Chapter Three Interest rates in the Financial System.pptEbsaAbdi1
There are two main economic theories that explain interest rate determination: the loanable funds theory and the liquidity preference theory. The loanable funds theory states that interest rates are determined by the supply and demand of loanable funds in the credit market. The liquidity preference theory argues that interest rates are determined by individuals' preferences to hold money balances rather than invest or spend. There are also various theories about the term structure of interest rates and how they vary based on maturity and risk.
chapter three interest rates in the financial system.pptxEbsaAbdi
There are two main economic theories that explain how interest rates are determined:
1) Loanable funds theory - Interest rates are determined by the supply and demand of loanable funds in the credit market. Demand comes from entities seeking to borrow, while supply comes from those willing to lend funds.
2) Liquidity preference theory - Interest rates are set by the demand and supply of money balances. Individuals may prefer to hold their wealth in liquid money form rather than invest due to uncertainty, affecting interest rates.
Additionally, the structure of interest rates varies based on factors like maturity, risk, and transaction costs associated with different financial instruments. Riskier loans command higher interest rates as compensation for default risk.
Financial Institution and Capital Market - Chapter 3-6.pdftemamoh2018
The document discusses theories around interest rate determination and structure. It explains that interest rates are determined by the supply and demand of loanable funds available according to the loanable funds theory, taking into account factors like savings, investment, and money supply. Alternatively, according to the liquidity preference theory, interest rates are determined by the supply and demand for money balances, as individuals trade off the liquidity of money versus earning interest on other investments. The document also outlines how interest rates vary based on maturity, risk, and transaction costs associated with different financial instruments.
This document discusses interest rates, their determination and structure. It provides information on key theories for how interest rates are determined such as the loanable funds theory and liquidity preference theory. It also discusses factors that influence the term structure of interest rates like time period, risk, and transaction costs. Different types of term structures are outlined like normal positive yield curves and steep yield curves.
Interest rates are determined by the interaction of supply and demand in the market for loanable funds. The supply comes from domestic savings, foreign lending, and money creation by banks. The demand comes from consumers, businesses, and governments seeking credit, as well as foreign borrowers. Equilibrium is reached where the supply and demand for loanable funds are equal. Factors such as expected inflation, default risk, liquidity risk, and monetary policy influence the supply and demand curves and thus impact interest rate levels.
The document discusses various topics related to bond yields and interest rates:
1) Bond yields are determined by risk-free rates plus credit risk premiums. The Fed uses tools like open market operations and reserve requirements to implement monetary policy.
2) Treasury securities include bills, notes, bonds, and inflation-protected bonds. Treasuries have little credit risk but are still exposed to interest rate and other risks.
3) The Treasury yield curve shows the relationship between Treasury yields and maturities. Factors like on-the-run status, liquidity, and reinvestment risk complicate this relationship.
4) Yield spreads measure differences in bond yields and are used to assess credit risk, liquidity
The document discusses various theories of interest rate determination. It begins by defining interest rates and how they are expressed. It then outlines four main theories: the classical theory which argues rates are determined by supply and demand of savings and investment; liquidity preference theory which adds demand for money holdings; loanable funds theory considering demand and supply of credit; and rational expectations theory where rates reflect expectations based on available information. The document also discusses how interest rates form a structure, with risk-free rates as the base and risk premiums added depending on an issuer's creditworthiness as assessed by rating agencies.
Interest Rates overview and knowledge insightjustmeyash17
1) Interest rates are determined by factors like expected inflation, default risk, liquidity, and maturity. The relationship between short and long-term interest rates is known as the term structure.
2) The term structure can be upward-sloping, flat, or downward-sloping (inverted). Upward slopes typically occur when short-term rates are low.
3) Three main theories explain the term structure: expectations theory, market segmentation, and liquidity premium theory. The liquidity premium theory best explains the empirical regularities by incorporating both expectations of future rates and investors' preference for liquidity.
Chapter Three Interest rates in the Financial System.pptEbsaAbdi1
There are two main economic theories that explain interest rate determination: the loanable funds theory and the liquidity preference theory. The loanable funds theory states that interest rates are determined by the supply and demand of loanable funds in the credit market. The liquidity preference theory argues that interest rates are determined by individuals' preferences to hold money balances rather than invest or spend. There are also various theories about the term structure of interest rates and how they vary based on maturity and risk.
chapter three interest rates in the financial system.pptxEbsaAbdi
There are two main economic theories that explain how interest rates are determined:
1) Loanable funds theory - Interest rates are determined by the supply and demand of loanable funds in the credit market. Demand comes from entities seeking to borrow, while supply comes from those willing to lend funds.
2) Liquidity preference theory - Interest rates are set by the demand and supply of money balances. Individuals may prefer to hold their wealth in liquid money form rather than invest due to uncertainty, affecting interest rates.
Additionally, the structure of interest rates varies based on factors like maturity, risk, and transaction costs associated with different financial instruments. Riskier loans command higher interest rates as compensation for default risk.
Financial Institution and Capital Market - Chapter 3-6.pdftemamoh2018
The document discusses theories around interest rate determination and structure. It explains that interest rates are determined by the supply and demand of loanable funds available according to the loanable funds theory, taking into account factors like savings, investment, and money supply. Alternatively, according to the liquidity preference theory, interest rates are determined by the supply and demand for money balances, as individuals trade off the liquidity of money versus earning interest on other investments. The document also outlines how interest rates vary based on maturity, risk, and transaction costs associated with different financial instruments.
This document discusses interest rates, their determination and structure. It provides information on key theories for how interest rates are determined such as the loanable funds theory and liquidity preference theory. It also discusses factors that influence the term structure of interest rates like time period, risk, and transaction costs. Different types of term structures are outlined like normal positive yield curves and steep yield curves.
Interest rates are determined by the interaction of supply and demand in the market for loanable funds. The supply comes from domestic savings, foreign lending, and money creation by banks. The demand comes from consumers, businesses, and governments seeking credit, as well as foreign borrowers. Equilibrium is reached where the supply and demand for loanable funds are equal. Factors such as expected inflation, default risk, liquidity risk, and monetary policy influence the supply and demand curves and thus impact interest rate levels.
The document discusses various topics related to bond yields and interest rates:
1) Bond yields are determined by risk-free rates plus credit risk premiums. The Fed uses tools like open market operations and reserve requirements to implement monetary policy.
2) Treasury securities include bills, notes, bonds, and inflation-protected bonds. Treasuries have little credit risk but are still exposed to interest rate and other risks.
3) The Treasury yield curve shows the relationship between Treasury yields and maturities. Factors like on-the-run status, liquidity, and reinvestment risk complicate this relationship.
4) Yield spreads measure differences in bond yields and are used to assess credit risk, liquidity
The document discusses various theories of interest rate determination. It begins by defining interest rates and how they are expressed. It then outlines four main theories: the classical theory which argues rates are determined by supply and demand of savings and investment; liquidity preference theory which adds demand for money holdings; loanable funds theory considering demand and supply of credit; and rational expectations theory where rates reflect expectations based on available information. The document also discusses how interest rates form a structure, with risk-free rates as the base and risk premiums added depending on an issuer's creditworthiness as assessed by rating agencies.
Interest Rates overview and knowledge insightjustmeyash17
1) Interest rates are determined by factors like expected inflation, default risk, liquidity, and maturity. The relationship between short and long-term interest rates is known as the term structure.
2) The term structure can be upward-sloping, flat, or downward-sloping (inverted). Upward slopes typically occur when short-term rates are low.
3) Three main theories explain the term structure: expectations theory, market segmentation, and liquidity premium theory. The liquidity premium theory best explains the empirical regularities by incorporating both expectations of future rates and investors' preference for liquidity.
Chapter 03_What Do Interest Rates Mean and What Is Their Role in Valuation?Rusman Mukhlis
This chapter discusses interest rates and their role in valuation. It defines key terms like yield to maturity, which is the most accurate measure of interest rates. It examines how to measure and understand different interest rates, the distinction between real and nominal rates, and the relationship between interest rates and returns. It also covers how the concept of present value is used to evaluate debt instruments and how duration is used to measure interest rate risk.
This chapter discusses the valuation of bonds and shares. It explains the characteristics of ordinary shares, preference shares, and bonds. It shows how present value concepts are used to value these securities. The chapter focuses on the price-earnings ratio and its proper and improper uses in valuation. It also covers the determinants of bond values such as maturity, yield to maturity, current yield, and sensitivity to interest rate changes.
This document provides an overview and learning goals for a lecture on interest rates and bonds. It discusses key concepts like the term structure of interest rates, bond yields, prices, and types. It also covers bond valuation basics, factors that influence interest rates, and theories of the term structure. Examples are provided to illustrate expectations theory and the impact of inflation on interest rates. The document reviews corporate bond features, costs, and ratings. Tables present bond characteristics, issuer risks, and rating scales.
This document discusses inflation, deflation, yield curves, and duration and how they impact interest rates and asset prices. It defines key terms like inflation, nominal and real interest rates, and explores theories on the relationship between inflation and interest rates. It also examines how yield curves are formed and used, and introduces the concept of duration as a measure of a debt security's price sensitivity to interest rate changes.
This document provides an overview of how debt security yields vary and the factors that influence them. It discusses the following key points in 3 sentences:
Debt security yields are influenced by credit risk, liquidity, tax status, and term of maturity. Higher risk securities offer higher yields to attract investors. The term structure of interest rates defines the relationship between yield and term to maturity and can be affected by expectations of future interest rates, liquidity preferences, and segmented markets.
The document summarizes several theories about what determines interest rates:
1) The classical theory argues that interest rates are determined by the supply of household savings and the demand for business investment.
2) The liquidity preference theory views interest rates as the price that induces people to hold cash rather than bonds given transactions, precautionary, and speculative demands for money.
3) The loanable funds theory sees interest rates as set by the overall demand for and supply of credit from various sources like domestic savings, money creation, and foreign lending.
A bond is a debt security where the issuer owes the holder a debt and is obliged to repay the principal and interest at maturity. Bonds have features like nominal value, coupon rate, maturity date, and call/put options. There are various types of bonds like fixed rate, floating rate, zero coupon bonds, and municipal bonds. Bond portfolio strategies include passive buy and hold strategies, active strategies like sector substitution, and semi-active strategies like immunization and duration matching to reduce interest rate risk. Bonds are evaluated based on the issuer's financial strength and past earnings, while valuation considers the present value of future cash flows and yield to maturity is the single discount rate that equals the current price.
A bond is a debt security where the issuer owes the holder a debt and is obliged to repay the principal and interest at maturity. Bonds have features like nominal value, coupon rate, maturity date, and call/put options. There are various types of bonds like fixed rate, floating rate, zero coupon bonds, and municipal bonds. Bond portfolio strategies include passive buy and hold strategies, active strategies like sector substitution, and semi-active strategies like immunization and duration matching to reduce interest rate risk. Bonds are evaluated based on the issuer's financial strength and past earnings, while valuation considers the present value of future cash flows and yield measures like current yield and yield to maturity.
ASSIGNMENT 3
g
[Name of the Student]
[Name of the University]
Running Head: ASSIGNMENT 1
General Essay Questions (5pts each)
1. What are TIPs? How do these securities provide a hedge against inflation? Discuss the spread between traditionally-structured Treasury notes and TIPs. What factors influence this spread relationship?
TIPs are the Treasury Inflation Protected securities. These are the bonds issued by the government that offer return after the inflation which is also known as a real return. they are different from the nominal or traditional bonds in which the returns are specifically before inflation. This is the way for the investors for offsetting the risk that comes with the inflation. These TIPs offer the hedge against inflation by providing a return which is calculated after taking out the risk of inflation. This is the best way for investors to offset the risk that comes due to the inflation in society. With the strengthening of the economy, inflation can increase, and the return is not expected to increase in the high rate of inflation, so for affording protection against inflation in the economy, TIPs are used in the form of fixed income investment for the destruction of inflation. TIPs are backed by the government and they offer high attractiveness for the investors because the level of risk in these securities is less.
TIP spread is when the yield of TIPS and other US Treasury securities is compared having the same date for the maturity. The difference that exists between both of them is used as payment adjustment for the inflation. The traditionally structured treasury notes do not consider inflation at the start and the yield is used for compensating the investors for the expected future rate of inflation. This spread between both securities is the indication for the market about inflation. The most important factor in influencing the spread relation is inflation because this spread is basically dependent on the inflation rate change. The spread is basically the projection for the inflation and it cannot be predicted how it will change in the future. Comprehensively, the TIP spread is considered to be a reliable measure for predicting the appropriate level of inflation.
2. Fully describe the fixed-income instruments of the money and capital markets. Make sure you cover all the money and bond markets we discussed. Do not just list the instruments.
Among financial markets, there are two most commonly used concepts, one is a capital market and the other one is the money market. The money market is used by the corporate entities and government for lending and borrowing money for a short term. In contrast, capital market contains long term assets with having the maturity of more than a year. In the capital market, the bonds and stock options are available. The securities in the capital market which offer a fixed rate of return are called as fixed - rate capital securities and a combination of features for the comm.
The document discusses several key concepts related to macroeconomic policy including:
1) The functions and supply of money, including different types of monetary aggregates (M1, M2, M3).
2) The roles and tools of central banks in conducting monetary policy, including open market operations and reserve requirements.
3) How monetary policy is transmitted through interest rates and aggregate demand to impact output and prices.
4) Fiscal policy tools like government spending and taxation and how they can be used in a discretionary manner for stabilization.
5) The multiplier effect whereby an initial change in spending is magnified in its impact on aggregate demand and output.
Week- 5 Interest Rates and Stock MarketMoney and Banking Econ .docxalanfhall8953
Week- 5 Interest Rates and Stock Market
Money and Banking Econ 311
Thursday 7 - 9:45
Instructor: Thomas L. Thomas
Response over Time to an Increase in Money Supply Growth
2
Risk Structure of Interest Rates
Bonds with the same maturity have different interest rates due to:
Default risk
Liquidity
Tax considerations
Long-Term Bond Yields, 1919–2011
Sources: Board of Governors of the Federal Reserve System, Banking and Monetary Statistics, 1941–1970; Federal Reserve; www.federalreserve.gov/releases/h15/data.htm.
4
Risk Structure of Interest Rates (cont’d)
Default risk: probability that the issuer of the bond is unable or unwilling to make interest payments or pay off the face value
U.S. Treasury bonds are considered default free (government can raise taxes).
Risk premium: the spread between the interest rates on bonds with default risk and the interest rates on (same maturity) Treasury bonds
5
Bond Ratings by Moody’s, Standard and Poor’s, and Fitch
6
Risk Structure of Interest Rates (cont’d)
Liquidity: the relative ease with which an asset can be converted into cash
Cost of selling a bond
Number of buyers/sellers in a bond market
Income tax considerations
Interest payments on municipal bonds are exempt from federal income taxes.
Term Structure of Interest Rates
Bonds with identical risk, liquidity, and tax characteristics may have different interest rates because the time remaining to maturity is different
Yield curve: a plot of the yield on bonds with differing terms to maturity but the same risk, liquidity and tax considerations
Upward-sloping: long-term rates are above
short-term rates
Flat: short- and long-term rates are the same
Inverted: long-term rates are below short-term rates
Facts that the Theory of the Term Structure of Interest Rates Must Explain
Interest rates on bonds of different maturities move together over time
When short-term interest rates are low, yield curves are more likely to have an upward slope; when short-term rates are high, yield curves are more likely to slope downward and be inverted
Yield curves almost always slope upward
9
Three Theories to Explain the Three Facts
Expectations theory explains the first two facts but not the third
Segmented markets theory explains fact three but not the first two
Liquidity premium theory combines the two theories to explain all three facts
10
Expectations Theory
The interest rate on a long-term bond will equal an average of the short-term interest rates that people expect to occur over the life of the long-term bond
Buyers of bonds do not prefer bonds of one maturity over another; they will not hold
any quantity of a bond if its expected return
is less than that of another bond with a different maturity
Bond holders consider bonds with different maturities to be perfect substitutes
11
Expectations Theory: Example
Let the c.
Interest rates play an important role in determining a country's liquidity position. Higher interest rates aim to decrease liquidity in the economy by increasing savings. Lower interest rates increase liquidity by making capital more accessible and encouraging borrowing. Theories of interest rate determination include the classical theory that real factors like savings and investment determine rates, and the Keynesian theory that interest rates are a monetary phenomenon influenced by the money supply. Different interest rates exist based on the maturity of financial instruments.
https://rb.gy/n89u77
Describe interest rate fundamentals, the term structure of interest rates, and risk premiums. Discuss the general features,
yields, prices, ratings, popular types, and international issues of
corporate bonds. Review the legal aspects of bond financing and bond cost.
The document discusses interest rate determination and the structure of interest rates. It covers several theories of interest rates including the classical theory, liquidity preference theory, loanable funds theory, and rational expectations theory. The classical theory argues that interest rates are determined by the supply and demand of savings and investment. The liquidity preference theory states that interest rates are determined by the demand and supply of money. The loanable funds theory considers the demand for and supply of loanable funds. And the rational expectations theory posits that interest rates reflect rational expectations of future rates based on available information. The document also discusses how interest rates are structured and determined by factors like risk, term of maturity, and monetary policy objectives.
ASSIGNMENT 4
g
[Name of the Student]
[Name of the University]
Running Head: ASSIGNMENT 1
General Essay Questions (5pts each)
1. What are TIPs? How do these securities provide a hedge against inflation? Discuss the spread between traditionally-structured Treasury notes and TIPs. What factors influence this spread relationship?
TIPs are the Treasury Inflation Protected securities. These are the bonds issued by the government that offer return after the inflation which is also known as a real return. they are different from the nominal or traditional bonds in which the returns are specifically before inflation. This is the way for the investors for offsetting the risk that comes with the inflation. These TIPs offer the hedge against inflation by providing a return which is calculated after taking out the risk of inflation. This is the best way for investors to offset the risk that comes due to the inflation in society. With the strengthening of the economy, inflation can increase, and the return is not expected to increase in the high rate of inflation, so for affording protection against inflation in the economy, TIPs are used in the form of fixed income investment for the destruction of inflation. TIPs are backed by the government and they offer high attractiveness for the investors because the level of risk in these securities is less.
TIP spread is when the yield of TIPS and other US Treasury securities is compared having the same date for the maturity. The difference that exists between both of them is used as payment adjustment for the inflation. The traditionally structured treasury notes do not consider inflation at the start and the yield is used for compensating the investors for the expected future rate of inflation. This spread between both securities is the indication for the market about inflation. The most important factor in influencing the spread relation is inflation because this spread is basically dependent on the inflation rate change. The spread is basically the projection for the inflation and it cannot be predicted how it will change in the future. Comprehensively, the TIP spread is considered to be a reliable measure for predicting the appropriate level of inflation.
2. Fully describe the fixed-income instruments of the money and capital markets. Make sure you cover all the money and bond markets we discussed. Do not just list the instruments.
Among financial markets, there are two most commonly used concepts, one is a capital market and the other one is the money market. The money market is used by the corporate entities and government for lending and borrowing money for a short term. In contrast, capital market contains long term assets with having the maturity of more than a year. In the capital market, the bonds and stock options are available. The securities in the capital market which offer a fixed rate of return are called as fixed - rate capital securities and a combination of features for the comm.
Interest rate risk management what regulators want in 2015 7.15.2015Craig Taggart MBA
Areas covered in this section
Why Interest Rate Risk (IRR) should not be ignored
• Forward Rate Agreements (FRA’s) Forwards, Futures
• Swaps, Options
Why Bank Regulators continue to have a poor handle on interest rate risk
• Interest Rate Caps, floors, Collars
• LIBOR and UBS & Barclays rigging rates
• How should Financial Institutions determine which IRR vendor models are appropriate?
IRR Measurement methodologies are institutions
The document discusses several theories of interest rate determination:
1. The classical theory argues that interest rates are determined by the supply of savings and demand for investment, where the equilibrium rate balances the two.
2. The liquidity preference theory views interest as the price of money, with rates set by demand for and supply of money in the economy.
3. The loanable funds theory sees rates as set by demand for and supply of credit in the economy from savers, borrowers, and foreign actors.
This document provides an overview of interest rates, bond valuation, and bond features. It discusses how interest rates are determined by the relationship between the supply and demand of funds. It also explains how nominal interest rates are comprised of expected inflation and risk premiums. The document covers bond valuation techniques, such as using the yield-to-maturity approach. Additionally, it describes various bond characteristics like call provisions, conversion features, and indentures.
Capital Market presentation from UMBC reporting. The struucture of rates and return. and others
Capital Market presentation from UMBC reporting. The struucture of rates and return. and others
Capital Market presentation from UMBC reporting. The struucture of rates and return. and others
Capital Market presentation from UMBC reporting. The struucture of rates and return. and others. It will p[ublich and increase as youy pick category and add more atgs
Interest rate analysis, inflation risk and yield.pptxRicha Joshi
Interest rates represent the price paid by borrowers to access funds now rather than later. They compensate lenders for delaying current consumption. Nominal interest rates factor in inflation while real rates do not. Long-term bonds are more sensitive to interest rate changes than short-term bonds. The yield curve maps interest rates against maturities, normally sloping upward due to liquidity and risk preferences. Different theories offer explanations for how interest rates are determined in markets.
Chapter 03_What Do Interest Rates Mean and What Is Their Role in Valuation?Rusman Mukhlis
This chapter discusses interest rates and their role in valuation. It defines key terms like yield to maturity, which is the most accurate measure of interest rates. It examines how to measure and understand different interest rates, the distinction between real and nominal rates, and the relationship between interest rates and returns. It also covers how the concept of present value is used to evaluate debt instruments and how duration is used to measure interest rate risk.
This chapter discusses the valuation of bonds and shares. It explains the characteristics of ordinary shares, preference shares, and bonds. It shows how present value concepts are used to value these securities. The chapter focuses on the price-earnings ratio and its proper and improper uses in valuation. It also covers the determinants of bond values such as maturity, yield to maturity, current yield, and sensitivity to interest rate changes.
This document provides an overview and learning goals for a lecture on interest rates and bonds. It discusses key concepts like the term structure of interest rates, bond yields, prices, and types. It also covers bond valuation basics, factors that influence interest rates, and theories of the term structure. Examples are provided to illustrate expectations theory and the impact of inflation on interest rates. The document reviews corporate bond features, costs, and ratings. Tables present bond characteristics, issuer risks, and rating scales.
This document discusses inflation, deflation, yield curves, and duration and how they impact interest rates and asset prices. It defines key terms like inflation, nominal and real interest rates, and explores theories on the relationship between inflation and interest rates. It also examines how yield curves are formed and used, and introduces the concept of duration as a measure of a debt security's price sensitivity to interest rate changes.
This document provides an overview of how debt security yields vary and the factors that influence them. It discusses the following key points in 3 sentences:
Debt security yields are influenced by credit risk, liquidity, tax status, and term of maturity. Higher risk securities offer higher yields to attract investors. The term structure of interest rates defines the relationship between yield and term to maturity and can be affected by expectations of future interest rates, liquidity preferences, and segmented markets.
The document summarizes several theories about what determines interest rates:
1) The classical theory argues that interest rates are determined by the supply of household savings and the demand for business investment.
2) The liquidity preference theory views interest rates as the price that induces people to hold cash rather than bonds given transactions, precautionary, and speculative demands for money.
3) The loanable funds theory sees interest rates as set by the overall demand for and supply of credit from various sources like domestic savings, money creation, and foreign lending.
A bond is a debt security where the issuer owes the holder a debt and is obliged to repay the principal and interest at maturity. Bonds have features like nominal value, coupon rate, maturity date, and call/put options. There are various types of bonds like fixed rate, floating rate, zero coupon bonds, and municipal bonds. Bond portfolio strategies include passive buy and hold strategies, active strategies like sector substitution, and semi-active strategies like immunization and duration matching to reduce interest rate risk. Bonds are evaluated based on the issuer's financial strength and past earnings, while valuation considers the present value of future cash flows and yield to maturity is the single discount rate that equals the current price.
A bond is a debt security where the issuer owes the holder a debt and is obliged to repay the principal and interest at maturity. Bonds have features like nominal value, coupon rate, maturity date, and call/put options. There are various types of bonds like fixed rate, floating rate, zero coupon bonds, and municipal bonds. Bond portfolio strategies include passive buy and hold strategies, active strategies like sector substitution, and semi-active strategies like immunization and duration matching to reduce interest rate risk. Bonds are evaluated based on the issuer's financial strength and past earnings, while valuation considers the present value of future cash flows and yield measures like current yield and yield to maturity.
ASSIGNMENT 3
g
[Name of the Student]
[Name of the University]
Running Head: ASSIGNMENT 1
General Essay Questions (5pts each)
1. What are TIPs? How do these securities provide a hedge against inflation? Discuss the spread between traditionally-structured Treasury notes and TIPs. What factors influence this spread relationship?
TIPs are the Treasury Inflation Protected securities. These are the bonds issued by the government that offer return after the inflation which is also known as a real return. they are different from the nominal or traditional bonds in which the returns are specifically before inflation. This is the way for the investors for offsetting the risk that comes with the inflation. These TIPs offer the hedge against inflation by providing a return which is calculated after taking out the risk of inflation. This is the best way for investors to offset the risk that comes due to the inflation in society. With the strengthening of the economy, inflation can increase, and the return is not expected to increase in the high rate of inflation, so for affording protection against inflation in the economy, TIPs are used in the form of fixed income investment for the destruction of inflation. TIPs are backed by the government and they offer high attractiveness for the investors because the level of risk in these securities is less.
TIP spread is when the yield of TIPS and other US Treasury securities is compared having the same date for the maturity. The difference that exists between both of them is used as payment adjustment for the inflation. The traditionally structured treasury notes do not consider inflation at the start and the yield is used for compensating the investors for the expected future rate of inflation. This spread between both securities is the indication for the market about inflation. The most important factor in influencing the spread relation is inflation because this spread is basically dependent on the inflation rate change. The spread is basically the projection for the inflation and it cannot be predicted how it will change in the future. Comprehensively, the TIP spread is considered to be a reliable measure for predicting the appropriate level of inflation.
2. Fully describe the fixed-income instruments of the money and capital markets. Make sure you cover all the money and bond markets we discussed. Do not just list the instruments.
Among financial markets, there are two most commonly used concepts, one is a capital market and the other one is the money market. The money market is used by the corporate entities and government for lending and borrowing money for a short term. In contrast, capital market contains long term assets with having the maturity of more than a year. In the capital market, the bonds and stock options are available. The securities in the capital market which offer a fixed rate of return are called as fixed - rate capital securities and a combination of features for the comm.
The document discusses several key concepts related to macroeconomic policy including:
1) The functions and supply of money, including different types of monetary aggregates (M1, M2, M3).
2) The roles and tools of central banks in conducting monetary policy, including open market operations and reserve requirements.
3) How monetary policy is transmitted through interest rates and aggregate demand to impact output and prices.
4) Fiscal policy tools like government spending and taxation and how they can be used in a discretionary manner for stabilization.
5) The multiplier effect whereby an initial change in spending is magnified in its impact on aggregate demand and output.
Week- 5 Interest Rates and Stock MarketMoney and Banking Econ .docxalanfhall8953
Week- 5 Interest Rates and Stock Market
Money and Banking Econ 311
Thursday 7 - 9:45
Instructor: Thomas L. Thomas
Response over Time to an Increase in Money Supply Growth
2
Risk Structure of Interest Rates
Bonds with the same maturity have different interest rates due to:
Default risk
Liquidity
Tax considerations
Long-Term Bond Yields, 1919–2011
Sources: Board of Governors of the Federal Reserve System, Banking and Monetary Statistics, 1941–1970; Federal Reserve; www.federalreserve.gov/releases/h15/data.htm.
4
Risk Structure of Interest Rates (cont’d)
Default risk: probability that the issuer of the bond is unable or unwilling to make interest payments or pay off the face value
U.S. Treasury bonds are considered default free (government can raise taxes).
Risk premium: the spread between the interest rates on bonds with default risk and the interest rates on (same maturity) Treasury bonds
5
Bond Ratings by Moody’s, Standard and Poor’s, and Fitch
6
Risk Structure of Interest Rates (cont’d)
Liquidity: the relative ease with which an asset can be converted into cash
Cost of selling a bond
Number of buyers/sellers in a bond market
Income tax considerations
Interest payments on municipal bonds are exempt from federal income taxes.
Term Structure of Interest Rates
Bonds with identical risk, liquidity, and tax characteristics may have different interest rates because the time remaining to maturity is different
Yield curve: a plot of the yield on bonds with differing terms to maturity but the same risk, liquidity and tax considerations
Upward-sloping: long-term rates are above
short-term rates
Flat: short- and long-term rates are the same
Inverted: long-term rates are below short-term rates
Facts that the Theory of the Term Structure of Interest Rates Must Explain
Interest rates on bonds of different maturities move together over time
When short-term interest rates are low, yield curves are more likely to have an upward slope; when short-term rates are high, yield curves are more likely to slope downward and be inverted
Yield curves almost always slope upward
9
Three Theories to Explain the Three Facts
Expectations theory explains the first two facts but not the third
Segmented markets theory explains fact three but not the first two
Liquidity premium theory combines the two theories to explain all three facts
10
Expectations Theory
The interest rate on a long-term bond will equal an average of the short-term interest rates that people expect to occur over the life of the long-term bond
Buyers of bonds do not prefer bonds of one maturity over another; they will not hold
any quantity of a bond if its expected return
is less than that of another bond with a different maturity
Bond holders consider bonds with different maturities to be perfect substitutes
11
Expectations Theory: Example
Let the c.
Interest rates play an important role in determining a country's liquidity position. Higher interest rates aim to decrease liquidity in the economy by increasing savings. Lower interest rates increase liquidity by making capital more accessible and encouraging borrowing. Theories of interest rate determination include the classical theory that real factors like savings and investment determine rates, and the Keynesian theory that interest rates are a monetary phenomenon influenced by the money supply. Different interest rates exist based on the maturity of financial instruments.
https://rb.gy/n89u77
Describe interest rate fundamentals, the term structure of interest rates, and risk premiums. Discuss the general features,
yields, prices, ratings, popular types, and international issues of
corporate bonds. Review the legal aspects of bond financing and bond cost.
The document discusses interest rate determination and the structure of interest rates. It covers several theories of interest rates including the classical theory, liquidity preference theory, loanable funds theory, and rational expectations theory. The classical theory argues that interest rates are determined by the supply and demand of savings and investment. The liquidity preference theory states that interest rates are determined by the demand and supply of money. The loanable funds theory considers the demand for and supply of loanable funds. And the rational expectations theory posits that interest rates reflect rational expectations of future rates based on available information. The document also discusses how interest rates are structured and determined by factors like risk, term of maturity, and monetary policy objectives.
ASSIGNMENT 4
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[Name of the Student]
[Name of the University]
Running Head: ASSIGNMENT 1
General Essay Questions (5pts each)
1. What are TIPs? How do these securities provide a hedge against inflation? Discuss the spread between traditionally-structured Treasury notes and TIPs. What factors influence this spread relationship?
TIPs are the Treasury Inflation Protected securities. These are the bonds issued by the government that offer return after the inflation which is also known as a real return. they are different from the nominal or traditional bonds in which the returns are specifically before inflation. This is the way for the investors for offsetting the risk that comes with the inflation. These TIPs offer the hedge against inflation by providing a return which is calculated after taking out the risk of inflation. This is the best way for investors to offset the risk that comes due to the inflation in society. With the strengthening of the economy, inflation can increase, and the return is not expected to increase in the high rate of inflation, so for affording protection against inflation in the economy, TIPs are used in the form of fixed income investment for the destruction of inflation. TIPs are backed by the government and they offer high attractiveness for the investors because the level of risk in these securities is less.
TIP spread is when the yield of TIPS and other US Treasury securities is compared having the same date for the maturity. The difference that exists between both of them is used as payment adjustment for the inflation. The traditionally structured treasury notes do not consider inflation at the start and the yield is used for compensating the investors for the expected future rate of inflation. This spread between both securities is the indication for the market about inflation. The most important factor in influencing the spread relation is inflation because this spread is basically dependent on the inflation rate change. The spread is basically the projection for the inflation and it cannot be predicted how it will change in the future. Comprehensively, the TIP spread is considered to be a reliable measure for predicting the appropriate level of inflation.
2. Fully describe the fixed-income instruments of the money and capital markets. Make sure you cover all the money and bond markets we discussed. Do not just list the instruments.
Among financial markets, there are two most commonly used concepts, one is a capital market and the other one is the money market. The money market is used by the corporate entities and government for lending and borrowing money for a short term. In contrast, capital market contains long term assets with having the maturity of more than a year. In the capital market, the bonds and stock options are available. The securities in the capital market which offer a fixed rate of return are called as fixed - rate capital securities and a combination of features for the comm.
Interest rate risk management what regulators want in 2015 7.15.2015Craig Taggart MBA
Areas covered in this section
Why Interest Rate Risk (IRR) should not be ignored
• Forward Rate Agreements (FRA’s) Forwards, Futures
• Swaps, Options
Why Bank Regulators continue to have a poor handle on interest rate risk
• Interest Rate Caps, floors, Collars
• LIBOR and UBS & Barclays rigging rates
• How should Financial Institutions determine which IRR vendor models are appropriate?
IRR Measurement methodologies are institutions
The document discusses several theories of interest rate determination:
1. The classical theory argues that interest rates are determined by the supply of savings and demand for investment, where the equilibrium rate balances the two.
2. The liquidity preference theory views interest as the price of money, with rates set by demand for and supply of money in the economy.
3. The loanable funds theory sees rates as set by demand for and supply of credit in the economy from savers, borrowers, and foreign actors.
This document provides an overview of interest rates, bond valuation, and bond features. It discusses how interest rates are determined by the relationship between the supply and demand of funds. It also explains how nominal interest rates are comprised of expected inflation and risk premiums. The document covers bond valuation techniques, such as using the yield-to-maturity approach. Additionally, it describes various bond characteristics like call provisions, conversion features, and indentures.
Capital Market presentation from UMBC reporting. The struucture of rates and return. and others
Capital Market presentation from UMBC reporting. The struucture of rates and return. and others
Capital Market presentation from UMBC reporting. The struucture of rates and return. and others
Capital Market presentation from UMBC reporting. The struucture of rates and return. and others. It will p[ublich and increase as youy pick category and add more atgs
Interest rate analysis, inflation risk and yield.pptxRicha Joshi
Interest rates represent the price paid by borrowers to access funds now rather than later. They compensate lenders for delaying current consumption. Nominal interest rates factor in inflation while real rates do not. Long-term bonds are more sensitive to interest rate changes than short-term bonds. The yield curve maps interest rates against maturities, normally sloping upward due to liquidity and risk preferences. Different theories offer explanations for how interest rates are determined in markets.
Similar to Chapter Three Interest rates in the Financial System.ppt (20)
FM CH 4.pptx best presentation for financial managementKalkaye
This chapter discusses the cost of capital, which is the minimum rate of return a firm must earn on its invested capital to maintain its market value. The cost of each source of capital (debt, preferred stock, common stock, retained earnings) is calculated separately as the component or specific cost of capital. The overall cost of capital is the weighted average cost of capital (WACC), which is calculated using either book values or market values of each capital source. The chapter provides examples of calculating the specific cost for each component and the WACC using both book value and market value methods. It also discusses calculating the weighted marginal cost of capital when additional capital is raised from multiple sources.
FM CH 3 ppt.pptx best presentation for financial managementKalkaye
Money has a time value that can be measured using present value (PV) and future value (FV). PV is the current worth of future money, while FV is the future worth of current money. Interest is the price paid to use money over time, and can be simple or compound. Simple interest is calculated on the initial investment only, while compound interest is calculated on the initial amount plus all accrued interest over time. Time value of money concepts like present and future value, interest rates, and annuities are used to evaluate financial decisions over different points in time.
cost II ch 5 ppt-1 (1).pptx best presentationKalkaye
The document discusses several topics related to relevant costs and decision making:
1. It defines relevant costs as future costs and revenues that differ among alternative courses of action being considered. Costs and revenues must be incremental and future to be relevant.
2. It provides examples of relevant costs like avoidable and opportunity costs. Non-relevant costs include sunk, committed, and spare capacity costs.
3. It discusses how identifying relevant costs and benefits is important for decision making and avoiding too much information.
4. It provides examples of decisions involving special orders, adding/dropping products, make-or-buy, product mix under capacity constraints, and processing joint products further.
The document discusses key concepts and terminology related to financial instruments, specifically long term debt and investments. It defines financial instruments, financial assets, financial liabilities, and equity instruments. It also covers initial recognition and measurement of financial instruments, classification of financial assets, subsequent measurement of financial assets at amortized cost and fair value through other comprehensive income, and types of bonds including convertible and callable bonds.
FA II - Chapter 2 & 3; Part II.pptx best presentationKalkaye
This document provides an example of accounting for serial bonds issued at a 9% yield and 11% yield over 10 years. It includes calculations of present value of interest and principal payments, journal entries to record bond issuances and premium/discount amortization, and examples of early extinguishment before maturity through cash payment, asset exchange, and modification of terms.
FA II - Chapter 6; IAS 8.pptx best presentationKalkaye
IAS 8 provides guidance on accounting policies, changes in accounting estimates, and correction of errors. It establishes the hierarchy for selecting accounting policies giving priority to applicable IFRS standards. Changes in accounting policies are generally accounted for retrospectively while changes in estimates are accounted for prospectively. Errors in prior period financial statements are corrected retrospectively.
FA II - Chapter 7; Accounting for Income Tax.pptxKalkaye
This document provides an overview of IAS 12, which establishes accounting requirements for income taxes. It defines key terms like tax base and carrying amount, and explains the differences between taxable income and accounting income. Temporary and permanent differences that arise are discussed. The standard requires deferred tax assets and liabilities to be recognized for temporary differences between the tax base and carrying amount of assets and liabilities. Several examples are provided to illustrate calculating deferred tax balances. Presentation and disclosure requirements are also summarized.
FA II - Chapter 4; Part II, Leases.pptx bestKalkaye
This document outlines the key concepts and accounting treatments related to lease accounting. It discusses lease accounting from the perspectives of both the lessee and the lessor. For lessees, it describes how to classify and account for operating and capital leases. For lessors, it distinguishes between operating, direct financing, and sales-type leases. It also discusses special topics that can complicate lease accounting, such as residual values, bargain purchase options, and initial direct costs. The document uses illustrations and journal entries to demonstrate how to apply lease accounting standards.
In a tight labour market, job-seekers gain bargaining power and leverage it into greater job quality—at least, that’s the conventional wisdom.
Michael, LMIC Economist, presented findings that reveal a weakened relationship between labour market tightness and job quality indicators following the pandemic. Labour market tightness coincided with growth in real wages for only a portion of workers: those in low-wage jobs requiring little education. Several factors—including labour market composition, worker and employer behaviour, and labour market practices—have contributed to the absence of worker benefits. These will be investigated further in future work.
OJP data from firms like Vicinity Jobs have emerged as a complement to traditional sources of labour demand data, such as the Job Vacancy and Wages Survey (JVWS). Ibrahim Abuallail, PhD Candidate, University of Ottawa, presented research relating to bias in OJPs and a proposed approach to effectively adjust OJP data to complement existing official data (such as from the JVWS) and improve the measurement of labour demand.
"Does Foreign Direct Investment Negatively Affect Preservation of Culture in the Global South? Case Studies in Thailand and Cambodia."
Do elements of globalization, such as Foreign Direct Investment (FDI), negatively affect the ability of countries in the Global South to preserve their culture? This research aims to answer this question by employing a cross-sectional comparative case study analysis utilizing methods of difference. Thailand and Cambodia are compared as they are in the same region and have a similar culture. The metric of difference between Thailand and Cambodia is their ability to preserve their culture. This ability is operationalized by their respective attitudes towards FDI; Thailand imposes stringent regulations and limitations on FDI while Cambodia does not hesitate to accept most FDI and imposes fewer limitations. The evidence from this study suggests that FDI from globally influential countries with high gross domestic products (GDPs) (e.g. China, U.S.) challenges the ability of countries with lower GDPs (e.g. Cambodia) to protect their culture. Furthermore, the ability, or lack thereof, of the receiving countries to protect their culture is amplified by the existence and implementation of restrictive FDI policies imposed by their governments.
My study abroad in Bali, Indonesia, inspired this research topic as I noticed how globalization is changing the culture of its people. I learned their language and way of life which helped me understand the beauty and importance of cultural preservation. I believe we could all benefit from learning new perspectives as they could help us ideate solutions to contemporary issues and empathize with others.
Seminar: Gender Board Diversity through Ownership NetworksGRAPE
Seminar on gender diversity spillovers through ownership networks at FAME|GRAPE. Presenting novel research. Studies in economics and management using econometrics methods.
Abhay Bhutada, the Managing Director of Poonawalla Fincorp Limited, is an accomplished leader with over 15 years of experience in commercial and retail lending. A Qualified Chartered Accountant, he has been pivotal in leveraging technology to enhance financial services. Starting his career at Bank of India, he later founded TAB Capital Limited and co-founded Poonawalla Finance Private Limited, emphasizing digital lending. Under his leadership, Poonawalla Fincorp achieved a 'AAA' credit rating, integrating acquisitions and emphasizing corporate governance. Actively involved in industry forums and CSR initiatives, Abhay has been recognized with awards like "Young Entrepreneur of India 2017" and "40 under 40 Most Influential Leader for 2020-21." Personally, he values mindfulness, enjoys gardening, yoga, and sees every day as an opportunity for growth and improvement.
Falcon stands out as a top-tier P2P Invoice Discounting platform in India, bridging esteemed blue-chip companies and eager investors. Our goal is to transform the investment landscape in India by establishing a comprehensive destination for borrowers and investors with diverse profiles and needs, all while minimizing risk. What sets Falcon apart is the elimination of intermediaries such as commercial banks and depository institutions, allowing investors to enjoy higher yields.
2. INTEREST RATES DETERMINATION AND STRUCTURE
The rate of interest
Interest rate is a rate of return paid by a borrower of
funds to a lender, or a price paid by a borrower for a
service, or the right to make use of funds for a
specified period. Thus, it is one form of yield on
financial instruments.
3. Cont’d
• There is interest rate at which banks are lending (the
offer rate) and interest rate they are paying for deposits
(the bid rate). The difference between them is called a
spread.
• The spread between offer and bid rates provides a
cover for administrative costs of the financial
intermediaries and includes their profit. The spread is
influenced by the degree of competition among
financial institutions.
4. Con’d
• In the short-term international money markets, the
spread is lower if there is considerable competition.
• on the other hand, the spread between banks
borrowing and lending rates to their retail customers
is larger in general due to considerably larger degree
of loan default risk.
• Thus, the lending rate (offer or ask rate) always
includes a risk premium.
5. Cont’d
• Risk premium is an addition to the interest rate
demanded by a lender to take into account the risk
that the borrower might default on the loan entirely
or may not repay on time (default risk).
6. Cont’d
• Factors that determine the risk premium for a non-
Government security, as compared with the
Government security of the same maturity are:
1. The perceived credit worthiness of the issuer,
2. provisions of securities, such as conversion provision, call
provision, put provision
3. Interest taxes, and
4. Expected liquidity of a security’s issue.
7. Cont’d
• In order to explain the determinants of interest rates
in general, the economic theory assumes there is
some particular interest rate, as a representative of
all interest rates in an economy.
• Such an interest rate usually depends upon the topic
considered, and can be represented by e.g.
1. interest rate on government short-term or long-term debt,
2. the base interest rate of the commercial banks, or
3. a short-term money market rate
8. Cont’d
• In such a case it is assumed that the interest rate
structure is stable and that all interest rates in the
economy are likely to move in the same direction.
• Interest rate structure is the relationships between
the various rates of interest in an economy on
financial instruments of different lengths (terms) or
of different degrees of risk.
9. Cont’d
• The rates of interest quoted by financial institutions
are nominal rates, and are used to calculate interest
payments to borrowers and lenders.
• The loan can be ‘rolled over’ at a newly set rate of
interest to reflect changes in the expected rate of
inflation.
• On the other hand, lenders can set a floating interest
rate, which is adjusted to the inflation rate changes.
10. Cont’d
• Real interest rate is the difference between the
nominal rate of interest and the expected rate of
inflation. It is a measure of the anticipated
opportunity cost of borrowing in terms of goods and
services forgone.
11. Cont’d
• The dependence between the real and nominal
interest rates is expressed using the following
equation:
i = (1+ r)(1+ ie) - 1
where i is the nominal rate of interest,
r is the real rate of interest and
ie is the expected rate of inflation.
12. Cont,d
Assume that a bank is willing to make a loan to you of
Br1,000 for one year at a real rate of interest of 3 per cent.
This means that at the end of the year the bank expects to
receive back Br1,030 of purchasing power at current prices.
However, if the bank expects a 10 per cent rate of inflation
over the next twelve months, it will want Br1,133 back (10
per cent above Br1,030). The interest rate required to
produce this sum would be 13.3 per cent.
14. The theory and structure of interest rates
There are two economic theories explaining the level
of real interest rates in an economy:
The loanable funds theory
Liquidity preference theory
15. Loanable funds theory
In an economy, there is a supply of loanable fund (i.e.,
credit) in the capital market by households, business,
and governments.
Loanable funds are funds borrowed and lent in an
economy during a specified period of time – the flow of
money from surplus to deficit units in the economy.
The higher the level of interest rates, the more such
entities are willing to supply loan funds; the lower the
level of interest, the less they are willing to supply.
16. Cont,d
• These same entities demand loanable funds, demanding
more when the level of interest rates is low and less
when interest rates are higher.
According to the scholars , the level of interest rates is
determined by the supply and demand of loanable funds
available in an economy’s credit market (i.e., the sector
of the capital markets for long-term debt instruments).
• This theory suggests that investment and savings in the
economy determine the level of long-term interest rates.
17. Cont,d
• Short-term interest rates, however, are determined
by an economy’s financial and monetary conditions.
According to loanable funds theory for the economy
as a whole:
Demand for loanable funds = net investment + net
additions to liquid reserves
Supply of loanable funds = net savings + increase in
the money supply
18. liquidity preference theory
Saving and investment of market participants under
economic uncertainty may be much more influenced
by expectations and by exogenous shocks than by
underlying real forces.
• A possible response of risk-averse savers is to vary
the form in which they hold their financial wealth
depending on their expectations about asset prices.
19. Cont,d
• Liquidity preference theory: which explains how
interest rates are determined based on the preferences of
households to hold money balances rather than
spending or investing those funds.
– Liquidity preference is preference for holding financial
wealth in the form of short-term, highly liquid assets rather
than long-term illiquid assets, based principally on the fear
that long-term assets will lose capital value over time.
20. Cont,d
• Money balances can be held in the form of currency or
checking accounts, however it does earn a very low
interest rate or no interest at all. A key element in the
theory is the motivation for individuals to hold money
balance despite the loss of interest income.
• According to the liquidity preference theory, the level of
interest rates is determined by the supply and demand
for money balances. The money supply is controlled by
the policy tools available to the country’s Central Bank.
21. Loanable funds and liquidity preference
• It is commonly argued that the two theories are, in fact,
complementary, merely looking at two different markets
which are:
1. The market for money and
2. The market for non-money financial assets,
• Both the above two markets of which have to be in
equilibrium if the system as a whole is in equilibrium.
22. Structure of interest rates
• Interest rate structure is the relationships between the various
rates of interest in an economy on financial instruments of
different lengths (terms) or of different degrees of risk.
The variety of interest rates that exist in the economy and the
structure of interest rates are subject to considerable change
due to different factors. Such changes are important to the
operation of monetary policy.
23. cont’d
• Interest rates vary because of differences in
• the time period,
• the degree of risk, and
• the transaction costs associated with different financial instruments
• The greater the risk of default associated with an asset,
the higher must be the interest rate paid upon it as
compensation for the risk. This explains why some
borrowers pay higher rates of interest than others.
24. cont’d
• The degree of risk associated with a request for a
loan may be determined based up on a
• company’s size,
• profitability or past performance;
• or, it may be determined more formally by credit rating
agencies.
• Borrowers with high credit ratings will be able to have
commercial bills accepted by banks, find willing takers
for their commercial paper or borrow directly from banks
at lower rates of interest.
25. Term Structure of Interest Rates
• The relationship between the yields on comparable
securities but different maturities is called the term
structure of interest rates.
• It is the relationship between short-term and long-
term interest rates.
• The primary focus here is the Treasury market.
• The graphic that depicts the relationship between
the yield on Treasury securities with different
maturities is known as the yield curve and,
therefore, the maturity spread is also referred to as
the yield curve spread.
26. Cont,d
• Yield curve shows the relationships between the
interest rates payable on bonds with different
lengths of time to maturity. That is, it shows the
term structure of interest rates.
27. Risk structure of interest rates
• Interest rates and yields on credit market
instruments of the same maturity vary because
of differences in
– default risk,
– liquidity,
– information costs, and
– taxation.
• These determinants are known collectively as
the risk structure of interest rates.
28. Theories of Term Structure of
Interest Rates
• There are several major economic theories
that explain the observed shapes of the yield
curve:
Expectations theory
Liquidity premium theory
Market segmentation theory
Preferred habitat theory
29. Expectations theory
• The pure expectations theory assumes that
investors are indifferent between investing for
a long period on the one hand and investing
for a shorter period with a view to reinvesting
the principal plus interest on the other hand.
30. Cont,d
• For example an investor would have no preference
between making a 12-month deposit and making a
6-month deposit with a view to reinvesting the
proceeds for a further six months as long as the
expected interest receipts are the same.
• This is equivalent to saying that the pure
expectations theory assumes that investors treat
alternative maturities as perfect substitutes for one
another.
31. Cont,d
• The pure expectations theory assumes that
investors are risk-neutral.
• A risk-neutral investor is not concerned about the
possibility that interest rate expectations will prove
to be incorrect, as long as potential favourable
deviations from expectations are as likely as
unfavourable ones. Risk is not regarded negatively.
32. Liquidity Premium Theory
• Some investors may prefer to own shorter
rather than longe term securities because a
shorter maturity represents greater liquidity.
• In such case they will be willing to hold long
term securities only if compensated with a
premium for the lower degree of liquidity.
33. Cont,d
• Though long-term securities may be liquidated
prior to maturity, their prices are more
sensitive to interest rate movements.
• Short-term securities are usually considered to
be more liquid because they are more likely to
be converted to cash without a loss in value.
• Thus there is a liquidity premium for less
liquid securities which changes over time.
34. Market Segmentation Theory
• According to the market segmentation theory,
interest rates for different maturities are
determined independently of one another.
The interest rate for short maturities is
determined by the supply and demand for
short-term funds.
• Long-term interest rates are those that equate
the sums that investors wish to lend long term
with the amounts that borrowers are seeking
on a long-term basis.
35. Cont,d
• According to market segmentation theory,
investors and borrowers do not consider their
short-term investments or borrowings as
substitutes for long-term ones.
• This lack of substitutability keeps interest rates
of differing maturities independent of one
another.
• If investors or borrowers considered
alternative maturities as substitutes, they may
switch between maturities.
36. Cont,d
• . However, if investors and borrowers switch
between maturities in response to interest
rate changes, interest rates for different
maturities would no longer be independent of
each other. An interest rate change for one
maturity would affect demand and supply, and
hence interest rates, for other maturities.
37. The Preferred Habitat Theory
• Preferred habitat theory is a variation on the
market segmentation theory. The preferred
habitat theory allows for some substitutability
between maturities. However the preferred
habitat theory views that interest premiums
are needed to attract investors from their
preferred maturities to other maturities.
38. Cont,d
• According to the market segmentation and
preferred habitat explanations, government
can have a direct impact on the yield curve.
Governments borrow by selling bills and
bonds of various maturities.
• If government borrows by selling long-term
bonds, it will push up long-term interest rates
(by pushing down long-term bond prices) and
cause the yield curve to be more upward
sloping (or less downward sloping)
39. Cont,d
• . If the borrowing were at the short maturity
end, short-term interest rates would be
pushed up.