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http://eco375.posterous.com/commercial-‐paper-‐interest-‐rate
4. Show
a
comparative
statics
analysis.
b. Inflation
i. What
change
in
behavior
would
an
increase
in
expected
inflation
bring
about?
1. Spending
is
brought
forward/supply
of
savings
in
decreased
–
this
can
also
show
up
as
increased
borrowing
2. Both
of
these
actions
lead
to
an
increase
in
interest
rates
ii. Example
#3:
1. Based
on
this
graph
and
assuming
that
individuals
assume
current
inflation
rates
are
the
best
predictor
of
future
inflation
rates,
when
would
you
have
expected
interest
rates
to
be
highest?
http://eco375.posterous.com/inflation-‐graph
http://eco375.posterous.com/10-‐year-‐treasury-‐rate
c. Monetary
policy
(see
notes
from
week
#2)
d. Budget
deficit
(increase
in
demand)
i. Crowding
out
effect
1. Is
the
the
gov’t
demand
curve
vertical?
2. What
does
that
mean
for
other
sources
of
demand
e. Foreign
flows
i. Supply
and
demand
characteristics
vary
among
currencies
based
on
inflation,
economic
growth,
size
and
scale
of
economy,
etc
III. Forecasting
Interest
Rates
a. Calculate
Net
demand
i. If
net
demand
in
positive,
interest
rates
will
rise
until
mkt
is
in
equilibrium
ii. If
net
demand
is
negative,
interest
rates
will
decline
until
mkt
is
in
equilibrium
IV. What
causes
yields
to
vary?
a. Credit
risk
http://eco375.posterous.com/treasury-‐and-‐baa
b. Liquidity
c. Tax
status
i. Tax
equivalent
yield
1. Yield
(after-‐tax)
=
yield
(before-‐tax)*(1-‐
tax
rate)
d. Term
to
maturity
i. Yield
Curve
http://www.bloomberg.com/markets/rates/index.html
V. Estimate
the
appropriate
yield
a. Use
the
components
above
to
“build”
the
appropriate
yield
for
a
security
VI. Does
reality
match
theory?
a. http://www.frbsf.org/publications/economics/letter/2008/el2008-‐
10.html
i. “They
find
that
liquidity
risk
is
priced
into
credit
spreads
and
explains
a
significant
portion
of
observed
credit
spreads.
The
size
of
the
liquidity
premium
is
determined
by
the
size
of
the
bond
issuance,
the
yield
volatility,
and
the
age
of
the
bond.
They
also
find
that
the
liquidity
risk
premium
is
time-‐varying.”
ii. “Despite
this
careful
setup
there
is
still
about
one-‐third
of
the
credit
spread
for
the
average
BBB-‐rated
firm
that
is
not
explained
by
Driessen's
model.
He
refers
to
this
missing
piece
as
a
large
risk
premium
possibly
caused
by
a
tendency
for
firms
to
default
in
waves.
This
is
a
risk
that
is
difficult
to
eliminate
by
diversification
and
therefore
investors
could
require
a
premium
to
be
willing
to
carry
it.”
VII. More
about
the
term
structure
a. Pure
Expectations
theory
i. Term
structure
is
determined
solely
by
expectations
of
future
interest
rates
1. Impact
of
expected
increase
in
IR
on:
a. short
term
supply
and
demand
b. long
term
supply
and
demand
2. Impact
of
expected
decrease
in
IR
on:
a. short
term
supply
and
demand
b. long
term
supply
and
demand
b. Liquidity
preference
theory
i. Short
term
securities
tend
to
be
more
liquid
c. Segmented
market
theory
i. Buyers
and
sellers
choose
securities
that
march
their
cash-‐flow
needs