2.

Interest Rates
 Some Financial Assets
Giving Rise to Interest Rates
Can be issued by

Central bank loans

Lend to corporation
Some interest rates
 Agenda

1. Interest Rate Measurement

2. Interest Rate Determination

3. Risk and Term Structure of Interest Rates

1. Measuring Interest Rates
Alternative Financial Instruments

Interest Rate V/S Rate of Return

Real Interest Rates

 Interest Rates in...
1. Loan or Bond

CF
Pb
1 i
 Interest Rates in...
1. Loan or Bond

CF
Pb
1 i
2. Loan with fixed payments

CF CF CF
Pb ...
1 i 1 i 2
1 i n
 Interest Rates in...
3. Bond with coupons

C C C FV
Pb ...
1 i 1 i 1 i
2 n

4. Perpetual bonds

C C
Pb j 1


(1 i ) j
i
 Interest Rates in...
5. Discount bonds

FV
Pb
iPrices go in opposite
1Bond
Key idea: Interest Rates and
directions
Interest RateV/S Rate of Return
(in Fixed Income!)
Rate of Return= Interest Rate+ Capital Gains

In long-term bonds, investors usually buy and sell bonds, taking advantage of
C Pb (t 1) Pb (t )
increases and lowering of bond prices (interest rate risk)
RR
Pb (t ) Pb (t )
 Real Interest Rates
Ex - post:

rt ,t 1 it ,t 1 t ,t 1
Interest rate - in

Ex - ante

rt ,t 1 it ,t 1 Et [ t ,t 1 ] Nominal Inte
 Real Interest Rates:
Two Issues
Which one is more important?
Ex-ante for investment/consumption decisions
Ex-post to measure realized real returns

Companies/households are interested in low real interest rates, while savers are
interested in high expected real interest rates
What is appropriate from the monetary policy perspective? for macro economy, low
rates typically increases GDP as it encourages spending, but in the long run increase
inflation
 Effective Real Interest Rates
Gross

rt ,t 1 it ,t 1 Et [ t ,t 1 ]

Net (effective)
rt ,t 1 (1 )it ,t 1 Et [ t ,t 1 ]
 Real Interest Rates:
A historical perspective, the USA
The Great Depression (1929-1933)
1950-1980: USA

More or less constant, except 1973 (oil shock

 In general, inflation goes down, real rates go up (via

USA: A historical perspective

Japan: A country in recession (the
90s)
Spain: Nominal and Real Interest Rates
The Great Inflation and Dis-Inflation
A Theory on Real Interest Rates:
Fisher Effect

it ,t 1 r Et [ t ,t 1 ]

Theory: Real interest rates tend to be constant

2. Interest Rate Determination

Determinants in the bond market

Asset Demand
Asset Supply
Preference for liquidity
Through monetary policy actions
Asset Demand Determination

- Individual Wealth buy more assets

- Expected Returns higher expected, higher investmen t

r e ri pi
- Risk, relative to other
i
assets (higher risk, higher
demand)

p (r r )
i i i
e 2
Asset Demand Determination

Individual Wealth
Expected Returns
Risk
Expected Inflation- higher expected
inflation (Decreases demand)- if you are
an investor, if expected inflation is high,
you lend less cause real return is lower
Liquidity
Asset Supply Determination

Investment Opportunities
Expected Inflation (if expected inflation
is high, real rate is lower, greater
supply, as borrowers want to borrow
more)
Government Deficit
 Supply / Demand of Bonds
P
D S

P(0
)

B
 Fisher Effect
Constant Interest Rate

it ,t 1 r Et [ t ,t 1 ]

1.By No-Arbitrage Argument applied to all

assets, r should be the same across assets
2.Expected inflation pass-through to
nominal interest rates
 Fisher Effect: Expected Inflation
P
D S

S
D

P(0
)

P(1
)

B
 Simple Illustration of the Fisher Effect:
Expected Inflation Increases, Price of Bond
Decreases, as a result, Interest Rate
Increases
 Preference for Liquidity
Determination

Two Types of Assets: Money and

Bonds
M B M B
d d s s
 Preference for Liquidity
Determination

Money Demand: Factors:

Wealth Effect: increases money demand
and interest rates (wealthier, you spend
more)
Price Level Effect: increases money
demand and interest rates (if prices go
up, you demand more money as
everything is more expensive)
 Preference for Liquidity Determination

Money Supply: Factors:

Expansionary / Contractionary Money
Supply: increases (decreases) money supply,
interest rates fall (determined by govt)
Price Level Effect: Lowers Real Money
Supply, interest rates increase (real money
supply decreases as price increases
because your dollar is worth less)
 Fisher Effect Illustration Once More: Prices
Increase, real money supply decreases,
money demand increases:
Preference for Liquidity Determination

i M(s)/P

M(d)/P

i(0
)

M/P
Preference for Liquidity Determination

i M(d)/ M(s)/P
M(s)/P
P
i(1
)
M(d)/
P
i(0
)

M/P
 Monetary Policy determines the inter-bank
(very short-term) interest rate

The interest rates set by a central bank influences

Monetary Policy determines the inter-bank (very
short-term) interest rate
(The 1st Interest rate the bank sets)
(even if same bank HSBC, in different countries,
have an interbank interest rate.
Interbank rate is a floor)

How is Monetary Policy interest rate set?

 Monetary Policy Rule

E.g. Taylor Rule (1993)

it1 ( t ~t ) ( yt ~
yt )

How to set interest rates: ideal for developed economies,

not so much for countries with inflation volatility, production
volatility (cause beta will multiply a 10% inflation gap by a lot)
Monetary Policy (short-term) interest rate
transmits to longer term interest rates (both
sovereign and corporate)

And other variables (real nominal, default) also

affect long rates more than short rates

Do long rates move with short risk?

The term structure of interest rates
(Yield curve)
Some interest rates are short-term (monetary policy), some
others are long term
My assets may be long-term loans, whereas liabilities may
be short-term borrowings: what happens if short-term rates
increase but long-term rates fall?
What is the relation between short and long-rates
US Treasuries Interest Rates
Yield Curve: A general and Useful Model

Long Rates =
Expectations of short-rate + risk premium
Long-rate is an average of the short-rates plus a risk premium (rp_t)

rp_t is the variable risk premium, which depends on a number of macro-

finance factors (default, inflation risk, liquidity)
Expected increases in short-rates (contractionary monetary
policy) imply high long-rates, whereas expected falls imply
low long-rates
Expectations of short-rates and long rates
- On that day investors expect short-term rates to increase: Makes sense! Short-term rates were (and are) real
low now!
- Monetary policy influences the short-end of the yield curve and through expectations, the long-end.
- A year and a half later: the yield curve shifts down at medium and high end, and expectations
are again that short-rates should increase
- A year and a half later: expectations are fulfilled and the yield curve shifts up at the medium
and high end
Inverted Yield Curve (UK, 2005)

- Investors expect short-rates will fall (probably due to a recession)

Expect the bank to lower rates
Yield curve and prediction of
future economic activity

In general, a positively sloped yield curve indicates that the

real economy will recover in the future and/or there will be
inflation (which will allow the Central Bank to increase
interest rates), whereas the opposite is true with an
inverted yield curve (as the Central Bank will lower rates)
Slope of the yield curve and spreads

Upward sloping yield curve => Positive Spread between long-term

bond and short-term bond rates => Expansion down the road

Downward sloping yield curve => Negative Spread between long-

term bond and short-term bond rates => Recession down the road
Source:Morningst
ar
Source:Morningst
ar
Source:Morningst
ar
AND NOW

YIELD CURVE: LEARN & FUN

Can we have negative nominal interest rates?
Can we have negative nominal interest rates?

YES
Reasons for negative interest rates
Central Banks charge commercial banks for holding over-night deposits (excess reserves) in the Central
Bank: they do it as an incentive to lend (ECB, Denmark, Switzerland)=> Economic Stimulus
These negative rates over-night rates transmit to short-term, medium-term and some times long rates!

Also flight to safety in times of turbulence: investors eager to accept negative rates in a safe place

still real rate may be positive if there is deflation!