Tài chính kế toán - Chapter 13: An introduction to interest rate determination and forecasting

Chapter 13An introduction to interest ratedetermination and forecastingLearning objectivesDescribe the macroeconomic context of interest rate determination Explain the loanable funds approach to interest rate determination, including supply and demand variables for loanable funds, equilibrium and the effect of changes in variables on interest ratesUnderstand yields, yield curves and term structures of interest rates, and apply the expectations theory, segmented markets theory and liquidity premium theoryExplain the risk structure of interest rates and the impact of default risk on interest ratesChapter organisation13.1 Macroeconomic context of interest rate determination13.2 Loanable funds approach to interest rate determination13.3 Term structure of interest rates13.4 Risk Structure of interest rates 13.5 Summary13.1 Macroeconomic context of interest rate determinationIn most developed economies monetary policy actions are directed at influencing interest ratesBy understanding what motivates a central bank in its implementation of interest rates policy:financial market participants can anticipate changes in a government’s interest rate policylenders and borrowers can make better-informed decisions13.1 Macroeconomic context of interest rate determination (cont.)A central bank may increase interest rates if there is: inflation above target rangeexcessive growth in GDP a large deficit in the balance of paymentsrapid growth in credit and debt levelsexcessive ‘downward’ pressure on FX markets13.1 Macroeconomic context of interest rate determination (cont.)An increase in interest rates (i.e. tightening of monetary policy) will:eventually increase long-term ratesslow consumer spendingreducing inflation and demand for importsdecrease the size of the current accountpossibly attract foreign investment, causing the domestic currency to appreciate13.1 Macroeconomic context of interest rate determination (cont.)Three effects of changes in interest rates1. Liquidity effectThe effect of the RBA’s market operations on the money supply and system liquidityE.g. RBA increases rates (i.e. tightens monetary policy) by selling CGSs2. 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 levels13.1 Macroeconomic context of interest rate determination (cont.)Three effects of changes in interest rates (cont.)3. Inflation effectAs the rate of growth in economic activity slows, demand for loans also slowsThis results in an easing of the rate of inflation13.1 Macroeconomic context of interest rate determination (cont.)(cont.)13.1 Macroeconomic context of interest rate determination (cont.)Liquidity, income and inflation effects of changes in interest rates (cont.)It is difficult to forecast the extent of liquidity, income and inflation effects on changes in interest ratesParticularly when the business cycle is about to change, i.e. is at a peak or troughEconomic indicators provide an insight into possible future economic growth and the likelihood of central bank intervention(cont.)13.1 Macroeconomic context of interest rate determination (cont.)Economic indicatorsLeading indicatorsEconomic variables that change before a change in the business cycleCoincident indicatorsEconomic variables that change at the same time as the business cycle changesLagging indicatorsEconomic variables that change after the business cycle changes(cont.)13.1 Macroeconomic context of interest rate determination (cont.)Economic indicators (cont.)Difficulties exist with:knowing 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 indicatorsChapter organisation13.1 Macroeconomic context of interest rate determination13.2 Loanable funds approach to interest rate determination13.3 Term structure of interest rates13.4 Risk Structure of interest rates 13.5 Summary13.2 Loanable funds approach to interest rate determinationThe loanable funds (LF) approach is the preferred way of explaining and forecasting interest rates because it is:preferred by financial market analystsa conceptually simplistic modelAlternatively, macroeconomics uses demand and supply of money to explain rates(cont.)13.2 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 increases(cont.)13.2 Loanable funds approach to interest rate determination (cont.)Demand for loanable fundsTwo sectors1. Business demand for funds (B)Short-term working capitalLonger-term capital investment2. Government demand for funds (G)Finance budget deficits and intra-year liquidityDemand for loanable funds (B + G)(cont.)13.2 Loanable funds approach to interest rate determination (cont.)(cont.)13.2 Loanable funds approach to interest rate determination (cont.)Supply of loanable fundsComprises 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 and more securities are purchased for the higher yield available(cont.)13.2 Loanable funds approach to interest rate determination (cont.)(cont.)13.2 Loanable funds approach to interest rate determination (cont.)Equilibrium in the LF market In Figure 13.9 equilibrium is point E and the equilibrium rate is i0E is a temporary equilibrium because the supply and demand curves are not independentThe level of dishoarding will changeThe money supply is unlikely to increase proportionately in subsequent periodsA change in business and/or government demand(cont.)13.2 Loanable funds approach to interest rate determination (cont.)(cont.)13.2 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 occursInflationary expectationsThe demand curve shifts to the right and the supply curve shifts to the left, resulting in higher interest rates and unchanged equilibrium quantityChapter organisation13.1 Macroeconomic context of interest rate determination13.2 Loanable funds approach to interest rate determination13.3 Term structure of interest rates13.4 Risk Structure of interest rates 13.5 Summary13.3 Term 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 maturity(cont.)13.3 Term structure of interest rates (cont.)(cont.)13.3 Term 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 ratesHumped yield curveShape of yield curve changes over time from normal to inverse(cont.)13.3 Term 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 ratesThree theories have been advanced to explain the shape of the yield curve:Expectations theoryMarket segmentation theoryLiquidity premium theory1. Expectations theoryThe current short-term interest rate and expectations about future short-term interest rates are used to explain the shape and changes in shape of the yield curveLonger term rates will be equal to the average of the short-term rates expected over the periodThe theory is based on assumptions, e.g.:Large number of investors with reasonably homogenous expectationsNo transactions costs and no impediments to interest rates moving to their competitive equilibrium levelsInvestors aim to maximise returns and view all bonds as perfect substitutes regardless of term to maturity(cont.)Expectations theory (cont.)Example: The rate on a one-year instrument is 7% per annum. The investor expects to obtain 9% per annum on a one-year investment starting in one year’s time. What is the current two-year rate?(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 ratesHumped yield curveInvestors expect short-term rates to rise in the future but to fall in subsequent periods2. Segmented markets theoryAssumes that securities in different maturity ranges are viewed by market participants as imperfect substitutes (i.e. investors will operate within some preferred maturity range)Rejects two assumptions of the expectations theoryPreferences of participants are motivated by reducing the risk of their portfolios; i.e. minimising exposure to fluctuations in prices and yieldsThe shape and slope of the yield curve are determined by the relative demand and supply of securities along the maturity spectrum(cont.)Segmented markets theory (cont.)(cont.)Segmented markets theory (cont.)(cont.)Segmented markets theory (cont.)If the central bank increases the average maturity of bonds by purchasing short-term bonds and selling long-term bondsSegmented markets theory suggests:short-term yields decrease and long-term yields increasealthough financial system liquidity is unchanged, economic activity is affected because areas of expenditure sensitive to:short-term interest rates will expandlong-term interest rates will contractExpectations theory suggests:no effect on expectations about future short-term interest rates, and therefore no effect on the economyExpectations approach versus segmented markets approachThe emphasis of the segmented markets theory on risk management denies the existence of investors seeking:arbitrage opportunitieswithout their participation, the extreme segmentation theory would facilitate discontinuities in the yield curvespeculative profitspeculators’ trading actions are dictated by expectations3. Liquidity premium 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’(cont.)Liquidity premium theory (cont.)The liquidity premium can be included in the expectations theory equationL is the size of the liquidity premium(cont.)Liquidity premium theory (cont.)(cont.)Liquidity premium theory (cont.)(cont.)Liquidity premium theory (cont.)Chapter organisation13.1 Macroeconomic context of interest rate determination13.2 Loanable funds approach to interest rate determination13.3 Term structure of interest rates13.4 Risk Structure of interest rates 13.5 Summary13.4 Risk structure of interest ratesDefault risk is the risk that the borrower (i.e. issuer) will fail to meet its interest payment obligationsCommonwealth government bonds are assumed to have zero default riskAs they are risk-free, they offer a risk-free rate of returnSome borrowers may have greater risk of default (i.e. state government or private sector firms)Investors will require compensation for bearing the extra default risk(cont.)13.4 Risk structure of interest rates (cont.)(cont.)13.4 Risk structure of interest rates (cont.)Chapter organisation13.1 Macroeconomic context of interest rate determination13.2 Loanable funds approach to interest rate determination13.3 Term structure of interest rates13.4 Risk Structure of interest rates 13.5 Summary13.5 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, likely future monetary policy actions and the effect on interest ratesA more disciplined approach to forming a view on future interest rates is provided by the loanable funds theory(cont.)13.5 Summary (cont.)The 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 shapeThe risk structure of interest rates reflects the level of credit risk, over time, of a particular debt issue