Bonds contd.

3. Risk: an increase in the riskiness of bonds causes the demand for bonds to fall; conversely, an increase in the riskiness of alternative assets (like stocks) causes the demand for bonds to rise 4. Liquidity: increased liquidity of the bond market results in an increased demand for bonds; conversely, increased liquidity of alternative asset markets (like the stock market) lowers the demand for bonds

Shifts in the Supply Curve

1. 2. 3. Expected Profitability of Investment Opportunities Expected Inflation Government Activities like government deficit (With increase in any of the above variables the supply will be more)

Shift in the Supply Curve for Bonds

Shifts in the Supply of Bonds

1. Expected Profitability of Investment Opportunities: in a business cycle expansion, the supply of bonds increases; conversely, in a recession, when there are far fewer expected profitable investment opportunities, the supply of bonds falls

2.

Expected Inflation: an increase in expected inflation, leading to expected reduction in the real cost of borrowing, causes the supply of bonds to increase
Government Activities: higher government deficits increase the supply of bonds; conversely, government surpluses decrease the supply of bonds

3.

Supply and Demand Analysis of Bonds

The supply and demand analysis for bonds, known as the loanable funds framework, provides one theory of how interest rates are determined. It predicts that interest rates will change when there is a change in demand because of changes in Income or wealth, Expected returns, Risk, or Liquidity, or when there is change in supply, because of changes in the Attractiveness of investment opportunities, Real cost of borrowing, or Government activities