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A/Prof Jason Zein

Email: j.zein@unsw.edu.au
Tel: 9385-5875
Consult: Wednesday 2-4pm
Room: BUS 310

Copyright 2012 McGraw-Hill Australia Pty Ltd


PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips
Slides prepared by Peter Phillips

13-1
1

INTEREST RATE DETERMINATION

Copyright 2012 McGraw-Hill Australia Pty Ltd


PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips
Slides prepared by Peter Phillips

13-2

LEARNING OBJECTIVES
Describe the macroeconomic context of interest rate

determination
Explain the loanable funds approach to interest rate

determination, including supply and demand variables for


loanable funds, equilibrium and the effect of changes in
variables on interest rates
Understand yields, yield curves and term structures of

interest rates, and apply the expectations theory,


segmented markets theory and liquidity premium theory
Explain the risk structure of interest rates and the impact

of default risk on interest rates

Copyright 2012 McGraw-Hill Australia Pty Ltd


PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips
Slides prepared by Peter Phillips

13-3

CHAPTER ORGANISATION
13.1 Macroeconomic context of interest rate
determination
13.2 Loanable funds approach to interest rate
determination
13.3

Term structure of interest rates

13.4

Risk Structure of interest rates

13.5

Summary

Copyright 2012 McGraw-Hill Australia Pty Ltd


PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips
Slides prepared by Peter Phillips

13-4

13.1MACROECONOMIC CONTEXT OF
INTEREST
RATE DETERMINATION
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 a


governments interest rate policy

lenders and borrowers can make better-informed decisions

Copyright 2012 McGraw-Hill Australia Pty Ltd


PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips
Slides prepared by Peter Phillips

13-5

13.1MACROECONOMIC CONTEXT OF
INTEREST RATE DETERMINATION
(CONT.)
A central bank may increase interest rates if

there is:

inflation above target range

excessive growth in GDP

a large deficit in the balance of payments

rapid growth in credit and debt levels

excessive downward pressure on FX markets

Copyright 2012 McGraw-Hill Australia Pty Ltd


PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips
Slides prepared by Peter Phillips

13-6

13.1MACROECONOMIC CONTEXT OF
INTEREST RATE DETERMINATION
(CONT.)
An increase in interest rates (i.e. tightening of

monetary policy) will:

eventually increase long-term rates

slow consumer spending

reducing inflation and demand for imports

decrease the size of the current account

possibly attract foreign investment, causing the domestic


currency to appreciate

Copyright 2012 McGraw-Hill Australia Pty Ltd


PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips
Slides prepared by Peter Phillips

13-7

13.1MACROECONOMIC CONTEXT OF
INTEREST
RATE DETERMINATION
(CONT.)
Three effects of changes in interest rates
1. Liquidity effect

The effect of the RBAs market operations on the money supply and
system liquidity

E.g. RBA increases rates (i.e. tightens monetary policy) by selling


CGSs

2. Income effect

A flow-on effect from the liquidity effect

If interest rates rise, economic activity will slow, allowing rates to ease

Increased rates reduce spending levels and income levels

Copyright 2012 McGraw-Hill Australia Pty Ltd


PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips
Slides prepared by Peter Phillips

13-8

13.1MACROECONOMIC CONTEXT OF
INTEREST RATE DETERMINATION
(CONT.)
Three effects of changes in interest rates (cont.)
3. Inflation effect

As the rate of growth in economic activity slows, demand for


loans also slows

This results in an easing of the rate of inflation

Copyright 2012 McGraw-Hill Australia Pty Ltd


PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips
Slides prepared by Peter Phillips

13-9

13.1MACROECONOMIC CONTEXT OF
INTEREST RATE DETERMINATION
(CONT.)

(cont.
)
Copyright 2012 McGraw-Hill Australia Pty Ltd
PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips
Slides prepared by Peter Phillips

13-10

13.1MACROECONOMIC CONTEXT OF
INTEREST
RATE DETERMINATION
(CONT.)
Liquidity, income and inflation effects of changes

in interest rates (cont.)

It is difficult to forecast the extent of liquidity, income and


inflation effects on changes in interest rates

Particularly when the business cycle is about to change, i.e. is at


a peak or trough

Economic indicators provide an insight into possible future


economic growth and the likelihood of central bank
intervention

(cont.
)
Copyright 2012 McGraw-Hill Australia Pty Ltd
PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips
Slides prepared by Peter Phillips

13-11

13.1MACROECONOMIC CONTEXT OF
INTEREST
RATE DETERMINATION
(CONT.)
Economic indicators

Leading indicators

Coincident indicators

Economic variables that change before a change in the business


cycle
Economic variables that change at the same time as the
business cycle changes

Lagging indicators

Economic variables that change after the business cycle


changes

(cont.
)
Copyright 2012 McGraw-Hill Australia Pty Ltd
PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips
Slides prepared by Peter Phillips

13-12

13.1MACROECONOMIC 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

Copyright 2012 McGraw-Hill Australia Pty Ltd


PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips
Slides prepared by Peter Phillips

13-13

CHAPTER ORGANISATION
13.1 Macroeconomic context of interest rate
determination
13.2 Loanable funds approach to interest rate
determination
13.3

Term structure of interest rates

13.4

Risk Structure of interest rates

13.5

Summary

Copyright 2012 McGraw-Hill Australia Pty Ltd


PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips
Slides prepared by Peter Phillips

13-14

13.2LOANABLE FUNDS APPROACH TO


INTEREST RATE DETERMINATION
The loanable funds (LF) approach is the preferred

way of explaining and forecasting interest rates


because it is:

preferred by financial market analysts

a conceptually simplistic model

Alternatively, macroeconomics uses demand and

supply of money to explain rates

(cont.
)
Copyright 2012 McGraw-Hill Australia Pty Ltd
PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips
Slides prepared by Peter Phillips

13-15

13.2LOANABLE FUNDS APPROACH TO


INTEREST RATE DETERMINATION
(CONT.)
The loanable funds (LF) approach

LF are the funds available in the financial system for lending

Assumes a downward-sloping demand curve and an upwardsloping supply curve in the loanable funds market; i.e.:

as interest rates rise demand falls

as interest rates rise supply increases

(cont.
)
Copyright 2012 McGraw-Hill Australia Pty Ltd
PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips
Slides prepared by Peter Phillips

13-16

13.2LOANABLE FUNDS APPROACH TO


INTEREST RATE DETERMINATION
(CONT.)
Demand for loanable funds

Two sectors
1. Business demand for funds (B)

Short-term working capital

Longer-term capital investment

2. Government demand for funds (G)

Finance budget deficits and intra-year liquidity

Demand for loanable funds (B + G)

(cont.
)
Copyright 2012 McGraw-Hill Australia Pty Ltd
PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips
Slides prepared by Peter Phillips

13-17

13.2LOANABLE FUNDS APPROACH TO


INTEREST RATE DETERMINATION
(CONT.)

(cont.
)
Copyright 2012 McGraw-Hill Australia Pty Ltd
PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips
Slides prepared by Peter Phillips

13-18

13.2LOANABLE FUNDS APPROACH TO


INTEREST RATE DETERMINATION
(CONT.)
Supply of loanable funds

Comprises three principal sources


1. Savings of household sector (S)
2. Changes in money supply (M)
3. Dishoarding (D)

Hoarding is the proportion of total savings in economy held as


currency

Dishoarding occurs (i.e. currency holdings decrease) as interest rates


rise and more securities are purchased for the higher yield available

(cont.
)
Copyright 2012 McGraw-Hill Australia Pty Ltd
PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips
Slides prepared by Peter Phillips

13-19

13.2LOANABLE FUNDS APPROACH TO


INTEREST RATE DETERMINATION
(CONT.)

(cont.
)
Copyright 2012 McGraw-Hill Australia Pty Ltd
PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips
Slides prepared by Peter Phillips

13-20

13.2LOANABLE FUNDS APPROACH TO


INTEREST RATE DETERMINATION
(CONT.)
Equilibrium in the LF market

In Figure 13.9 equilibrium is point E and the equilibrium rate is

i0
E is a temporary equilibrium because the supply and demand

curves are not independent

The level of dishoarding will change

The money supply is unlikely to increase proportionately in


subsequent periods

A change in business and/or government demand

(cont.
)
Copyright 2012 McGraw-Hill Australia Pty Ltd
PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips
Slides prepared by Peter Phillips

13-21

13.2LOANABLE FUNDS APPROACH TO


INTEREST RATE DETERMINATION
(CONT.)

(cont.
)
Copyright 2012 McGraw-Hill Australia Pty Ltd
PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips
Slides prepared by Peter Phillips

13-22

13.2LOANABLE FUNDS APPROACH TO


INTEREST RATE DETERMINATION
(CONT.)
Impact of disturbances on rates

Expected increase in economic activity

Initial effect is that businesses sell securities, yields increase


(price decreases), dishoarding occurs

Inflationary expectations

The demand curve shifts to the right and the supply curve shifts
to the left, resulting in higher interest rates and unchanged
equilibrium quantity

Copyright 2012 McGraw-Hill Australia Pty Ltd


PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips
Slides prepared by Peter Phillips

13-23

CHAPTER ORGANISATION
13.1 Macroeconomic context of interest rate
determination
13.2 Loanable funds approach to interest rate
determination
13.3

Term structure of interest rates

13.4

Risk Structure of interest rates

13.5

Summary

Copyright 2012 McGraw-Hill Australia Pty Ltd


PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips
Slides prepared by Peter Phillips

13-24

13.3TERM STRUCTURE OF INTEREST


RATES
Yield is the total return on an investment, comprising

interest received and any capital gain (or loss)


Yield curve is a graph, at a point in time, of yields on an

identical security with different terms to maturity

(cont.
)
Copyright 2012 McGraw-Hill Australia Pty Ltd
PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips
Slides prepared by Peter Phillips

13-25

13.3TERM STRUCTURE OF INTEREST


RATES (CONT.)

(cont.
)
Copyright 2012 McGraw-Hill Australia Pty Ltd
PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips
Slides prepared by Peter Phillips

13-26

13.3TERM STRUCTURE OF INTEREST


RATES (CONT.)
Differently shaped yield curves are evident from

time to time

Normal or positive yield curve

Inverse or negative yield curve

Longer term interest rates are higher than shorter term rates
Short-term interest rates are higher than longer term rates

Humped yield curve

Shape of yield curve changes over time from normal to inverse

(cont.
)
Copyright 2012 McGraw-Hill Australia Pty Ltd
PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips
Slides prepared by Peter Phillips

13-27

13.3TERM STRUCTURE OF INTEREST


RATES (CONT.)
The fact that the shape of the yield curve changes over

time suggests that monetary policy interest rate changes


are not the only factor affecting interest rates
Three theories have been advanced to explain the shape

of the yield curve:


1.

Expectations theory

2.

Market segmentation theory

3.

Liquidity premium theory

Copyright 2012 McGraw-Hill Australia Pty Ltd


PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips
Slides prepared by Peter Phillips

13-28

1. EXPECTATIONS THEORY
The current short-term interest rate and expectations

about future short-term interest rates are used to explain


the shape and changes in shape of the yield curve
Longer term rates will be equal to the average of the

short-term rates expected over the period


The theory is based on assumptions, e.g.:

Large number of investors with reasonably homogenous expectations

No transactions costs and no impediments to interest rates moving to


their competitive equilibrium levels

Investors aim to maximise returns and view all bonds as perfect


substitutes regardless of term to maturity

Copyright 2012 McGraw-Hill Australia Pty Ltd


PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips
Slides prepared by Peter Phillips

(cont.
)
13-29

EXPECTATIONS THEORY (CONT.)


Example: The rate on a one-year instrument is 7% per

annum. The investor expects to obtain 9% per annum


on a one-year investment starting in one years time.
What is the current two-year rate?

(cont.
)
Copyright 2012 McGraw-Hill Australia Pty Ltd
PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips
Slides prepared by Peter Phillips

13-30

EXPECTATIONS THEORY (CONT.)


Explanation for the shape of yield curves

Inverse yield curve

Normal yield curve

Will result if the market expects future short-term rates to be


lower than current short-term rates
Will result from expectations that future short-term rates will be
higher than current short-term rates

Humped yield curve

Investors expect short-term rates to rise in the future but to fall


in subsequent periods

Copyright 2012 McGraw-Hill Australia Pty Ltd


PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips
Slides prepared by Peter Phillips

13-31

2. SEGMENTED MARKETS THEORY


Assumes that securities in different maturity ranges

are viewed by market participants as imperfect


substitutes (i.e. investors will operate within some
preferred maturity range)

Rejects two assumptions of the expectations theory


Preferences of participants are motivated by reducing the risk of their
portfolios; i.e. minimising exposure to fluctuations in prices and yields

The shape and slope of the yield curve are determined

by the relative demand and supply of securities along


the maturity spectrum

(cont.
)
Copyright 2012 McGraw-Hill Australia Pty Ltd
PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips
Slides prepared by Peter Phillips

13-32

SEGMENTED MARKETS THEORY (CONT.)

(cont.
)
Copyright 2012 McGraw-Hill Australia Pty Ltd
PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips
Slides prepared by Peter Phillips

13-33

SEGMENTED MARKETS THEORY (CONT.)

(cont.
)
Copyright 2012 McGraw-Hill Australia Pty Ltd
PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips
Slides prepared by Peter Phillips

13-34

SEGMENTED MARKETS THEORY (CONT.)


If the central bank increases the average maturity of

bonds by purchasing short-term bonds and selling


long-term bonds

Segmented markets theory suggests:

short-term yields decrease and long-term yields increase

although financial system liquidity is unchanged, economic activity is


affected because areas of expenditure sensitive to:

short-term interest rates will expand

long-term interest rates will contract

Expectations theory suggests:

no effect on expectations about future short-term interest rates, and


therefore no effect on the economy

Copyright 2012 McGraw-Hill Australia Pty Ltd


PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips
Slides prepared by Peter Phillips

13-35

EXPECTATIONS APPROACH VERSUS


SEGMENTED MARKETS APPROACH

The emphasis of the segmented markets theory

on risk management denies the existence of


investors seeking:

arbitrage opportunities

without their participation, the extreme segmentation theory


would facilitate discontinuities in the yield curve

speculative profit

speculators trading actions are dictated by expectations

Copyright 2012 McGraw-Hill Australia Pty Ltd


PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips
Slides prepared by Peter Phillips

13-36

3. LIQUIDITY PREMIUM THEORY

Assumes investors prefer shorter term

instruments, which have greater liquidity and


less maturity and interest rate risk and,
therefore, require compensation for investing
longer term
This compensation is called liquidity premium

(cont.
)
Copyright 2012 McGraw-Hill Australia Pty Ltd
PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips
Slides prepared by Peter Phillips

13-37

LIQUIDITY PREMIUM THEORY (CONT.)


The liquidity premium can be included in the expectations

theory equation

L is the size of the liquidity premium

i E i L
i 0 1 11
02
2

(cont.
)
Copyright 2012 McGraw-Hill Australia Pty Ltd
PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips
Slides prepared by Peter Phillips

13-38

LIQUIDITY PREMIUM THEORY (CONT.)

(cont.
)
Copyright 2012 McGraw-Hill Australia Pty Ltd
PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips
Slides prepared by Peter Phillips

13-39

LIQUIDITY PREMIUM THEORY (CONT.)

(cont.
)
Copyright 2012 McGraw-Hill Australia Pty Ltd
PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips
Slides prepared by Peter Phillips

13-40

LIQUIDITY PREMIUM THEORY (CONT.)

Copyright 2012 McGraw-Hill Australia Pty Ltd


PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips
Slides prepared by Peter Phillips

13-41

CHAPTER ORGANISATION
13.1 Macroeconomic context of interest rate
determination
13.2 Loanable funds approach to interest rate
determination
13.3

Term structure of interest rates

13.4

Risk Structure of interest rates

13.5

Summary

Copyright 2012 McGraw-Hill Australia Pty Ltd


PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips
Slides prepared by Peter Phillips

13-42

13.4RISK STRUCTURE OF INTEREST


RATES
Default risk is the risk that the borrower (i.e. issuer) will fail

to meet its interest payment obligations

Commonwealth government bonds are assumed to have

zero default risk

As they are risk-free, they offer a risk-free rate of return

Some borrowers may have greater risk of default (i.e. state

government or private sector firms)

Investors will require compensation for bearing the extra

default risk

(cont.
)
Copyright 2012 McGraw-Hill Australia Pty Ltd
PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips
Slides prepared by Peter Phillips

13-43

13.4RISK STRUCTURE OF INTEREST


RATES (CONT.)

(cont.
)
Copyright 2012 McGraw-Hill Australia Pty Ltd
PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips
Slides prepared by Peter Phillips

13-44

13.4RISK STRUCTURE OF INTEREST


RATES (CONT.)

Copyright 2012 McGraw-Hill Australia Pty Ltd


PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips
Slides prepared by Peter Phillips

13-45

CHAPTER ORGANISATION
13.1 Macroeconomic context of interest rate
determination
13.2 Loanable funds approach to interest rate
determination
13.3

Term structure of interest rates

13.4

Risk Structure of interest rates

13.5

Summary

Copyright 2012 McGraw-Hill Australia Pty Ltd


PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips
Slides prepared by Peter Phillips

13-46

13.5

SUMMARY

Changes in monetary policy interest rate settings are

likely to affect the state of the economy, which in turn


affects interest rates generally

This occurs through the liquidity effect, income effect and inflation
effect

Leading, coincident and lagging economic indicators

assist in assessing the direction of the economy, likely


future monetary policy actions and the effect on
interest rates
A more disciplined approach to forming a view on future
interest rates is provided by the loanable funds theory

(cont.
)
Copyright 2012 McGraw-Hill Australia Pty Ltd
PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips
Slides prepared by Peter Phillips

13-47

13.5

SUMMARY (CONT.)

The term structure of interest rates is represented by

a yield curve, which may be normal, inverse, humped


or flat
The expectations, segmented markets and liquidity

preference theories describe how a yield curve


obtains its shape
The risk structure of interest rates reflects the level

of credit risk, over time, of a particular debt issue

Copyright 2012 McGraw-Hill Australia Pty Ltd


PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips
Slides prepared by Peter Phillips

13-48