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Interest Rates

Interest rates are closely watched variables that affect decisions by consumers, businesses, and policymakers. Movements in interest rates have important implications for the economy and financial markets. Forecasting interest rates is useful for market participants and central banks to assess the impact of policy changes. Interest rates can be classified into groups like market-determined rates that are set by supply and demand. An interest rate is what you pay to borrow money or earn as a lender.

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0% found this document useful (0 votes)
357 views48 pages

Interest Rates

Interest rates are closely watched variables that affect decisions by consumers, businesses, and policymakers. Movements in interest rates have important implications for the economy and financial markets. Forecasting interest rates is useful for market participants and central banks to assess the impact of policy changes. Interest rates can be classified into groups like market-determined rates that are set by supply and demand. An interest rate is what you pay to borrow money or earn as a lender.

Uploaded by

Sakshi Sharma
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PPTX, PDF, TXT or read online on Scribd
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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.

• Movements in interest rates have important implications for the


economy’s business cycle and are crucial to understanding financial
developments and changes in economic policy.
• Timely forecasts of interest rates can therefore provide valuable
information to financial market participants and policymakers.
• Forecasts of interest rates can also help to reduce interest rate risk
faced by individuals and firms.
• Forecasting interest rates is very useful to central banks in assessing
the overall impact (including feedback and expectation effects) of its
policy changes and taking appropriate corrective action, if necessary
A primer
• An interest rate is what you pay as a borrower, when you borrow money, and what
you earn, when you are the lender of this money. ¨
• While we run into a multitude of interest rates during the course of our lives, from
fixed deposit rates on our bank savings to mortgage rates when we borrow money to
buy houses and credit card rates, when we fail to make our credit card payments in
full, these rates can broadly be classified into the following groups:
• Market-determined rates, where the rate is set by demand and supply
• Market-influenced rates, where the rate is based upon a market-determined value
• Entity-set rates, where an entity (bank, credit card company) sets the rates
• Negotiated rates, where rates are based upon negotiating power and need. Those
market determined rates are driven by demand and supply and the question of what
causes these rates to change over time, and be higher in some periods than others,
has been a source of endless debate.
Key Interest Rates Over Time
Figure 2–1 Key U.S. Interest Rates, 1972–2016

Source: Federal Reserve Board website, May 2016. www.federalreserve.gov

Access the long description slide. 2-7


Intrinsic versus Market-set Interest
6
Rates
The Central Bank’s Interest
7
Rate Plays
3

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
1942
1944
1946
1948
1950
1952
1954
1956
1958
1960
1962

T.Bill
1964
3-month
1966
1968
1970
1972
1974
1976
rate

1978
1980
1982
10 year T.Bond

1984
1986
1988
US Treasury Rates: 1928

1990
1992
1994
US Treasuries: 3-month and 10-year from 1928 - 2019

1996
1998
2000
2002
2004
2006
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

• Point A: if the bond was selling for $950.


Derivation of Demand Curve (cont.)
• Point B: if the bond was selling for $900.
Derivation of Demand Curve
How do we know the demand (Bd) at point A is 100 and at point B is
200?
Well, we are just making-up those numbers. But we are applying basic
economics—more people will want (demand) the bonds if the expected
return is higher.
Derivation of Demand Curve
To continue …
•Point C: P = $850 i = 17.6%Bd = 300
•Point D: P = $800 i = 25.0%Bd = 400
•Point E: P = $750 i = 33.0%Bd = 500
•Demand Curve is Bd in Figure 4.1 which connects points A, B, C, D, E.
─ Has usual downward slope
Supply and Demand for Bonds
Figure 4.1
Supply and
Demand for
Bonds
Derivation of Supply Curve
In the last figure, we snuck the supply curve in—the line connecting
points F, G, C, H, and I. The derivation follows the same idea as the
demand curve.
Derivation of Supply Curve
• Point F: P = $750 i = 33.0%Bs = 100
• Point G: P = $800 i = 25.0%Bs = 200
• Point C: P = $850 i = 17.6%Bs = 300
• Point H: P = $900 i = 11.1%Bs = 400
• Point I: P = $950 i = 5.3% Bs = 500
• Supply Curve is Bs that connects points F, G, C, H, I, and has an upward
slope
Derivation of Demand Curve
• How do we know the supply (Bs) at point F is 100 and at point G is
200?
• Again, like the demand curve, we are just making-up those numbers.
But we are applying basic economics—more people will offer (supply)
the bonds if the expected return (cost) is lower.
Market Equilibrium
The equilibrium follows what we know from supply-demand analysis:
• Occurs when Bd = Bs, at P* = 850, i* = 17.6%
• When P = $950, i = 5.3%, Bs > Bd
(excess supply): P  to P*, i  to i*
• When P = $750, i = 33.0, Bd > Bs
(excess demand): P  to P*, i  to i*
Market Conditions
Market equilibrium occurs when the amount that people are willing to buy
(demand) equals the amount that people are willing to sell (supply) at a given price
Excess supply occurs when the amount that people are willing to sell (supply) is
greater than the amount people are willing to buy (demand) at a given price
Excess demand occurs when the amount that people are willing to buy (demand) is
greater than the amount that people are willing to sell (supply) at a given price
•.

Both premiums have fluctuated together, with the Baa risk


premium always about 1% greater than the Aaa risk premium.
The Aaa risk premium (%) fluctuated from just over 0% in the
late 1970s until about 1.5% in 2015.
Factors That Shift Demand Curve
Table 4.2 Summary Factors That Shift the Demand
Curve for Bonds
Factors That Shift Demand Curve (b)
Table 4.2 Summary Factors That Shift the Demand
Curve for Bonds
Shifts in Supply curve
Relationship Between Price
and Yield to Maturity
Yields to Maturity on a 10% Coupon Rate Bond Maturing in 10 Years (Face
Value = $1,000)

• Three interesting facts in Table 3.1


1. When bond is at par, yield equals coupon rate
2. Price and yield are negatively related
3. Yield greater than coupon rate when bond price is below par value
Term Structure of Interest Rates:
the Yield Curve and economy
(a) Upward sloping
(b) Inverted or
downward sloping
(c) Flat

Access the long description slide. 2-29


The Yield
10
Curve
 The yield curve is a graph of market interest rates
on bonds issued by a given entity (government or
corporate) against bond maturities.
 Thus, it looks at the rate on short term
borrowings against long term borrowings, and
the slope of the curve can be:
 Upward sloping, if long term rates are higher than
short term rates
 Flat, if the rates are similar across maturities
 Downward sloping, if long term rates are lower than
short term rates
US Treasury Yield Curves
11
over time
10-year Government Bond Rates: By Currency
3
(March 9, 2016)
Real Riskless Interest Rates
Additional purchasing power required to forego
current consumption.
• What causes differences in nominal and real interest rates?
• If you wish to earn a 3% real return and prices are expected to
increase by 2%, what rate must you charge?
• Irving Fisher first postulated that interest rates contain a
premium for expected inflation.

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%
54
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20

20
20
20
20
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).

• Evaluation of out-of-sample forecasts for the call money rate suggests


that an ARMA-GARCH model is best suited for very short-term
forecasting while a BVAR model with a loose prior can be used for
longer-term forecastin
• Treasury Bill rate (15-91 days) The following variables are included in
the multivariate models for the Treasury Bill rate (15-91 days):
inflation rate (year-onyear), Bank Rate, yield spread, liquidity, foreign
interest rate (3- months Libor), and forward premium (3-months).
• In the case of the 15-91 day Treasury Bill rate, the VAR model in levels
produces the most accurate short- and longterm forecasts.
• Government Security 1 year l The multivariate models for 1 year government
securities utilize the following variables: inflation rate (year-on-year), Bank Rate; yield
spread, liquidity, foreign interest rate (6- months Libor), forward premium (6-months).
• The performance of the out-of-sample forecasts for 1-year government securities
indicates that BVAR models out-perform the alternatives at the short and long ends.
Government Security 5 years
• The multivariate models for 5 years government securities include the following:
inflation rate (year-on-year), Bank Rate; yield spread, credit, foreign interest rate (6-
months Libor), and forward premium (6-months).
• For 5-year government securities, the BVAR models do not perform well. Overall,
VECM outperforms all the alternative models. VECM also generally outperforms the
alternatives at the short and long run forecast horizons
• Government Security : 10 years : The following variables are used in
the multivariate models for 10 years government securities: inflation
rate (year-on year), Bank Rate, yield spread, credit, foreign interest
rate (6-months Libor), and forward premium (6-months)

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