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1、Chapter 4Why Do Interest Rates Change?Copyright 2009 Pearson Prentice Hall. All rights reserved.4-2Chapter PreviewIn the early 1950s, short-term Treasury bills were yielding about 1%. By 1981, the yields rose to 15% and higher. But then dropped back to 1% by 2003.What causes these changes?Copyright
2、2009 Pearson Prentice Hall. All rights reserved.4-3Chapter PreviewIn this chapter, we examine the forces the move interest rates and the theories behind those movements. Topics include:Determining Asset DemandSupply and Demand in the Bond MarketChanges in Equilibrium Interest RatesCopyright 2009 Pea
3、rson Prentice Hall. All rights reserved.4-4Determinants of Asset DemandAn 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 to
4、tal resources owned by the individual, including all assets2.Expected return (the return expected over the next period) on one asset relative to alternative assets3.Risk (the degree of uncertainty associated with the return) on one asset relative to alternative assets4.Liquidity (the ease and speed
5、with which an asset can be turned into cash) relative to alternative assetsCopyright 2009 Pearson Prentice Hall. All rights reserved.4-5EXAMPLE 1: Expected ReturnWhat is the expected return on an Exxon-Mobil bond if the return is 12% two-thirds of the time and 8% one-third of the time?SolutionThe ex
6、pected return is 10.68%.Re = p1R1 + p2R2wherep1 = probability of occurrence of return 1 = 2/3=.67R1 = return in state 1= 12% = 0.12p2 = probability of occurrence return 2= 1/3=.33R2 = return in state 2= 8%=0.08ThusRe = (.67)(0.12) + (.33)(0.08) = 0.1068 = 10.68%Copyright 2009 Pearson Prentice Hall.
7、All rights reserved.4-6EXAMPLE 2: Standard Deviation (a)Consider the following two companies and their forecasted returns for the upcoming year:Copyright 2009 Pearson Prentice Hall. All rights reserved.4-7EXAMPLE 2: Standard Deviation (b)What is the standard deviation of the returns on the Fly-by-Ni
8、ght Airlines stock and Feet-on-the-Ground Bus Company, with the return outcomes and probabilities described above? Of these two stocks, which is riskier?Copyright 2009 Pearson Prentice Hall. All rights reserved.4-8EXAMPLE 2: Standard Deviation (c)SolutionFly-by-Night Airlines has a standard deviatio
9、n of returns of 5%.Copyright 2009 Pearson Prentice Hall. All rights reserved.4-9EXAMPLE 2: Standard Deviation (d)Feet-on-the-Ground Bus Company has a standard deviation of returns of 0%.Copyright 2009 Pearson Prentice Hall. All rights reserved.4-10EXAMPLE 2: Standard Deviation (e)Fly-by-Night Airlin
10、es has a standard deviation of returns of 5%; Feet-on-the-Ground Bus Company 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 Com
11、pany, which has a certain returnA risk-averse person prefers stock in the Feet-on-the-Ground (the sure thing) to Fly-by-Night stock (the riskier asset), even though the stocks have the same expected return, 10%. By contrast, a person who prefers risk is a risk preferrer or risk lover. We assume peop
12、le are risk-averse, especially in their financial decisions Copyright 2009 Pearson Prentice Hall. All rights reserved.4-11Determinants of Asset Demand (2)The quantity demanded of an asset differs by factor. 1.Wealth: Holding everything else constant, an increase in wealth raises the quantity demande
13、d of an asset2.Expected return: An increase in an assets expected return relative to that of an alternative asset, holding everything else unchanged, raises the quantity demanded of the asset3.Risk: Holding everything else constant, if an assets risk rises relative to that of alternative assets, its
14、 quantity demanded will fall4.Liquidity: The more liquid an asset is relative to alternative assets, holding everything else unchanged, the more desirable it is, and the greater will be the quantity demandedCopyright 2009 Pearson Prentice Hall. All rights reserved.4-12Determinants of Asset Demand (3
15、) Copyright 2009 Pearson Prentice Hall. All rights reserved.4-13Supply & Demand in the Bond MarketWe now turn our attention to the mechanics of interest rates. That is, we are going to examine how interest rates are determined from a demand and supply perspective. Keep in mind that these forces act
16、differently in different bond markets. That is, current supply/demand conditions in the corporate bond market are not necessarily the same as, say, in the mortgage market. However, because rates tend to move together, we will proceed as if there is one interest rate for the entire economy.Copyright
17、2009 Pearson Prentice Hall. All rights reserved.4-14The Demand CurveLets start with the demand curve.Lets consider a one-year discount bond with a face value of $1,000. In this case, the return on this bond is entirely determined by its price. The return is, then, the bonds yield to maturity.Copyrig
18、ht 2009 Pearson Prentice Hall. All rights reserved.4-15Point B: if the bond was selling for $900.Derivation of Demand CurvePoint A: if the bond was selling for $950.Copyright 2009 Pearson Prentice Hall. All rights reserved.4-16Derivation of Demand CurveHow do we know the demand (Bd) at point A is 10
19、0 and at point B is 200?Well, we are just making-up those numbers. But we are applying basic economics more people will want (demand) the bonds if the expected return is higher.Copyright 2009 Pearson Prentice Hall. All rights reserved.4-17Derivation of Demand CurveTo continue Point C:P = $850 i = 17
20、.6% Bd = 300Point D:P = $800 i = 25.0% Bd = 400Point E:P = $750 i = 33.0% Bd = 500Demand Curve is Bd in Figure 1 which connects points A, B, C, D, E.Has usual downward slopeCopyright 2009 Pearson Prentice Hall. All rights reserved.4-18Supply and Demand for BondsCopyright 2009 Pearson Prentice Hall.
21、All rights reserved.4-19Derivation of Supply CurveIn the last figure, we snuck the supply curve in the line connecting points F, G, C, H, and I. The derivation follows the same idea as the demand curve.Copyright 2009 Pearson Prentice Hall. All rights reserved.4-20Derivation of Supply Curve Point F:
22、P = $750 i = 33.0% Bs = 100Point G:P = $800 i = 25.0% Bs = 200Point C:P = $850 i = 17.6% Bs = 300Point H:P = $900 i = 11.1% Bs = 400Point I: P = $950 i = 5.3% Bs = 500Supply Curve is Bs that connects points F, G, C, H, I, and has upward slopeCopyright 2009 Pearson Prentice Hall. All rights reserved.
23、4-21Derivation of Demand CurveHow do we know the supply (Bs) at point P is 100 and at point G is 200?Again, like the demand curve, we are just making-up those numbers. But we are applying basic economics more people will offer (supply) the bonds if the expected return is lower.Copyright 2009 Pearson
24、 Prentice Hall. All rights reserved.4-22Market EquilibriumThe equilibrium follows what we know from supply-demand analysis:1.Occurs when Bd = Bs, at P* = 850, i* = 17.6%2.When P = $950, i = 5.3%, Bs Bd (excess supply): P to P*, i to i*3.When P = $750, i = 33.0, Bd Bs (excess demand): P to P*, i to i
25、*Copyright 2009 Pearson Prentice Hall. All rights reserved.4-23Market ConditionsMarket equilibrium occurs when the amount that people are willing to buy (demand) equals the amount that people are willing to sell (supply) at a given priceExcess supply occurs when the amount that people are willing to
26、 sell (supply) is greater than the amount people are willing to buy (demand) at a given priceExcess demand occurs when the amount that people are willing to buy (demand) is greater than the amount that people are willing to sell (supply) at a given priceCopyright 2009 Pearson Prentice Hall. All righ
27、ts reserved.4-24Supply & Demand AnalysisNotice in Figure 1 that we use two different verticle axes one with price, which is high-to-low starting from the top, and one with interest rates, which is low-to-high starting from the top.This just illustrates what we already know: bond prices and interest
28、rates are inversely related.Also note that this analysis is an asset market approach based on the stock of bonds. Another way to do this is to examine the flows. However, the flows approach is tricky, especially with inflation in the mix. So we will focus on the stock approach.Copyright 2009 Pearson
29、 Prentice Hall. All rights reserved.4-25Changes in Equilibrium Interest RatesWe now turn our attention to changes in interest rate. We focus on actual shifts in the curves. Remember: movements along the curve will be due to price changes alone.First, we examine shifts in the demand for bonds. Then w
30、e will turn to the supply side.Factors That Shift Demand CurveCopyright 2009 Pearson Prentice Hall. All rights reserved.4-27How Factors Shift the Demand Curve1.Wealth/savingEconomy , wealth Bd , Bd shifts out to rightOREconomy , wealth Bd , Bd shifts out to rightCopyright 2009 Pearson Prentice Hall.
31、 All rights reserved.4-28How Factors Shift the Demand Curve2. Expected Returns on bondsi in future, Re for long-term bonds Bd shifts out to rightORe , relative Re Bd shifts out to rightCopyright 2009 Pearson Prentice Hall. All rights reserved.4-29How Factors Shift the Demand Curve2.and Expected Retu
32、rns on other assetsER on other asset (stock) Re for long-term bonds Bd shifts out to leftThese are closely tied to expected interest rate and expected inflation from Table 4.2Copyright 2009 Pearson Prentice Hall. All rights reserved.4-30How Factors Shift the Demand Curve3.RiskRisk of bonds , Bd Bd s
33、hifts out to rightORRisk of other assets , Bd Bd shifts out to rightCopyright 2009 Pearson Prentice Hall. All rights reserved.4-31How Factors Shift the Demand Curve4. LiquidityLiquidity of bonds , Bd Bd shifts out to rightORLiquidity of other assets , Bd Bd shifts out to rightCopyright 2009 Pearson
34、Prentice Hall. All rights reserved.4-32Shifts in the Demand CurveCopyright 2009 Pearson Prentice Hall. All rights reserved.4-33Summary of Shifts in the Demand for Bonds1.Wealth: in a business cycle expansion with growing wealth, the demand for bonds rises, conversely, in a recession, when income and
35、 wealth are falling, the demand for bonds falls2.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 bondsCopyright 2009 Pearson Prentice Hall. All rights res
36、erved.4-34Summary of Shifts in the Demand for Bonds (2)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 rise4.Liquidity: increased liquidity of the bond marke
37、t results in an increased demand for bonds, conversely, increased liquidity of alternative asset markets (like the stock market) lowers the demand for bondsFactors That Shift Supply CurveWe now turn to the supply curve. We summarize the effects in this table:Copyright 2009 Pearson Prentice Hall. All
38、 rights reserved.4-36Shifts in the Supply Curve1.Profitability of Investment OpportunitiesBusiness cycle expansion,investment opportunities , Bs , Bs shifts out to rightCopyright 2009 Pearson Prentice Hall. All rights reserved.4-37Shifts in the Supply Curve2.Expected Inflatione , Bs Bs shifts out to
39、 right3.Government ActivitiesDeficits , Bs Bs shifts out to rightCopyright 2009 Pearson Prentice Hall. All rights reserved.4-38Shifts in the Supply CurveCopyright 2009 Pearson Prentice Hall. All rights reserved.4-39Summary of Shifts in the Supply of Bonds1.Expected Profitability of Investment Opport
40、unities: 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 falls2.Expected Inflation: an increase in expected inflation causes the supply of bonds to increase3.Governmen
41、t Activities: higher government deficits increase the supply of bonds, conversely, government surpluses decrease the supply of bondsCopyright 2009 Pearson Prentice Hall. All rights reserved.4-40Copyright 2009 Pearson Prentice Hall. All rights reserved.4-41Case: Fisher EffectWeve done the hard work.
42、Now we turn to some special cases. The first is the Fisher Effect. Recall that rates are composed of several components: a real rate, an inflation premium, and various risk premiums.What if there is only a change in expected inflation?Copyright 2009 Pearson Prentice Hall. All rights reserved.4-42Cha
43、nges in e: The Fisher Effect If e 1.Relative Re , Bd shifts in to left2.Bs , Bs shifts out to right3.P , i Copyright 2009 Pearson Prentice Hall. All rights reserved.4-43Evidence on the Fisher Effect in the United StatesCopyright 2009 Pearson Prentice Hall. All rights reserved.4-44Summary of the Fish
44、er Effect1.If expected inflation rises from 5% to 10%, the expected return on bonds relative to real assets falls and, as a result, the demand for bonds falls2.The rise in expected inflation also means that the real cost of borrowing has declined, causing the quantity of bonds supplied to increase3.
45、When the demand for bonds falls and the quantity of bonds supplied increases, the equilibrium bond price falls4.Since the bond price is negatively related to the interest rate, this means that the interest rate will riseCopyright 2009 Pearson Prentice Hall. All rights reserved.4-45Case: Business Cyc
46、le ExpansionAnother good thing to examine is an expansionary business cycle. Here, the amount of goods and services for the country is increasing, so national income is increasing.What is the expected effect on interest rates?Copyright 2009 Pearson Prentice Hall. All rights reserved.4-46Business Cyc
47、le Expansion1.Wealth , Bd , Bd shifts out to right2.Investment , Bs , Bs shifts right3.If Bs shifts more than Bd then P , i Copyright 2009 Pearson Prentice Hall. All rights reserved.4-47Evidence on Business Cycles and Interest RatesCopyright 2009 Pearson Prentice Hall. All rights reserved.4-48Case:
48、Low Japanese Interest RatesIn November 1998, Japanese interest rates on six-month Treasury bills turned slightly negative. How can we explain that within the framework discussed so far?Its a little tricky, but we can do it!Copyright 2009 Pearson Prentice Hall. All rights reserved.4-49Case: Low Japan
49、ese Interest Rates1.Negative inflation lead to Bd Bd shifts out to right2.Negative inflation lead to in real ratesBs shifts out to leftNet effect was an increase in bond prices (falling interest rates).Copyright 2009 Pearson Prentice Hall. All rights reserved.4-50Case: Low Japanese Interest Rates3.B
50、usiness cycle contraction lead to in interest ratesBs shifts out to leftBd shifts out to leftBut the shift in Bd is less significant than the shift in Bs, so the net effect was also an increase in bond prices.Copyright 2009 Pearson Prentice Hall. All rights reserved.4-51Case: WSJ “Credit Markets”Eve
51、ryday, the Wall Street Journal reports on developments in the bond market in its “Credit Markets” column.Take a look at page 91 in your text for an example of how to interpret what it says.Copyright 2009 Pearson Prentice Hall. All rights reserved.4-52Case: WSJ “Credit Markets”What is this article te
52、lling us?Strength in a sector helped lower T-bond prices (increase rates). That follows what we learned!A stronger economy shifts both curves to the right, but the supply curve by more, so prices will fall.Copyright 2009 Pearson Prentice Hall. All rights reserved.4-53Case: WSJ “Credit Markets”Articl
53、e also points out that yields on govt bonds in Germany and Japan are rising. Money will move from the U.S. Treasury market to these markets, shifting the demand curve to the left (falling prices).The strong economy also suggests a lower chance of future Fed rate cuts, further shifting the demand cur
54、ve to the left.Copyright 2009 Pearson Prentice Hall. All rights reserved.4-54The Practicing ManagerWe now turn to a more practical side to all this. Many firms have economists or hire consultants to forecast interest rates. Although this can be difficult to get right, it is important to understand w
55、hat to do with a given interest rate forecast.Copyright 2009 Pearson Prentice Hall. All rights reserved.4-55Profiting from Interest-Rate ForecastsMethods for forecasting1. Supply and demand for bonds: use Flow of Funds Accounts and judgment2. Econometric Models: large in scale, use interlocking equa
56、tions that assume past financial relationships will hold in the futureCopyright 2009 Pearson Prentice Hall. All rights reserved.4-56Profiting from Interest-Rate Forecasts (cont.)Make decisions about assets to hold1.Forecast i , buy long bonds2.Forecast i , buy short bondsMake decisions about how to
57、borrow1.Forecast i , borrow short2.Forecast i , borrow longCopyright 2009 Pearson Prentice Hall. All rights reserved.4-57Chapter SummaryDetermining Asset Demand: We examined the forces that affect the demand and supply of assets.Supply and Demand in the Bond Market: We examine those forces in the co
58、ntext of bonds, and examined the impact on interest rates.Copyright 2009 Pearson Prentice Hall. All rights reserved.4-58Chapter Summary (cont.)Changes in Equilibrium Interest Rates: We further examined the dynamics of changes in supply and demand in the bond market, and the corresponding effect on bond prices and interest rates.
