1、Chapter 4Why Do Interest Rates Change?Chapter PreviewIn the early 1950s, short-term Treasury bills were yielding about 1%. By 1981, the yields rose to 15% and higher, then fell to 3% in 1993, rose above 5% by the mid-1990s, dropped back to 1% by 2003, then began rising again to over 5% by 2007.What

2、causes these changes?2Copyright 2009 Pearson Prentice Hall. All rights reserved.Chapter PreviewIn this chapter, we examine the forces the move interest rates and the theories behind those movements. Topics include:Determinants of Asset DemandSupply and Demand in the Bond MarketChanges in Equilibrium

3、 Interest Rates3Copyright 2009 Pearson Prentice Hall. All rights reserved.Determinants of Asset DemandWealthThe total resources owned by the individual, including all assetsPositive RelationshipExpected returnThe return expected over the next period on one asset relative to alternative assetsPositiv

4、e RelationshipRisk The degree of uncertainty associated with the return on one asset relative to alternative assetsNegative RelationshipLiquidity The ease and speed with which an asset can be turned into cash relative to alternative assetsPositive Relationship.Determinants of Asset DemandAn asset is

5、 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:4Copyright 2009 Pearson Prentice Hall. All rights reserved.EXAMPLE 1: Expected ReturnWhat is the e

6、xpected return on an Exxon-Mobil bond if the return is 12% two-thirds of the time and 8% one-third of the time?SolutionThe expected 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=.33

7、R2 = return in state 2=8%=0.08ThusRe = (.67)(0.12) + (.33)(0.08) = 0.1068 = 10.68%.5Copyright 2009 Pearson Prentice Hall. All rights reserved.EXAMPLE 2: Standard Deviation (a)Consider the following two companies and their forecasted returns for the upcoming year:What is the standard deviation of the

8、 returns on the Fly-by-Night Airlines stock and Feet-on-the-Ground Bus Company, with the return outcomes and probabilities described above? Of these two stocks, which is riskier?6Copyright 2009 Pearson Prentice Hall. All rights reserved.EXAMPLE 2: Standard Deviation (c)SolutionFly-by-Night Airlines

9、has a standard deviation of returns of 5%.7Copyright 2009 Pearson Prentice Hall. All rights reserved.EXAMPLE 2: Standard Deviation (d)Feet-on-the-Ground Bus Company has a standard deviation of returns of 0%.8Copyright 2009 Pearson Prentice Hall. All rights reserved.EXAMPLE 2: Standard Deviation (e)F

10、ly-by-Night Airlines 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-

11、the-Ground Bus Company, which has a certain return。9Copyright 2009 Pearson Prentice Hall. All rights reserved.EXAMPLE 2: Standard Deviation (e)A 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

12、 expected return, 10%. By contrast, a person who prefers risk is a risk preferrer or risk lover. We assume people are risk-averse, especially in their financial decisions.10Copyright 2009 Pearson Prentice Hall. All rights reserved.Determinants of Asset Demand The quantity demanded of an asset differ

13、s by factor. Wealth: Holding everything else constant, an increase in wealth raises the quantity demanded of an assetExpected 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 assetRisk: H

14、olding everything else constant, if an assets risk rises relative to that of alternative assets, its quantity demanded will fallLiquidity: 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 dem

15、anded11Copyright 2009 Pearson Prentice Hall. All rights reserved.Determinants of Asset Demand 12Copyright 2009 Pearson Prentice Hall. All rights reserved.QuestionsExplain why you would be more or less willing to buy a share of Polaroid stock in the following situations:a. You just inherited 100,000b

16、.You expect it to appreciate in valuec.The bond market becomes more liquid.d.You expect gold to appreciate in valuee.Prices in the bond market become more volatile.13Copyright 2009 Pearson Prentice Hall. All rights reserved.Quantitative ProblemsYou own a $1,000-par zero-coupon bond that has 5 years

17、of remaining maturity. You plan on selling the bond in one year, and believe that the required yield next year will have the following probability distribution:a.What is your expected price when you sell the bond?b.What is the standard deviation of the bond price?ProbabilityRequired Yield0.16.60%0.2

18、6.75%0.47.00%0.27.20%0.17.45%14Copyright 2009 Pearson Prentice Hall. All rights reserved.Quantitative ProblemsConsider a $1,000-par junk bond paying a 12% annual coupon. The issuing company has 20% chance of defaulting this year; in which case, the bond would not pay anything. If the company survive

19、s the first year, paying the annual coupon payment, it then has a 25% chance of defaulting in the second year. If the company defaults in the second year, neither the final coupon payment nor par value of the bond will be paid. What price must investors pay for this bond to expect a 10% yield to mat

20、urity? At that price, what is the expected holding period return? Standard deviation of returns? Assume that periodic cash flows are reinvested at 10%.15Copyright 2009 Pearson Prentice Hall. All rights reserved.Supply & Demand in the Bond MarketInterest rates are negatively related to the price of b

21、onds, so we will apply supply and demand analysis to examine how bond prices and interest rates changess. because rates tend to move together, we will proceed as if there is one interest rate for the entire economy.The analysis of interest rate determination by the supply of and demand for bonds16Co

22、pyright 2009 Pearson Prentice Hall. All rights reserved.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.Demand Curveit shows the relationsh

23、ip between the quantity demanded and the price of a bond when all other economic variables are held constant.17Copyright 2009 Pearson Prentice Hall. All rights reserved.Point B: if the bond was selling for $900.Derivation of Demand CurvePoint A: if the bond was selling for $950.How do we know the de

24、mand (Bd) at point A is 100 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.18Copyright 2009 Pearson Prentice Hall. All rights reserved.Derivation of Demand CurveTo continue

25、 Point C:P = $850i = 17.6%Bd = 300Point D:P = $800i = 25.0%Bd = 400Point E:P = $750i = 33.0%Bd = 500Demand Curve is Bd in Figure 1 which connects points A, B, C, D, E.Has usual downward slope19Copyright 2009 Pearson Prentice Hall. All rights reserved.Supply and Demand for Bonds20Copyright 2009 Pears

26、on Prentice Hall. All rights reserved.Derivation of Supply CurveSupply Curveit shows the relationship between the quantity supplied and the price of a bond when all other economic variables are held constant.Point F:P = $750i = 33.0%Bs = 100Point G:P = $800i = 25.0%Bs = 200Point C:P = $850i = 17.6%B

27、s = 300Point H:P = $900i = 11.1%Bs = 400Point I:P = $950i = 5.3%Bs = 500Supply Curve is Bs that connects points F, G, C, H, I-Has upward slope21Copyright 2009 Pearson Prentice Hall. All rights reserved.Supply and Demand for Bonds22Copyright 2009 Pearson Prentice Hall. All rights reserved.Market Equi

28、libriumThe equilibrium follows what we know from supply-demand analysis:Occurs when Bd = Bs, at P* = 850, i* = 17.6%When P = $950, i = 5.3%, Bs Bd (excess supply): P to P*, i to i*When P = $750, i = 33.0, Bd Bs (excess demand): P to P*, i to i*23Copyright 2009 Pearson Prentice Hall. All rights reser

29、ved. occurs when the amount that people are willing to buy (demand) equals the amount that people are willing to sell (supply) at a given priceMarket Conditions Market Equilibrium1 occurs when the amount that people are willing to sell (supply) is greater than the amount people are willing to buy (d

30、emand) at a given priceExcess Supply2 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 priceExcess Demand324Copyright 2009 Pearson Prentice Hall. All rights reserved.Quantitative ProblemsAn economist has con

31、cluded that, near the point of equilibrium, the demand curve and supply curve for one-year discount bonds can be estimated using the following equations：Bd:Bs:a. What is the expected equilibrium price and quantity of bonds in this market?b.Given your answer to part(a), which is the expected interest

32、 rate in this marekt?25Copyright 2009 Pearson Prentice Hall. All rights reserved.Supply & 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

33、 just illustrates what we already know: bond prices and interest 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 m

34、ix. So we will focus on the stock approach.26Copyright 2009 Pearson Prentice Hall. All rights reserved.Theory of how the general level of interest rates are determinedLoanable Funds Theory of Interest Rate DeterminationLoanable Funds TheoryInterest rates determined by supply of and demand for loanab

35、le funds 27Copyright 2009 Pearson Prentice Hall. All rights reserved.Loanable Funds Theory, cont.Demand = borrowers, issuers of securities, deficit spending unitSupply = lenders, financial investors, buyers of securities, surplus spending unitAssume economy divided into sectors28Copyright 2009 Pears

36、on Prentice Hall. All rights reserved.Sectors of the EconomyHousehold Sector:Usually a net supplier of loanable fundsSectors of the EconomyForeign Sector:Net supplierGovernment Sector:Demander for loanable fundsBusiness Sector:Usually a net demander in growth periods29Copyright 2009 Pearson Prentice

37、 Hall. All rights reserved.Demand for Loanable Funds Households demand loanable funds to finance housing, automobiles, household itemsThese purchases result in installment debt. Installment debt increases with the level of incomeThere is an inverse relationship between the interest rate and the quan

38、tity of loanable funds demanded Household demand for loanable funds130Copyright 2009 Pearson Prentice Hall. All rights reserved.Demand for Loanable Funds Businesses demand loanable funds to invest in assetsQuantity of funds demanded depends on how many projects to be implementedBusinesses choose pro

39、jects by calculating the projects Net Present Value, and projects with a positive NPV are accepted because the present value of their benefits outweighs their costsIf interest rates decrease, more projects will have a positive NPV Business demand for loanable funds231Copyright 2009 Pearson Prentice

40、Hall. All rights reserved.Demand for Loanable Funds When planned expenditures exceed revenues from taxes, the government demands loanable fundsMunicipal (state and local) governments issue municipal bondsFederal government and its agencies issue Treasury securities and federal agency securities.Gove

41、rnment demand for funds is interest-inelastic Government demand for loanable funds332Copyright 2009 Pearson Prentice Hall. All rights reserved.Demand for Loanable Funds A foreign countrys demand for U.S. funds is influenced by the differential between its interest rates and U.S. ratesThe quantity of

42、 U.S. loanable funds demanded by foreign investors will be inversely related to U.S. interest rates Foreign demand for loanable funds433Copyright 2009 Pearson Prentice Hall. All rights reserved.Demand for Loanable FundsThe aggregate demand for loanable funds is the sum of the quantities demanded by

43、the separate sectorsThe aggregate demand for loanable funds is inversely related to interest ratesInterest RateQuantity of Loanable Funds34Copyright 2009 Pearson Prentice Hall. All rights reserved.Sector Supply of Loanable FundsHouseholds are major suppliers of loanable fundsBusinesses and governmen

44、ts may invest (loan) funds temporarilyForeign sector a net supplier of funds in last twenty yearsFederal Reserves monetary policy impacts supply of loanable funds35Copyright 2009 Pearson Prentice Hall. All rights reserved.Supply of Loanable FundsThe aggregate supply of loanable funds is sum of secto

45、r supply (quantity) at varying levels of interest rates Quantity supplied directly related to interest ratesInterestRateQuantity of Loanable FundsS36Copyright 2009 Pearson Prentice Hall. All rights reserved.Loanable Funds TheoryEquilibrium Interest RateAggregate DemandDA = Dh + Db + Dg + Dm + DfAggr

46、egate SupplySA = Sh + Sb + Sg + Sm + SfIn equilibrium, DA = SA37Copyright 2009 Pearson Prentice Hall. All rights reserved.Loanable Funds TheoryDemand for Loanable FundsSupply of Loanable FundsInterest RatesQuantity of Loanable Funds38Copyright 2009 Pearson Prentice Hall. All rights reserved.Changes

47、in Equilibrium Interest RatesAnalyze why interest rates change by using the supply and demand framework for bonds. To avoid confusion:Movements along a demand(supply) curveShifts in a demand(supply) curveA change in the price of the bond/interest rateA change in some other factor besides the bonds p

48、rice/interest rate39Copyright 2009 Pearson Prentice Hall. All rights reserved.Factors That Shift Demand Curve40Copyright 2009 Pearson Prentice Hall. All rights reserved.How Factors Shift the Demand CurveWealth/SavingEconomy , wealth Bd , Bd shifts to rightOREconomy , wealth Bd , Bd shifts to left41C

49、opyright 2009 Pearson Prentice Hall. All rights reserved.How Factors Shift the Demand Curve2.Expected Returns on bondsi in future, Re for long-term bonds Bd shifts to rightER on other asset (stock) Re for long-term bonds Bd shifts to righte , relative Re Bd shifts to right42Copyright 2009 Pearson Pr

50、entice Hall. All rights reserved.How Factors Shift the Demand CurveRiskRisk of bonds , Bd Bd shifts to rightORRisk of other assets , Bd Bd shifts to right43Copyright 2009 Pearson Prentice Hall. All rights reserved.How Factors Shift the Demand Curve4.LiquidityLiquidity of bonds , Bd Bd shifts to righ

51、tORLiquidity of other assets , Bd Bd shifts to right44Copyright 2009 Pearson Prentice Hall. All rights reserved.Summary of Shifts in the Demand for BondsWealth: in a business cycle expansion with growing wealth, the demand for bonds rises, conversely, in a recession, when income and wealth are falli

52、ng, the demand for bonds fallsExpected 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 bonds45Copyright 2009 Pearson Prentice Hall. All rights reserved.Summary of

53、Shifts in the Demand for Bonds (2)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 riseLiquidity: increased liquidity of the bond market results in an increased

54、 demand for bonds, conversely, increased liquidity of alternative asset markets (like the stock market) lowers the demand for bonds46Copyright 2009 Pearson Prentice Hall. All rights reserved.Quantitative ProblemsThe demand curve and supply curve for bonds are estimated using the following equations:

55、 Bd: Price= Bs: Price =Quantity +500Following a dramatic increase in the value of the stock market, many retirees started moving money out of the stock market and into bonds. This resulted in a parallel shift in the demand for bonds, such that the price of bonds at all quantities increased $50. Assu

56、ming no change in the supply equation for bonds, what is the new equilibrium price and quantity? What is the new market interest rate?47Copyright 2009 Pearson Prentice Hall. All rights reserved.Factors That Shift Supply CurveFactors that shiftsupply curveShifts in the Supply CurveProfitability of In

57、vestment OpportunitiesBusiness cycle expansion,investment opportunities , Bs , Bs shifts to right49Copyright 2009 Pearson Prentice Hall. All rights reserved.Shifts in the Supply Curve3.Expected Inflatione , Bs Bs shifts to right2.Government ActivitiesDeficits , Bs Bs shifts to right50Copyright 2009

58、Pearson Prentice Hall. All rights reserved.Summary of Shifts in the Supply of BondsExpected 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

59、supply of bonds fallsGovernment Activities: higher government deficits increase the supply of bonds, conversely, government surpluses decrease the supply of bondsExpected Inflation: an increase in expected inflation causes the supply of bonds to increase51Copyright 2009 Pearson Prentice Hall. All ri

60、ghts reserved.Case: Fisher EffectRecall 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?If e Relative Re , Bd shifts to leftBs , Bs shifts to right3. P , i 52Copyright 2009 Pearson Prenti