Tài chính doanh nghiệp - Chapter 13: An introduction to interest rate determination and forecasting

Chapter 13An Introductionto Interest RateDetermination andForecastingCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye WatsonLearning ObjectivesExplain the reasons for a change in the RBA’s interest rate policyDescribe how changes in interest rates affect the rest of the economyOutline the possible shapes of a yield curveExplain the theories that describe how a yield curve obtains its shapeCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye WatsonChapter Organisation13.1 Introduction13.2 Macroeconomic Context of Interest Rate Determination13.3 Loanable Funds Approach to Interest Rate Determination13.4 Term and Risk Structure of Interest Rates13.5 SummaryCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson13.1 IntroductionIn most developed economies monetary policy actions are directed at influencing interest ratesBy understanding what motivates a central bank in its implementation of interest rates policyFinancial market participants can anticipate changes in a govt’s interest rate policyLenders and borrowers can make better-informed decisionsCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye WatsonChapter Organisation13.1 Introduction13.2 Macroeconomic Context of Interest Rate Determination13.3 Loanable Funds Approach to Interest Rate Determination13.4 Term and Risk Structure of Interest Rates13.5 SummaryCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson13.2 Macroeconomic Context of Interest Rate DeterminationA central bank may increase interest rates if there is Inflation above three per centExcessive growth in GDP A large deficit in the balance of paymentsRapid growth in credit and debt levelsExcessive ‘downward’ pressure on the Australian dollarCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson13.2 Macroeconomic Context of Interest Rate Determination (cont.)An increase in interest rates (i.e. tightening of monetary policy) willEventually increase long-term ratesSlow consumer spendingReducing inflation and demand for importsCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson13.2 Macroeconomic Context of Interest Rate Determination (cont.)An increase in interest rates (i.e. tightening of monetary policy) will (cont.)Decrease the size of the current accountMay attract foreign investment causing the domestic currency to appreciateCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson13.2 Macroeconomic Context of Interest Rate Determination (cont.)Three effects of changes in interest ratesLiquidity effectThe affect of the RBA’s market operations on the money supply and system liquiditye.g. RBA increases rates (i.e. tightens monetary policy) by selling CGSCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson13.2 Macroeconomic Context of Interest Rate Determination (cont.)Three effects of changes in interest rates (cont.)Income effectA flow-on effect from the liquidity effectIf interest rates rise, economic activity will slow, allowing rates to easeIncreased rates reduce spending levels and income levelsCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson13.2 Macroeconomic Context of Interest Rate Determination (cont.)Three effects of changes in interest rates (cont.)Inflation effectAs the rate of growth in economic activity slows, demand for loans also slowsThis results in an easing of the rate of inflationCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson13.2 Macroeconomic Context of Interest Rate Determination (cont.)Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson13.2 Macroeconomic Context of Interest Rate Determination (cont.)Three effects of changes in interest rates (cont.)While the mechanism for interest rate determination is understood, it is difficult to forecast the extent of the liquidity, income and inflation effects on a change in interest ratesCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson13.2 Macroeconomic Context of Interest Rate Determination (cont.)Three effects of changes in interest rates (cont.)This is particularly the case when the business cycle is about to change i.e. is at a peak or troughCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson13.2 Macroeconomic Context of Interest Rate Determination (cont.)Three effects of changes in interest rates (cont.)Economic indicators provide market participants with insight into possible future economic growth and the likelihood of central bank interventionCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson13.2 Macroeconomic Context of Interest Rate Determination (cont.)Economic indicatorsLeading indicatorsEconomic variables that change before a change in the business cycleCoincident indicatorsEconomic variable that change at the same time as the business cycle changesCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson13.2 Macroeconomic Context of Interest Rate Determination (cont.)Economic indicators (cont.)Lagging indicatorsEconomic variables that change after the business cycle changesCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson13.2 Macroeconomic Context of Interest Rate Determination (cont.)Economic indicators (cont.)Difficulties exist withKnowing the extent of the timing lead or lag of such indicatorsConsistently performing indicators e.g. rates of growth in money measures were once lead indicators and are now lagging indicatorsCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye WatsonChapter Organisation13.1 Introduction13.2 Macroeconomic Context of Interest Rate Determination13.3 Loanable Funds Approach to Interest Rate Determination13.4 Term and Risk Structure of Interest Rates13.5 SummaryCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson13.3 Loanable Funds Approach to Interest Rate DeterminationThe loanable funds (LF) approach is the preferred way of explaining and forecasting interest rates as it isPreferred by financial market analystsA conceptually simplistic modelAlternatively, macroeconomics uses demand and supply to explain ratesCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson13.3 Loanable Funds Approach to Interest Rate Determination (cont.)The loanable funds (LF) approachLF are the funds available in the financial system for lendingAssumes a downward-sloping demand curve and an upward-sloping supply curve in the loanable funds market i.e.As interest rates rise demand fallsAs interest rates rise supply increasesCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson13.3 Loanable Funds Approach to Interest Rate Determination (cont.)Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson13.3 Loanable Funds Approach to Interest Rate Determination (cont.)Demand for loanable fundsTwo componentsBusiness demand for funds (B)Short-term working capitalLonger-term capital investmentGovernment demand for funds (G)Finance budget deficits and intra-year liqudityDemand for loanable funds (B + G)Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson13.3 Loanable Funds Approach to Interest Rate Determination (cont.)Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson13.3 Loanable Funds Approach to Interest Rate Determination (cont.)Supply of loanable fundsComprised of three principal sourcesSavings of household sector (S)Changes in money supply (M)Dishoarding (D)Hoarding is the proportion of total savings in economy held as currencyDishoarding occurs (i.e. currency holdings decrease) as interest rates rise as more securities are purchased for the higher yield availableCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson13.3 Loanable Funds Approach to Interest Rate Determination (cont.)Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson13.3 Loanable Funds Approach to Interest Rate Determination (cont.)Equilibrium in the LF market In Figure 13.8 equilibrium is point E and the equilibrium rate is i0E is a temporary equilibrium as the supply and demand curves are not independentThe level of dishoarding will changeCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson13.3 Loanable Funds Approach to Interest Rate Determination (cont.)Equilibrium in the LF market (cont.)E is a temporary equilibrium as the supply and demand curves are not independent (cont.)The money supply is unlikely to increase proportionately in subsequent periodsA change in business and/or government demandCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson13.3 Loanable Funds Approach to Interest Rate Determination (cont.)Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson13.3 Loanable Funds Approach to Interest Rate Determination (cont.)Impact of disturbances on ratesExpected increase in economic activityInitial effect is that businesses sell securities, yields increase (price decreases), dishoarding occursCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson13.3 Loanable Funds Approach to Interest Rate Determination (cont.)Impact of disturbances on rates (cont.)Inflationary expectationsThe demand shifts to the right and the supply curve shifts to the left resulting in higher interest rates and unchanged equilibrium quantityCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye WatsonChapter Organisation13.1 Introduction13.2 Macroeconomic Context of Interest Rate Determination13.3 Loanable Funds Approach to Interest Rate Determination13.4 Term and Risk Structure of Interest Rates13.5 SummaryCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson13.4 Term and Risk Structure of Interest RatesYield is the total return on an investment, comprising interest received and any capital gain (or loss)Yield curve is a graph, at a point in time, of yields on an identical security with different terms to maturityCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson13.4 Term and Risk Structure of Interest Rates (cont.)Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson13.4 Term and Risk Structure of Interest Rates (cont.)Differently shaped yield curves are evident from time to timeNormal or positive yield curveLonger-term interest rates are higher than shorter-term ratesInverse or negative yield curveShort-term interest rates are higher than longer-term ratesCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson13.4 Term and Risk Structure of Interest Rates (cont.)Differently shaped yield curves are evident from time to time (cont.)Humped yield curveShape of yield curve changes over time from being normal to inverseCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson13.4 Term and Risk Structure of Interest Rates (cont.)The fact that the shape of the yield curve changes over time suggests that monetary policy interest rate changes are not the only factor affecting interest ratesCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson13.4 Term and Risk Structure of Interest Rates (cont.)Three theories have been advanced explaining the shape of the yield curvePure expectations hypothesisMarket segmentation hypothesisLiquidity premiumCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson13.4 Term and Risk Structure of Interest Rates (cont.)Expectations theoryThe current short-term interest rate and expectations about future short-term interest rates are used to explain the shape and changes in the yield curveLonger-term rates will be equal to the average of the short-term rates that are expected to prevail over the periodCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson13.4 Term and Risk Structure of Interest Rates (cont.)Expectations theory (cont.)The theory is based on assumptionsThe rate on a one year instrument is 7% p.a. The investor expects to obtain 9% p.a. on a one-year investment commencing in one-years time. What is the current two-year rate?Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson13.4 Term and Risk Structure of Interest Rates (cont.)Expectations theory (cont.)(13.1)Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson13.4 Term and Risk Structure of Interest Rates (cont.)Expectations theory (cont.)However, in pricing bonds, it is assumed that the first interest payment coupon is reinvested at the prevailing interest rate for the second period. As a result, the compounding of interest should be acknowledged in the foregoing equation (that is, the rate should be calculated as a geometric average). This can be expressed as:Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson13.4 Term and Risk Structure of Interest Rates (cont.)Expectations theory (cont.)orsoCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson13.4 Term and Risk Structure of Interest Rates (cont.)Expectations theory (cont.)For example: if = 10%, and = 12%, then: Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson13.4 Term and Risk Structure of Interest Rates (cont.)Expectations theory (cont.)Explanation for the shape of yield curvesInverse yield curveWill result if the market expects future short-term rates to be lower than current short-term ratesNormal yield curveWill result from expectations that future short-term rates will be higher than current short-term ratesCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson13.4 Term and Risk Structure of Interest Rates (cont.)Expectations theory (cont.)Explanation for the shape of yield curves (cont.)Humped yield curveInvestors expect short-term rates to rise in the future, but to fall in subsequent periodsCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson13.4 Term and Risk Structure of Interest Rates (cont.)Segmented markets theoryAssumes that securities in different maturity ranges are viewed by various market participants as being imperfect substitutes (i.e. investors will operate within some chosen maturity range)Rejects expectations theory assumption that all bonds are perfect substitutesCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson13.4 Term and Risk Structure of Interest Rates (cont.)Segmented markets theoryAssumes that securities in different maturity ranges are viewed by various market participants as being imperfect substitutes (i.e. investors will operate within some chosen maturity range) (cont.)Investors assumed to try to minimise risk, rather than maximise profitCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson13.4 Term and Risk Structure of Interest Rates (cont.)Segmented markets theory (cont.)Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson13.4 Term and Risk Structure of Interest Rates (cont.)Segmented markets theory (cont.)Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson13.4 Term and Risk Structure of Interest Rates (cont.)Expectations approach versus segmented markets approachThe emphasis of the segmented markets theory on risk management denies the existence of investors seekingArbitrage opportunitiesThis could cause discontinuities in the yield curveSpeculative profitCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson13.4 Term and Risk Structure of Interest Rates (cont.)Liquidity preference theoryAssumes investors prefer shorter-term instruments which have greater liquidity, and less maturity and interest rate risk, and, therefore, require compensation for investing longer termThis compensation is called ‘liquidity premium’Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson13.4 Term and Risk Structure of Interest Rates (cont.)Liquidity preference theory (cont.)The liquidity premium can be included in the expectations theory equationL is the size of the liquidity premium(13.2)Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson13.4 Term and Risk Structure of Interest Rates (cont.)Liquidity preference theory (cont.)Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson13.4 Term and Risk Structure of Interest Rates (cont.)Liquidity preference theory (cont.)Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson13.4 Term and Risk Structure of Interest Rates (cont.)Liquidity preference theory (cont.)Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson13.4 Term and Risk Structure of Interest Rates (cont.)Risk structure of interest ratesDefault risk refers to the risk that the borrower (i.e. issuer) will fail to meet its interest payment obligationsCommonwealth government bonds are assumed to have zero default risk i.e. as they are risk-free, they offer a risk-free rate of returnCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson13.4 Term and Risk Structure of Interest Rates (cont.)Risk structure of interest rates (cont.)Some borrowers may have greater risk of default (i.e. state government or private sector firms)Investors will require compensation for bearing the extra default riskCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson13.4 Term and Risk Structure of Interest Rates (cont.)Risk structure of interest rates (cont.)Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson13.4 Term and Risk Structure of Interest Rates (cont.)Risk structure of interest rates (cont.)Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson13.4 Term and Risk Structure of Interest Rates (cont.)Yield curve and expectations theory calculationsThis section considers calculations for forecasting interest rates based on the expectations theoryCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson13.4 Term and Risk Structure of Interest Rates (cont.)Yield curve and expectations theory calculations (cont.)Equation 13.1 is modified to accommodate multiperiod terms and the reinvestment of coupon interest received to give equation 13.3Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson13.4 Term and Risk Structure of Interest Rates (cont.)Yield curve and expectations theory calculations (cont.)(13.3)Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson13.4 Term and Risk Structure of Interest Rates (cont.)Yield curve and expectations theory calculations (cont.)Implicit forward (future) interest rates can be deduced from current rates(13.5)Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye WatsonChapter Organisation13.1 Introduction13.2 Macroeconomic Context of Interest Rate Determination13.3 Loanable Funds Approach to Interest Rate Determination13.4 Term and Risk Structure of Interest Rates13.5 SummaryCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson13.5 SummaryChanges in monetary policy interest rate settings are likely to affect the state of the economy, which in turn affects interest rates generallyThis occurs through the liquidity effect, income effect and inflation effectLeading, coincident and lagging economic indicators assist in assessing the direction of the economy, and likely future monetary policy actions and effect on interest ratesCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson13.5 Summary (cont.)A more disciplined approach to forming a view on future interest rates is provided by the loanable funds theoryThe term structure of interest rates is represented by a yield curve, which may be normal, inverse, humped or flatThe expectations, segmented markets and liquidity preference theories describe how a yield curve obtains its shapeCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson