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Week Four

Market participants and reasons for trading


Price behaviour
The impact of maturity date
The risk and term structures of interest rates
Trading strategies and rate forecasting
Viney Chapter 13

Week 4

Learning Objectives

Explain the reasons for a change in the


Central Bank interest rate policy
Describe how changes in official interest
rates affect the rest of the economy
Describe how a yield curve is constructed
Explain the theories that describe how a yield
curve obtains its shape
Week 4

Introduction

In most developed economies monetary


policy actions are directed at influencing
interest rates
By understanding what motivates a central
bank in its implementation of interest rates
policy

Financial market participants can anticipate


changes in interest rate policy
Lenders and borrowers can make better-informed
decisions
Week 4

RBA Responsibilities

"It is the duty of the Reserve Bank Board, within the limits of its
powers, to ensure that the monetary and banking policy of the
Bank is directed to the greatest advantage of the people of
Australia and that the powers of the Bank ... are exercised in
such a manner as, in the opinion of the Reserve Bank Board,
will best contribute to:
(a) the stability of the currency of Australia;
(b) the maintenance of full employment in Australia; and
(c) the economic prosperity and welfare of the people of
Australia."

Source http://www.rba.gov.au/MonetaryPolicy/about_monetary_policy.html

Monetary policy seeks to achieve this over the medium term,


and subject to that, encourage strong and sustainable growth in
the long-term.

Week 4

Macroeconomic Context of
Interest Rate Determination

A central bank may increase interest rates if


there is

Inflation above three per cent (in Australia)


Excessive growth in GDP
A large deficit in the balance of payments
Rapid growth in credit and debt levels
Excessive downward pressure on the domestic
currency
Week 4

Macroeconomic Context of Interest


Rate Determination (cont.)

An expected increase in interest rates (i.e.


tightening of monetary policy) will

Eventually increase long-term rates (if it has not


already done so).
Slow consumer spending

Reducing inflation and demand for imports

Week 4

Macroeconomic Context of Interest


Rate Determination (cont.)

Effects of changes in interest rates

Economic indicators provide market participants


with insight into possible future economic growth
and the likelihood of central bank intervention

Week 4

Macroeconomic Context of Interest


Rate Determination (cont.)

Economic indicators

Leading indicators (Examples??)

Coincident indicators (Examples ??)

Economic series that change at the same time as the


rest of the economy.

Lagging indicators (Examples??)

Economic series that tend to rise or fall in advance of


the rest of the economy.

Economic series that change after the rest of the


economy.
Week 4

Macroeconomic Context of Interest


Rate Determination (cont.)

Economic indicators (cont.)

Difficulties exist with

Knowing the extent of the timing lead or lag of such


indicators
Consistently performing indicators e.g. rates of growth in
money measures were once lead indicators and are now
lagging indicators

Week 4

So Which Indicators Should you


Watch?

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CPI
Unemployment
Retail sales
Home sales
New car sales
Surveys consumer or business sentiment,
business investment plans and expectations
Week 4

Term & Risk Structure of Rates

Definition: the term structure of interest rates is the


spread of yields of a security with a given issuer
across different maturities of that security

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Known as a YIELD CURVE

Definition: the risk structure of interest rates is the


spread of yields on securities with the same maturity
across different issuers at that maturity

Week 4

Term Structure of Interest Rates

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The yield curve is a chart showing the


schedule of yields for various maturities of a
security

Week 4

Term Structure - continued

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Two basic types of yield curve:


normal - upward sloping

Week 4

Term Structure - continued

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inverse - downward sloping

Week 4

Term Structure - continued

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The gap between the yield curves on two securities


indicates their different credit risk

Week 4

Term Structure - continued

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The term structure affects borrowing and investing


strategies
Example : an investor decides to purchase bonds
over a 10-year horizon. From the last chart the
choices include:
1. Buy a single 10-yr bond at 6%
2. Buy a 5-yr bond at 7% then another 5-yr bond
3. Buy a 2-yr bond at 8% then four 2-yr bonds
4. Buy a 15-yr bond at 7% and sell after 10 years

Week 4

Term Structure - continued

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The term structure can be used to lock in


future interest rates

Definition: the forward rate is an interest rate


which is fixed for a future transaction

By a correct combination of spot transactions


we can fix a forward interest rate today
Week 4

Term Structure - continued

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Example: a company knows it will need to borrow


$104,000 for a term of one year in exactly twelve
months time and wishes to fix the interest rate in
advance
Solution: assuming the yield curve on the next slide
the forward rate is secured by:
1. borrowing for 2 years at 5%, and
2. investing the proceeds for 1 year at 4%

Week 4

Term Structure - continued

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Week 4

Term Structure - continued

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Example continued: the cash flow from the


borrowing is $110,250/(1.05)2 = $100,000
and the company then invests this at 4% to
give $100,000(1.04) = $104,000 in 12
months
The net ratio is $110,250/$104,000 = 1.0601.
That is, the company has secured a 1-year
forward rate of 6.01%.
We observe that (1.0601)1 = (1.05)2/(1.04)1
Week 4

Term Structure - continued

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Generalising from the above example: the


forward interest rate rx.y on a security that
commences in year x and matures in year y
can be found by combining spot rates:
(rx,y)1 = (1 + r0,y)y / (1 + r0,x)x
E.g. if the 3-year spot is 6% and 2-year spot
is 5% then (1+r2,3)1 = (1.06)3 / (1.05)2 =
1.0803
Week 4

Term Structure Theories : PET

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Pure Expectations Theory (PET) says the shape of


the yield curve is determined solely by market
interest rate expectations
Assumptions:
- no transactions costs
- investors view securities with different
maturities as perfect substitutes
- long dated securities carry same risk as short
dated securities
Week 4

Theories of the Term Structure


PET continued

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Implications of PET:
upward sloping yield curve always means the
market expects rising future rates
investing a single n-year bond will yield the
same return as n 1-year bonds
observed forward rates equal (unobservable)
expected future spot rates
the term structure embodies predictions of
future spot rates
Week 4

Theories of the Term Structure


PET continued
Empirical evidence:
PET explains the phenomenon of
inverse yield curves
The role of expectations helps explain
volatility in yield curves
The yield curve can often predict the
economic cycle

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Week 4

Term Structure Theories : LPT

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Liquidity Premium Theory (LPT) says


compensation is included in longer term
yields to reward investors for tying their
money up for extended periods
Longer dated bonds therefore contain a risk
premium
E.g: if the expected future rate is 6% and the
risk premium is 1%, the forward rate is 7%
Week 4

Theories of the Term Structure


LPT continued

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Implications of LPT:
the yield curve should slope upwards more
often than downwards
investing in consecutive short term bonds will
not provide same return as investing in a
single long term bond
implied forward rates are greater than
expected future spot rates
the term structure cannot tell us much
Week 4

Term Structure Theories : SMT

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Segmented Markets Theory (SMT) says the


markets for different maturities of a security
are segmented so that the yield on each
maturity is determined by supply and
demand in that maturity band
Bond markets are seen as dominated by
large institutional players with preferences for
certain maturities
Week 4

Theories of the Term Structure


SMT continued

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Implications of Segmented Markets Theory

An upward sloping yield curve is due to


excess demand for short term securities
and/or excess supply of long term ones

The yield curve contains no information


about the markets expectations
Week 4

Term Structure Theories : PHT

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Preferred Habitat Theory (PHT) combines


PET, LPT and SMT

Investors have a preferred habitat (SMT),


demand a premium to move out of this
maturity (LPT) and base their decisions on
expected future spot rates (PET)

Week 4

Risk Structure of Interest Rates

The yield spread is the gap between the


yields on two securities with the same
maturity but different issuers
Three factors influence the yield spread:

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Credit risk
Liquidity
Supply of securities

Week 4

Risk Structure - continued

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Credit risk is the risk that a borrower will not


repay the interest and/or principal on a debt.
Also known as default risk.
CGS are regarded by the market as having
zero default risk
Private sector bonds have non-zero default
risk, reflected in a risk premium over CGS

Week 4

Risk Structure - continued

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Credit Ratings measure the likelihood of


default and are made by an independent
rating agency
Ratings are based on factors such as the
issuers financial accounts, management
quality and strategic direction
Ratings allow the market to price paper for
credit risk
Week 4

Risk structure - continued

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Week 4

Conclusion

This lecture has covered

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The role of the Central Bank in the interest rate


markets
The factors that influence the Central Bank
Term structure of interest rates yield curve
Risk structure of interest rates.

Week 4

Week Five

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The roles of government in the financial


markets
Reasons for borrowing by government.
The dual role of the central bank - monetary
management and financial stability.
The implementation of monetary policy.
The relationship between the central bank
and government
Week 4