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3323ch4-5

3323ch4-5 - Chapter 4 Interest Rate Measurement and...

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Chapter 4 Interest Rate Measurement and Behavior Chapter 5 The Risk and Term Structure of Interest Rates LEVEL OF INTEREST RATES Fisher Effect (risk-free rate) Interest rate has 2 components: (1) real rate (2) inflation premium I = r+ IP STRUCTURE OF INTEREST RATES http://www.ratecurve.com/yc2.html Term Structure of Interest Rates - defines the relationship between maturity & annualized yield, holding other factors such as risk, taxes, etc., constant. Graphic presentation is the yield curve. Curve shifts and twists through time. Four Basic Shapes: Positive Yield Curve: upward sloping Negative Yield Curve: downward sloping Flat Yield Curve Humped Yield Curve Level of Interest Rates: Loanable Funds Theory -- market interest rate is determined by the factors that control the supply of and demand for loanable funds. Demand Factors Household: Y increases then installment debt increases R increases then installment debt falls

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Business: Government: interest inelastic 1980: debt/GNP =25% 1987: debt/GNP=42% Foreign Foreign interest rates vs. U.S. rates Supply Households - largest suppliers Very steep slope for supply. Why? What happens if expect higher inflation? Savers - ) i + (1 CF 1 = T n + I - = NPV t t (?) NPV decrease i if _
Liquidity Preference Theory - Market rate of interest is determined by demand/supply of money balances. Demand of Money + Transaction f(y) + Precautionary f(y) - Speculative f(r) Supply of Money Fed basically determines supply Few uncontrollable factors (1) banks lending (2) public's preference for cash Letting D=S then solve for interest rate: ) e p + , m - , y + ( f = r _

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THEORIES ON SHAPE OF YIELD CURVE Unbiased Expectations expected future short-term interest rates. A 2 year security should offer a return that is similar to the anticipated return from investing in 2 consecutive one-year securities. t+1 r 1 / one year interest rate that is anticipated as of time t+1. t+2 r 1 / one year interest rate that is anticipated as of time t+2. R 1 } R 2 } Known annualized rate on 1 year security, 2 year security, 3 year security. R 3 } ) r + )(1 R + (1 = ) R + (1 1 1 + t 1 t 2 2 t ) r + )(1 r + )(1 R + (1 = ) R + (1 1 2 + t 1 1 + t 1 t 3 3 t
Eg. if then Expect interest rates to rise: investor (saver) wants s-t security borrowers want L-T security Borrowers are the suppliers of securities (IOU's) therefore s-t demand > supply then increase in Price which results in a decrease in yield and we have an upward sloping curve. Risk neutral

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3323ch4-5 - Chapter 4 Interest Rate Measurement and...

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