dear all you can download this file

2. Chapter 7
Inflation & Deflation, Yield
Curves, and Duration: Impact on
Interest Rates and Asset Prices

3. 7 - 3
McGraw-Hill/Irwin
Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
 Learning Objectives 
• To learn what inflation is and how it can impact interest rates
and the prices of financial assets.
• To understand the greater concern today over deflation and
how it may affect the economy and financial system.
• To see how yield curves arise and explore the ideas about what
determines the shape of the yield curve.

4. 7 - 4
McGraw-Hill/Irwin
Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
 Learning Objectives 
• To discover how yield curves can be a useful tool for those
interested in investing their money and in tracking the health
of the economy.
• To look at the concept of duration and see how it can be used
to assist in making investment choices and in protecting
against the risk of changes in interest rates.

5. 7 - 5
McGraw-Hill/Irwin
Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
Introduction
• Why are the interest rates on U.S. Treasury bills, Treasury
bonds, municipal bonds, corporate bonds, personal loans, etc.
so different from one another?
• Understanding the factors that cause interest rates to differ is
an indispensable aid to the investor and saver in choosing
financial assets for a portfolio.

6. 7 - 6
McGraw-Hill/Irwin
Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
Inflation and Interest Rates
• Inflation refers to the rise in the average level of prices for all
goods and services.

7. 7 - 7
McGraw-Hill/Irwin
Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
Inflation and Interest Rates
• In recent years, the U.S. inflation and interest rates appear to
be fairly strongly correlated.
Source: U.S. Department of Commerce and Board of Governors of the Federal Reserve System

8. 7 - 8
McGraw-Hill/Irwin
Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
Inflation and Interest Rates
Nominal and Real Interest Rates
• In general, lenders will attempt to charge nominal rates of
interest that give them their desired real rates of return on their
loanable funds based upon their expectations regarding
inflation.
nominal rate = published or quoted rate
real rate = rate measured in terms of the actual
purchasing power

9. 7 - 9
McGraw-Hill/Irwin
Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
Inflation and Interest Rates
The Fisher Effect
• In a 1896 classic article, economist Irving Fisher argued that
expected nominal interest rate
= expected real rate + inflation premium
+ (expected real rate  inflation premium)
 expected real rate + inflation premium
 The inflation premium measures the rate of inflation expected by investors
in the marketplace during the life of a particular financial instrument.

10. 7 - 10
McGraw-Hill/Irwin
Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
Inflation and Interest Rates
Alternative Views
• While the Fisher effect is among the most popular
explanations of the linkages between inflation and interest
rates, several alternative views have emerged over the years.

11. 7 - 11
McGraw-Hill/Irwin
Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
Inflation and Interest Rates
The Harrod-Keynes Effect of Inflation
• Building upon the Keynesian liquidity preference theory,
Harrod argued that unless inflation affects money demand or
supply, the expected nominal interest rate must be the same
regardless of inflationary expectations.
• So, a rise in inflationary expectations will lower the real rate
of interest.

12. 7 - 12
McGraw-Hill/Irwin
Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
Inflation and Interest Rates
Anticipated versus Unanticipated Inflation
• One of the most obvious weaknesses of the Fisher effect was
its failure to distinguish between anticipated (or expected) and
unanticipated (or unexpected) inflation.
• In particular, there is no way to be certain about what the
equilibrium nominal interest rate will be if all or a portion of
the increase in inflation is unanticipated.

13. 7 - 13
McGraw-Hill/Irwin
Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
Inflation and Interest Rates
The Impact of Fully Anticipated Inflation on Interest Rates

14. 7 - 14
McGraw-Hill/Irwin
Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
Inflation and Interest Rates
The Inflation Risk Premium
• Inflation risk premium represents compensation paid to a
lender for that component of inflation that is not expected.
• Recent research suggested that the inflation-interest rate
equation may look more like:
nominal interest rate = real interest rate
+ expected inflation rate
+ inflation risk premium

15. 7 - 15
McGraw-Hill/Irwin
Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
Inflation and Interest Rates
The Inflation-Caused Income Tax Effect
• Lenders and investors not exempt from income taxes make
lending and investing decisions on the basis of their expected
real rate of return after taxes.
• This effect may actually widen movements in nominal interest
rates, resulting in nominal rates changing by more than any
given change in expected inflation.

16. 7 - 16
McGraw-Hill/Irwin
Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
Inflation and Interest Rates
Conclusions
• The inflation-nominal interest rate relationship appears to be
positive: higher rates of inflation mostly lead to higher
nominal interest rates.
• However, nominal interest rates tend to change by less than the
expected change in the inflation rate.
• Note that this topic is plagued by numerous measurement
problems.

17. 7 - 17
McGraw-Hill/Irwin
Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
Inflation and Interest Rates
The Nature and Impact of Price Deflation
• There is growing concern that deflation – a fall in the average
level of prices – may eventually replace inflation as a
significant economic problem for the future.
• Past experiences indicate that price deflation may result in
lower output (production) of goods and services, and force real
interest rates upward.

18. 7 - 18
McGraw-Hill/Irwin
Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
Inflation and Stock Prices
• Common stock is widely viewed as a hedge against inflation.
However, the facts are often contradictory.
• There are several conflicting arguments on the inflation-stock
price relationship.
• One line of argument suggested that the impact will vary from
firm to firm and from industry to industry depending on the
actual inflation rate and the terms of existing nominal
contracts.

19. 7 - 19
McGraw-Hill/Irwin
Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
Inflation-Adjusted Securities
• The U.S. Treasury offers TIPS (Treasury Inflation Protected
Securities) and “I bonds” for investors who want some
protection against inflation.
• Annual nominal interest payment from a TIPS
= inflation-adjusted  promised
nominal value coupon rate
• When the public expects higher inflation, inflation-adjusted
securities rise in value.

20. 7 - 20
McGraw-Hill/Irwin
Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
Inflation-Adjusted Securities
• Note that the TIPS investor’s real rate of return has not changed:

21. 7 - 21
McGraw-Hill/Irwin
Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
Inflation-Adjusted Securities
Source: Economic Trends, Federal Reserve Bank of Cleveland, Aug & Dec 2003

22. 7 - 22
McGraw-Hill/Irwin
Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
The Maturity of a Loan
• One important factor causing interest rates to differ from one
another is differences in the maturity (or term) of securities
and loans.
• The relationship between the rates of return on financial
instruments and their maturity is called the term structure of
interest rates.
• This term structure may be represented visually by drawing a
yield curve for all financial assets having the same credit
quality.

23. 7 - 23
McGraw-Hill/Irwin
Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
Source: Economic Trends, Federal Reserve Bank of Cleveland, June 2001
The Maturity of a Loan
• Yield curves may be
upward sloping,
downward sloping, or
horizontal (flat).

24. 7 - 24
McGraw-Hill/Irwin
Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
The Maturity of a Loan
• The unbiased expectations hypothesis argues that investor
expectations regarding future changes in short-term interest
rates determine the shape of the curve.
• Thus, changes in the relative quantities of long-term versus
short-term financial assets will not affect the shape of the yield
curve unless investor expectations are also affected.

25. 7 - 25
McGraw-Hill/Irwin
Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
The Maturity of a Loan
• The liquidity premium view of the yield curve suggests that
there is a bias toward positively-sloped yield curves.
• Longer-term securities tend to have more volatile market
prices and hence, greater risk of capital loss.
• So, investors must be paid an interest rate premium (the
liquidity premium) to encourage them to purchase long-term
securities.

26. 7 - 26
McGraw-Hill/Irwin
Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
The Segmented-Markets and Preferred
Habitat Arguments
• The market segmentation argument of the yield curve
separates the financial markets into several distinct markets
according to the maturity preferences of the investors.
• The implication is that governments can alter the shape of the
yield curve by shifting the available supplies of securities
relative to the demand for those securities in each distinct
market.

27. 7 - 27
McGraw-Hill/Irwin
Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
The Segmented-Markets and Preferred
Habitat Arguments
• The preferred habitat or composite theory of the yield curve
argues that investors seek out their preferred habitat – they
choose securities that match their risk preferences, tax
exposure, liquidity needs, regulatory requirements, and
planned holding periods.
• An investor will not normally stray from his or her preferred
habitat unless the rates of return on some other securities are
high enough to overcome his or her preferences.

28. 7 - 28
McGraw-Hill/Irwin
Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
Research Evidence on Yield Curves
• Empirical studies on the various yield curve theories have
produced mixed results.
• As such, recent research as delved more deeply into the issue
of what kinds of events cause the yield curve’s overall shape to
change.
- Statistically, yield curves may change along any of at least three
different dimensions: level, slope, or curvature.

29. 7 - 29
McGraw-Hill/Irwin
Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
Research Evidence on Yield Curves
The Level, Slope, and Curvature of Yield Curves

30. 7 - 30
McGraw-Hill/Irwin
Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
Uses of the Yield Curve
• The yield curve is a useful tool for …
- forecasting interest rates – a downward-sloping yield curve
suggests near-term declines in rates
- identifying portfolio management strategies – a rising yield
curve favors short-term borrowing and long-term lending
- detecting over- and under-priced financial assets
- indicating trade-offs between maturity and yield
- “riding” the yield curve – active investors may gain by timely
portfolio switching

31. 7 - 31
McGraw-Hill/Irwin
Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
Duration: A Different Approach to Maturity
• A popular measure of how responsive a debt security’s price is
to changes in interest rates is its price elasticity (E).
• Greater price elasticity means that an asset goes through a
greater price change for a given change in market rates of
interest.
0
0
1
0
0
1
y
y
y
P
P
P
E




% D in a security’s price
over time
% D in a security’s yield
over time

32. 7 - 32
McGraw-Hill/Irwin
Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
Duration: A Different Approach to Maturity
• Longer-term debt securities generally have a larger price
elasticity than shorter-term securities.
• Debt securities with lower coupon rates also tend to have a
larger price elasticity than those with higher coupon rates,
since a greater proportion of the lower-coupon security’s total
return lies in the final payment at maturity. This is called the
coupon effect.

33. 7 - 33
McGraw-Hill/Irwin
Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
Duration: A Different Approach to Maturity
• To enable financial analysts to construct a linear relationship
between maturity and security price elasticity, regardless of
differing coupon rates, a maturity measure called duration (D)
was introduced.

34. 7 - 34
McGraw-Hill/Irwin
Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
Duration: A Different Approach to Maturity
• Duration is thus a weighted average of the time required for
the investor to receive the promised payments. The weights are
the present values of those payments.
 
 













 n
t
t
t
n
t
t
t
y
C
t
y
C
D
1
1
1
1
Ct = the expected principal/interest
payment in time period t
y = the security’s yield to maturity,
with maturity reached at the
end of n periods

35. 7 - 35
McGraw-Hill/Irwin
Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
Duration: A Different Approach to Maturity

36. 7 - 36
McGraw-Hill/Irwin
Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
Duration: A Different Approach to Maturity
• The relationship between a financial asset’s change in market
price and its change in yield or interest rate is called convexity.
• Research shows that convexity increases with a financial
asset’s duration.
• Moreover, an asset’s change in price is greater at lower market
interest rates than it is at higher market interest rates in
general.

37. 7 - 37
McGraw-Hill/Irwin
Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
Duration: A Different Approach to Maturity
Uses of Duration
• Estimating asset price changes
- % D in asset price  100
1
D 







D


r
r
• Portfolio immunization against interest rate changes
- This can be achieved by acquiring a portfolio of assets whose
average duration equals the length of the investor’s desired
holding period.

38. 7 - 38
McGraw-Hill/Irwin
Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
Duration: A Different Approach to Maturity
Limitations of Duration
• In practice, it is often difficult to find a group of assets with a
certain average duration.
• As time passes, constant adjustments are also needed to ensure
that the average duration decreases at the same pace.
• There is some risk associated with the use of conventional
measures of duration due to uncertain future interest rate
movements.

39. 7 - 39
McGraw-Hill/Irwin
Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
Markets on the Net
• Central Bank Websites at www.bis.gov/cbanks.htm
• European Central Bank at www.ecb.int
• Federal Reserve System at www.federalreserve.gov
• Global Financial Data at www.globalfindata.com
• Interest Rate Calculator at www.interestratecalculator.com

40. 7 - 40
McGraw-Hill/Irwin
Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
Markets on the Net
• The Economist at www.economist.com
• The Bond Market Association at www.investinginbonds.com
• The Financial Pipeline at www.finpipe.com
• U.S. Savings Bonds Online at www.savingsbond.com

41. 7 - 41
McGraw-Hill/Irwin
Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
Chapter Review
• Introduction
• Inflation and Interest Rates
- Correlation between Inflation and Interest Rates
- Nominal and Real Interest Rates
- The Fisher Effect
- The Harrod-Keynes Effect of Inflation
- Anticipated versus Unanticipated Inflation
- The Inflation Risk Premium
- The Inflation-Caused Income Tax Effect
- The Nature and Impact of Price Deflation

42. 7 - 42
McGraw-Hill/Irwin
Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
Chapter Review
• Inflation and Stock Prices
• The Development of Inflation-Adjusted Securities
• The Maturity of a Loan
- The Yield Curve and the Term Structure of Interest Rates
- Types of Yield Curves
- The Unbiased Expectations Hypothesis
- The Liquidity Premium View of the Yield Curve

43. 7 - 43
McGraw-Hill/Irwin
Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
Chapter Review
• The Segmented-Markets and Preferred Habitat Arguments
- The Possible Impact of Segmented Markets on the Yield Curve
- The Preferred Habitat or Composite Theory of the Yield Curve
- Research Evidence on Yield Curves
• Uses of the Yield Curve

44. 7 - 44
McGraw-Hill/Irwin
Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
Chapter Review
• Duration: A Different Approach to Maturity
- The Price Elasticity of a Bond or other Debt Security
- The Impact of Varying Coupon Rates
- An Alternative Maturity Index for a Financial Asset: Duration
- The Convexity Factor
- Uses of Duration
- Limitations of Duration