ECONF312_L13.pptx.pdf topics covered interest rate

mbfm bits pilani course . money banking and financial mangement

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Part – II : Fundamentals of
Financial Market
Chapter 4: Why Do interest rate
change?

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•Discussed the concept of Duration – the average life
time of a debt securities' stream of payment, is a
measure of effective maturity.
•The terms to effective maturity accurately measures
the interest rate risk.
•We have learnt that everything being equal, greater the
duration of a bond, greater the percentage change in
the market value of the security, given the change in
the interest rate.
•Therefore, greater is the duration of a security, greater
is the interest rate risk.
Recapitulation of the Last Class on
11
th

September (Friday), 2020

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•We have learned in the earlier chapter that interest rates
are negatively related to piece of the bonds.
•This chapter we will explore why the overall level of
nominal interest rate changes in the economy and
explain the factors that influence their behavior.
•As interest rate and bond prices are related, we can
explain the fluctuations in the interest rate by explaining
the fluctuations in the bond prices.
•In this context, we take the help of Supply-Demand
analysis and explain how bond price and interest rate
changes in the economy.
Preview

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•In the early 1950s, US short-term Treasury bills were
yielding about 1%.
•By 1981, the yields rose to 15% and higher. But then
dropped back to 1% by 2003.
•In 2007, rates jumped up to 5%, only to fall back to near
zero in 2008.
•What explains these fluctuations in interest rates?
•Because fluctuation/volatility in the interest rate decides
the flow of funds to the market

Introduction

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•Similarly in the early 1993s, nominal interest rates in
India on 91 – day treasury bills were about 10%
•By 1995, they had reached up to 12.97%
•And then fall to 6% by 1997 and rose to 10% by 2000
and fall to 3.10% by 2005.
•And then increased to 8% by 2008 and fall to 2% by
2009 and increased to 7% by 2010 and 2017 fall to 6%
and further fall to 3.1 in 2020.
•Between 1993 and 2020, the highest was 12.97 and
lowest was 3.1
•What explains these fluctuations in interest rates?
•This chapter will provide some explanation to this basic
question.

Fluctuations of interest rate in
India

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India’s T-Bill Rates

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•We will examine how the overall level of nominal interest
rate is determined?
•Which factors influences their behaviour?
•In the earlier chapter, we have established the inverse
link between bond price and interest rate.
•If we can find why bond price changes, then we can also
explain why interest rate changes.
•To do this we make use of the supply and demand
analysis for bond market and money market to explain
the variation in the interest rate in the market.

In this chapter…

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•What determines the demand for assets?
•The answer is given by theory of asset demand.
•The theory outlines the criteria that are important when
deciding how much of an asset to buy.
•After deriving the supply curve, and demand curves of
asset demand we can reach at market equilibrium.
•Hence, the analysis can explain the changes in the
equilibrium interest rates.

Asset Demand Theory

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•What determines the quantity demanded of an asset?
•Asset is a piece of property that is a store of value –
money, bonds, stocks, art, land, house, farm equipment,
manufacturing machinery etc.
•Whether to buy an asset rather than another, an
individual must consider the following factors.
Wealth: the total resources owned by the individual,
including all assets.
Expected returns: the returns expected over next period
on one assets relative to alternative assets.
Risk: the degree of uncertainty associated with the
returns on one assets relative to another assets.
Liquidity: the ease and speed with which an assets can
be turned into cash relative another asset.


Determinants of Asset
Demand

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•When we find our wealth has increased, we have more
resources available with which we can command over
many assets.
•This encourages us to purchase more assets and hence
create demand for assets.
•Hence, holding everything else constant, and
increase in the wealth increases the quantity
demanded of an asset.
Determinants of Asset
Demand
- Wealth

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•In the earlier chapter we have seen that the return of an
asset measures how much we gain from holding an
asset.
•When we make a decision to purchase one asset, we
are influenced by the return we expect from holding the
asset.
•When One bond has return of 15% half of the time and
5% half of the time, we expect that the average return on
the bond is 10%.
•More precisely, the average return is the weighted
average of the possible return.
Determinants of Asset
Demand
- Expected Return

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Determinants of Asset
Demand
- Expected Return

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•If the expected return of the oil bond rises relative to the
expected returns on the alternative assets, holding
everything else constant, it become more desirable to
purchase it, the demand for it increases.
•This occurs when the expected return on the oil bond
rises while an alternative bond return remain unchanged.
•When the alternative bond’s return fall and oil bond
return remain unchanged.
•Hence, an increase in an asset’s expected return
relative to that of an alternative asset, holding
everything else unchanged, raises the quantity
demanded of the asset.


Expected Returns

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•The degree of risk or uncertainty of an assets return also
affect the demand for an asset.
•Normally, we consider the measure of standard
deviation to calculate the risk associated with risk of an
asset.
•Consider two assets returns on the Fly-by-Night Airlines
stock and Feet-on-the Ground Bus Company stock.
•Suppose that the Fly-by-night stock has return 15% half
of the time and 5% another half of the time, making the
expected return of 10%.
•While, stock Feet-on-ground has return of 10%
•What is the standard deviation of the returns on the
Fly-by-Night Airlines stock and Feet-on-the Ground Bus
Company? Of these two stocks, which is riskier?

Determinants of Asset
Demand
- Risk

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Determinants of Asset
Demand
- Risk
Solution: Fly-by-Night Airlines has a standard deviation of returns of 5%.

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Determinants of Asset
Demand
- Risk
Feet-on-the-Ground Bus Company has a standard deviation of returns of0%.

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•Fly-by-Night Airlines has a standard deviation of returns
of 5%; Feet-on-the-Ground Bus Company has a
standard deviation of returns of 0%
•Clearly, Fly-by-Night Airlines is a riskier stock because its
standard deviation of returns of 5% is higher than the
zero standard deviation of returns for
Feet-on-the-Ground Bus Company, which has a certain
return
•A risk-averse person prefers stock in the
Feet-on-the-Ground (the sure thing) to Fly-by-Night stock
(the riskier asset), even though the stocks have the
same expected return, 10%. By contrast, a person who
prefers risk is a risk preferer or risk lover. Most people
are risk-averse, especially in their financial decisions

Determinants of Asset
Demand
- Risk

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•Another factor that affects the demand for an asset is
how quickly an asset can be converted into cash at low
cost i.e. Liquidity.
•An asset is liquid if the market in which it is traded has
depth and breadth i.e. market has many buyers and
sellers.
•The more liquid an asset is relative to alternative assets,
holding everything else unchanged, the more desirable it
is, and the greater will be the quantity demanded.

Determinants of Asset
Demand
- Liquidity

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The quantity demanded of an asset differs by factor.
•Wealth: Holding everything else constant, an increase
in wealth raises the quantity demanded of an asset
•Expected return: An increase in an asset’s expected
return relative to that of an alternative asset, holding
everything else unchanged, raises the quantity
demanded of the asset
•Risk: Holding everything else constant, if an asset’s
risk rises relative to that of alternative assets, its
quantity demanded
will fall
•Liquidity: The more liquid an asset is relative to
alternative assets, holding everything else unchanged,
the more desirable it is, and the greater will be the
quantity demanded

Determinants of Asset Demand and
Theory of Portfolio Choice

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Determinants of Asset
Demand and Theory of
Portfolio Choice

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•We approach the analysis of interest rate determination
by studying the supply of and demand for bonds.
•Because interest rates on different securities tend to
move together, we will take only one type of security and
single interest rate for entire economy.
•Next chapter we will expand our analysis to look into why
interest rates on different securities differ.
•First step to obtain the demand curve for bonds
assuming all other economic factors are held
constant


Supply and Demand in the
Bond Market

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•Consider the demand for one year discount bond,
which makes no coupon payment but pays the owner
the amount of face value $1000.
•If the bond sells for $950, the interest rate is 5.3%

Supply and Demand in the
Bond Market

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Supply and Demand in the
Bond Market
•Point A: if the bond was selling for $950.
Point B: if the bond was selling for $900.

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•How do we know the demand (B
d
) 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.
•To continue …
Point C:P = $850i = 17.6%B
d
= 300
Point D:P = $800i = 25.0%B
d
= 400
Point E:P = $750i = 33.0%B
d
= 500
Demand Curve is B
d
in Figure 4.1 which connects points A,
B, C, D, E.
•An important assumption that all the other economic variables are
held contact.

Supply and Demand in the
Bond Market

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Supply and Demand for
Bonds
Figure 4.1
Supply and
Demand for
Bonds

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Supply and Demand for
Bonds
•In the last figure, we can see the supply curve in the
line connecting points F, G, C, H, and I. The derivation
follows the same idea as the demand curve.
•Point F:P = $750i = 33.0%B
s
= 100
•Point G:P = $800i = 25.0%B
s
= 200
•Point C:P = $850i = 17.6%B
s
= 300
•Point H:P = $900i = 11.1%B
s
= 400
•Point I:P = $950i = 5.3%B
s
= 500
•Supply Curve is B
s
that connects points F, G, C, H, I,
and has an upward slope