Money banking and the financial system 1e by hubbard and OBrien chapter 04

Determining Interest RatesC H A P T E R 4 4.1 4.2 4.3 Discuss the most important factors in building an investment portfolio LEARNING OBJECTIVES After studying this chapter, you should b

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R GLENN

HUBBARD

ANTHONY PATRICKO’BRIEN

Money, Banking, and the Financial

System

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Determining Interest Rates

C H A P T E R 4

4.1 4.2 4.3

Discuss the most important factors in building an investment portfolio

LEARNING OBJECTIVES

After studying this chapter, you should be able to:

Use a model of demand and supply to determine market interest rates for bonds

Use the bond market model to explain changes in interest rates

4.4 Use the loanable funds model to analyze the international capital market

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IF INFLATION INCREASES, ARE BONDS A GOOD

INVESTMENT?

•Recently, interest rates on U.S Treasury notes and corporate bonds have been falling relative to their 30-year averages

•If interest rates on these securities rose back to their historical

averages, holders of bonds would suffer losses

•Not surprisingly, many financial advisers have warned investors that buying bonds could be risky

•In this chapter, we study how investors take into account

expectations of inflation, as well as other factors, such as risk and information costs, when making investment decisions

interest rates during 2010

Determining Interest Rates

C H A P T E R 4

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Key Issue and Question

Issue: Federal Reserve policies to combat the recession of 2007–

2009 led some economists to predict that inflation would rise and make long-term bonds a poor investment

Question: How do investors take into account expected inflation and other factors when making investment decisions?

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4.1 Learning

Objective

Discuss the most important factors in building an investment portfolio

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How to Build an Investment Portfolio

The Determinants of Portfolio Choice

The determinants of portfolio choice, sometimes referred to as determinants of

asset demand, are:

1.The saver’s wealth or total amount of savings to be allocated among

investments

2 The expected rate of return from an investment compared with the expected

rates of return on other investments

3 The degree of risk in the investment compared with the degree of risk in

other investments

4 The liquidity of the investment compared with the liquidity of other

investments

5 The cost of acquiring information about the investment compared with the

cost of acquiring information about other investments

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In general, when we view financial markets as a whole, we can assume that

an increase in wealth will increase the quantity demanded for most financial

assets

Wealth

Expected Rate of Return

Expected return The return expected on an asset during a future period; also

known as expected rate of return

We calculate the expected return on an investment using this formula:

Expected return = [(Probability of event 1 occurring) X (Value of event 1)]

+ [(Probability of event 2 occurring) X (Value of event 2)]

For example, with equal probability of a rate of return of 15% or a rate of return

of 5%:

Expected return = (0.50)(15%) + (0.50)(5%) = 10%

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Risk The degree of uncertainty in the return on an asset

• For example, if there is a probability of 50% that a bond will have a return of

12% or a probability of 50% that the bond will have a return of 8%, then the

expected return on the bond is

(0.50)(12%) + (0.50)(8%) = 10%

• Most investors are risk averse, which means that in choosing between two

assets with the same expected returns, they would choose the asset with the

lower risk For this reason, there is a trade-off between risk and return.

• There are also risk-loving investors who prefer to hold risky assets with the

possibility of maximizing returns, and risk-neutral investors, who make their

decisions on the basis of expected returns, ignoring risk

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Making the Connection

Fear the Black Swan!

• The table below illustrates the trade-off between risk and return

• Investors in stocks of small companies during these years experienced the

highest average returns but also accepted the most risk

• Investors in U.S Treasury bills experienced the lowest average returns but

also the least risk

• The term black swan event refers to rare events that have a large impact on

society or the economy Some economists see the financial crisis as a black swan event because before it occurred, few believed it was possible

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The Cost of Acquiring Information

• All else being equal, investors will accept a lower return on an asset that has lower costs of acquiring information

• We saw in Chapter 2 that liquidity is the ease with which an asset can be

exchanged for money

• The greater an asset’s liquidity, the more desirable the asset is to investors

We can summarize our discussion of the determinants of portfolio choice by

noting that desirable characteristics of a financial asset cause the quantity of

the asset demanded by investors to increase, and undesirable characteristics

of a financial asset cause the quantity of the asset demanded to decrease.

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Diversification Dividing wealth among many different assets to reduce risk.

Market (or systematic) risk Risk that is common to all assets of a certain type, such as the increases and decreases in stocks resulting from the business

cycle

Idiosyncratic (or unsystematic) risk Risk that pertains to a particular asset

rather than to the market as a whole, as when the price of a particular firm’s

stock fluctuates because of the success or failure of a new product

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Making the Connection

How Much Risk Should You Tolerate in Your Portfolio?

One important factor in deciding on the degree of risk to accept is your

time horizon.

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• In addition to your time horizon, you must consider the effects of inflation

and taxes in building a portfolio

• We saw in Chapter 3 the important difference between real and nominal

interest rates

• Depending on the investment, your real, after-tax return may be considerably

different from your nominal pretax return

• In Chapter 5, we will look further at how differences in tax treatment can

affect the returns on certain investments

• Understanding how risk, inflation, and taxation affect your investments will

help you reduce emotional reactions to market volatility and make

better-informed investment decisions

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4.2 Learning

Objective

Use a model of demand and supply to determine market interest rates for bonds

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Market Interest Rates and the Demand and Supply for Bonds

• Because the coupon payment and the face value do not change, once we

have determined the equilibrium price in the bond market, we have also

determined the equilibrium interest rate

• In the analysis that follows, remember that the bond market approach is

most useful when considering how the factors affecting the demand and

supply for bonds affect the interest rate

• The market for loanable funds approach, which treats the funds being traded

as the good, is most useful when considering how changes in the demand

and supply of funds affect the interest rate

• The price of a bond, P, and its yield to maturity, i, are linked by the arithmetic

of the equation showing the price of a bond with coupon payments C that

has a face value FV and that matures in n years:

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A Demand and Supply Graph of the Bond Market

Figure 4.1

The Market for Bonds

The equilibrium price of bonds is determined in the bond market.

By determining the price of bonds, the bond market also determines the interest rate on bonds

In this case, a one-year discount bond with a face value of $1,000 has an equilibrium price of $960, which means it has an interest rate (i) of 4.2%.

The equilibrium quantity of bonds

is $500 billion.•

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Figure 4.2

Equilibrium in Markets for Bonds

At the equilibrium price of bonds of

$960, the quantity of bonds demanded by investors equals the quantity of bonds supplied by

borrowers.

At any price above $960, there is an excess supply of bonds, and the price

of bonds will fall.

At any price below $960, there is an excess demand for bonds, and the price of bonds will rise

The behavior of bond buyers and sellers pushes the price of bonds to the equilibrium of $960.•

The interest rate on the bond is:

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Explaining Changes in Equilibrium Interest Rates

In drawing the demand and supply curves for bonds in Figure 4.1, we held

constant everything that could affect the willingness of investors to buy bonds—

or firms and investors to sell bonds—except for the price of bonds

If the price of bonds changes, we move along the demand (or supply) curve,

but the curve does not shift, so we have a change in quantity demanded (or

supplied)

If any other relevant variable—such as wealth or the expected rate of inflation

—changes, then the demand (or supply) curve shifts, and we have a change in demand (or supply)

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Factors That Shift the Demand Curve for Bonds

Five factors cause the demand curve for bonds to shift:

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As the demand curve for bonds shifts to the right, the

equilibrium price of bonds rises from $960 to $980, and the equilibrium quantity of bonds increases from $500 billion to

$600 billion •

Wealth

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equilibrium quantity

As the demand curve for bonds shifts to the left, the equilibrium price falls from $960 to $940, and the equilibrium quantity of bonds decreases from $500 billion to $400 billion.•

Wealth

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Expected return on bonds

If the expected return on bonds rises relative to expected returns on other

assets, investors will increase their demand for bonds, and the demand

curve for bonds will shift to the right

Risk

A decrease in the riskiness of bonds relative to the riskiness of other

assets increases the willingness of investors to buy bonds and causes

the demand curve for bonds to shift to the right

Liquidity

If the liquidity of bonds increases, investors demand more bonds at any

given price, and the demand curve for bonds shifts to the right

Information costs

As a result of the lower information costs, the demand curve for bonds

shifts to the right

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Table 4.2 (1 of 3) Factors That Shift the Demand Curve for Bonds

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Table 4.2 (2 of 3) Factors That Shift the Demand Curve for Bonds

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Factors That Shift the Supply Curve for Bonds

Four factors are most important in explaining shifts in the supply curve for bonds:

1 Expected pretax profitability of physical capital investments

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Expected pretax profitability of physical capital investments

Shifts in the Supply Curve for Bonds

An increase in firms’

expectations of the profitability

of investments in physical capital will, holding all other factors constant, shift the supply curve for bonds to the right as firms issue more bonds

at any given price.

As the supply curve for bonds shifts to the right, the

equilibrium price of bonds falls from $960 to $940, and the equilibrium quantity of bonds increases from $500 billion to

$575 billion.•

Figure 4.4 (1 of 2)

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Expected pretax profitability of physical capital investments

As the supply for bonds shifts

to the left, the equilibrium price increases from $960 to $975, and the equilibrium quantity of bonds decreases from $500 billion to $400 billion.•

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Business taxes

When business taxes are raised, the profits firms earn on new investments in

physical capital decline, and firms issue fewer bonds The result is that the

supply curve for bonds will shift to the left

Expected inflation

An increase in the expected rate of inflation reduces investors’ demand for

bonds by reducing the expected real interest rate that investors receive for

any given nominal interest rate

From the point of view of a firm issuing a bond, a lower expected real interest

rate is attractive because it means the firm pays less in real terms to borrow

funds

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Government borrowing

With the exception of a few years in the late 1990s, the federal government has typically

run a budget deficit The recession of 2007–2009 led to record deficits that required the

federal government to borrow heavily by selling bonds.•

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Government borrowing

When the government runs a deficit, households may look ahead and conclude that at some point the government will have to raise taxes to pay off the bonds

issued to finance the deficit

To prepare for those future higher tax payments, households may begin to

increase their saving This increased saving will shift the demand curve for

bonds to the right at the same time that the supply curve for bonds shifts to the

right because of the deficit

If nothing else changes, an increase in government borrowing shifts the bond

supply curve to the right, reducing the price of bonds and increasing the interest rate A fall in government borrowing shifts the bond supply curve to the left,

increasing the price of bonds and decreasing the interest rate

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Table 4.3 (1 of 2) Factors That Shift the Supply Curve for Bonds

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Table 4.3 (2 of 2) Factors That Shift the Supply Curve for Bonds

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4.3 Learning

Objective

Use the bond market model to explain changes in interest rates

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The Bond Market Model and Changes in Interest Rates

In this section, we consider two examples of using the bond market model to

explain changes in interest rates:

(1) The movement of interest rates over the business cycle, which refers to the

alternating periods of economic expansion and economic recession

experienced by the United States and most other economies; and

(2) The Fisher effect, which describes the movement of interest rates in

response to changes in the rate of inflation

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Why Do Interest Rates Fall during Recessions?

Interest Rate Changes in an Economic Downturn

1 From an initial equilibrium

at E1, an economic downturn reduces household wealth and decreases the demand for bonds at any bond price The bond demand curve

shifts to the left, from D1 to

D2.

2 The fall in expected profitability reduces lenders’ supply of bonds at any

bond price The bond supply curve shifts to the

left, from S1 to S2.

3 In the new equilibrium, E2,

the bond price rises from P1

to P .•

Figure 4.6

The Bond Market Model and Changes in Interest Rates

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