Interest Rates
Interest Rates
Session 3
Importance
• Interest rates are among the most closely watched variables in the
economy. It is imperative that what exactly is meant by the phrase
interest rates is understood.
• The interest rate is a key financial variable that affects decisions of
consumers, businesses, financial institutions, professional investors
and policymakers.
10.00%
12.00%
14.00%
16.00%
0.00%
2.00%
4.00%
6.00%
8.00%
1928
1930
1932
1934
1936
1938
- 2019
1940
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1944
1946
1948
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1952
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1962
T.Bill
1964
3-month
1966
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rate
1978
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1982
10 year T.Bond
1984
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US Treasury Rates: 1928
1990
1992
1994
US Treasuries: 3-month and 10-year from 1928 - 2019
1996
1998
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2008
2010
2012
2014
2016
2018
Interest Rates: A Market Set
5
Rate
Supply & Demand in the Bond Market
We now turn our attention to the mechanics of interest rates. That is, we are going
to examine how interest rates are determined—from a demand and supply
perspective. Keep in mind that these forces act differently in different bond
markets. That is, current supply/demand conditions in the corporate bond market
are not necessarily the same as, say, in the mortgage market. However, because
rates tend to move together, we will proceed as if there is one interest rate for the
entire economy.
The Demand Curve
Let’s start with the demand curve.
Let’s 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 bond’s yield to maturity.
Derivation of Demand Curve
2-33
The Fisher
5
Equation
While there are many forces that move interest
rates, there is one simple equation that lies at the
core, the Fisher equation:
¤ Nominal Interest Rate = Real Interest Rate + Expected
Inflation
¤ The real interest rate is a function of investor preferences for
current consumption, but it tends to also be a proxy for real
growth, with higher growth going with higher real interest
rates.
In the Fisher equation, it is worth noting that on
an expected basis:
¤ The nominal interest rate will generally be higher, as
expected inflation rises.
¤ In a world with deflation and really low or negative real
growth, the nominal interest rate can be negative.
U.S. Real and Nominal Interest Rates
Real and Nominal Interest Rates (Three-Month
Treasury Bill), 1953–2013
A Measure of Real Interest
4
Rates: TIPs
US TIPs versus 10-year US T Bond
5.00%
4.00%
3.00%
2.00%
1.00%
0.00%
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019
-1.00%
10-year 10-year T
TIPS Bond
An Intrinsic Riskfree
6
Rate
The Role of Central
7
Banks
Over the last century, central banks have taken
a bigger role in the interest rate market, and
in the eyes of some investors, they set rates.
That said, there are only a few rates that central
banks set, and their influence on the rest of the
rate market comes from the perception of central
banking power.
Put simply, a central bank that is perceived as
powerful can affect rates through actions it takes
on rates that, by themselves, have little
consequence.
The Central
Bank
8
Effect? The federal reserve Effect: T Bond and
25.00% Fed Funds Rate
20.00%
Fed Effect
15.00% = 10- year T.Bond Rate – Intrinsic Risk free rate
10.00%
5.00%
0.00%
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20
-5.00%
-
10.00%
The Fed Ten-year T.Bond Fed Funds
Effect rate Rate
Negative Interest
8
Rates
The conventional view of nominal interest rates is
that they cannot be negative, since you have the
option to hold cash (rather than save it at negative
rates).
This is based on the presumption that holding and
using cash is costless and that may not hold for two
reasons:
¤ Storing cash may require security (and its costs).
¤ Using cash for some transactions may be expensive and perhaps
infeasible.
If you introduce costs to holding and using cash, nominal
interest rates can be negative, albeit with a lower
bound, since at some interest rate, it will be less
expensive to hold cash.
Quantitative
9
Easing
After the 2008 crisis, central banks have
become much more activist in trying to
influence interest rates, markets and stock
prices.
¤ Quantitative Easing primarily captures the role that
central banks took in buying government bonds to keep
rates low.
¤ Central banks have even been willing to provide
backstops in corporate bond and lending markets,
allowing distressed firms lifelines to borrow more
money during market crisis.
Critics argue that central banking activism rewards
risk takers, by protecting them from their
mistakes, and increases the chances of inflation
Monetary Policy and Yields on Government Securities
Muneesh Kapur, Joice John and Pratik Mitra1
Forecasting
• Furthermore, the predicted variables should move in the same
direction as the actual series.
• The “best model” is defined as one that produces the most accurate
forecasts such that the predicted levels are close to the actual realized
values.
• Call money rate
• The multivariate models for the call money rate include the following:
inflation rate (week-to-week), Bank Rate, yield spread, liquidity,
foreign interest rate (3-months Libor), and forward premium (3-
months).