Financial Institutions, Instruments and Markets
8th edition
Instructor's Resource Manual
Christopher Viney and Peter Phillips
Chapter 13
An introduction to interest rate determination and forecasting
Learning objective 1: Describe at a macroeconomic level how the liquidity effect, the income
effect and the inflation effect influence the determination of interest rates

In forming a view on the future direction of interest rates, it is necessary to recognise that
changes in monetary policy settings are likely to affect the state of the economy, which in
turn affects interest rates generally.

Within the macroeconomic context, these progressive changes are referred to as the liquidity
effect, the income effect and the inflation effect on interest rates.

The liquidity effect derives from monetary-policy-induced changes to in interest rates such as
an increase in interest rates due to a reduction in liquidity in financial system.
 As interest rates rise, economic activity will slow and incomes fall. This will cause interest
rates to begin to ease or fall. This is the income effect.

The income effect will reduce upward pressures on prices as the economy slows and there is
likely to be a reduction in the rate of inflation, thus causing interest rates to fall further (the
inflation effect).

Therefore, when trying to forecast the state of an economy and future interest rates, policy
makers, economists and financial market participants consider a range of economic
indicators, such as the level of employment, productivity and housing approvals.
1

Indicators may be described as leading, coincident and lagging indicators of future economic
activity.
Learning objective 2: Explain the loanable funds approach to interest rate determination,
highlighting variables that affect the demand and supply for loanable funds. Consider the
effects of changes in those variables on interest rate equilibrium

A disciplined approach to forming a view on the future direction of interest rate movements
is provided by the loanable funds approach.

Typically, the demand for loanable funds within the financial system originates from the
business sector and the government sector and is represented by a downward sloping demand
curve.

The supply of loanable funds derives from the savings of the household sector, changes in
the money supply and the hoarding or dishoarding that takes place in response to changes in
interest rates. This is represented by an upward sloping supply curve.

Under the loanable funds approach, the prevailing rate of interest is determined by the
intersection of the demand and supply curves; the equilibrium point.

Factors that cause the demand or supply curves to change will result in a change in the rate of
interest.

While the framework is useful in identifying impacts on interest rates, its major shortcoming
is that the supply and demand curves are interdependent. For example, changes in the level of
economic activity or inflationary expectations may impact both the demand side and the
supply side of the curves. As a result, it is not possible to determine a unique equilibrium
interest rate.

Another shortcoming of the loanable funds approach is that it addresses interest rate
determination as if only one interest rate exists at a particular time. This is clearly not the
case in reality. At any point there are many rates of interest.

The differences in rates reflect the different terms to maturity of instruments and the credit
risk of a borrower. Differences between the interest rates on instruments of similar risk, but
with different terms to maturity, are explained by theories of the term structure of interest
2
rates.
Learning objective 3: Understand interest rate yields and the shape of various yield curves.
Apply the expectations theory, the segmented markets theory and the liquidity premium theory
within the context of the term structure of interest rates

The term structure of interest rates is represented by a yield curve.

The yield is the rate of return on debt instruments and a yield curve graphs the relationship
between interest rates and the term to maturity of debt instruments in the same risk class.

The shape of the yield curve may be normal, inverse or humped.

A normal yield curve is an upward-sloping curve where there is an expectation that short-term
interest rates in the future will rise. A steeper normal curve indicates an expectation that there
will be larger interest rate increases in the future.

An inverse yield curve is a downward-sloping curve, typically induced through a tightening of
monetary policy by a central bank. It indicates that current short-term interest rates are high, but
that there is an expectation that in the future there will be an easing of monetary policy and shortterm interest rates will begin to fall.

The expectations theory argues that, in an efficient market, interest rates on longer-term
instruments are determined by two factors: the current short-term interest rate and the shortterm rates that are expected to prevail over the longer term.

The segmented markets theory provides a further explanation of the shape of the yield curve. It
contends that investors do not view bonds of different maturities as being close substitutes. It is
argued that investors will have a preference to accumulate a majority of securities in an
investment portfolio that have predominantly short-term, medium-term or long-term maturities.
The implication is that the shape of the yield curve is explained by the demand and supply
conditions that are evident in the various maturity segments of the overall yield curve.

However, the arguments of the segmented markets theory ignore the role of market arbitrage and
speculation in ensuring that the yield curve over the maturity spectrum remains in equilibrium.
Also, in a modern financial market, risk managers are able to hedge such risk using synthetic risk
management products such as derivatives. As a result, the forecasts derived from the segmented
3
markets approach must be treated with caution.

An extension to the theory is obtained by the inclusion of a liquidity premium. The liquidity
premium theory contends that investors need to be compensated for a loss of liquidity and the
higher risk levels that may exist in long-term investments; that is, investors will require a
borrower to pay a liquidity premium before they are willing to give up their preference for
short-term assets. Therefore, the liquidity premium will change the slope of a yield curve.
Learning objective 4: Explain the risk structure of interest rates, discuss the so-called risk-free
interest rate and consider the effect of default risk on interest rates

The other element that has to be considered in explaining the range of interest rates that are
available at any one moment in time is the default or credit risk of the borrower. Higher-risk
borrowers must pay a higher rate of return than would be required of lower-risk borrowers.

The risk-free rate of interest is defined as the yield on government Treasury bonds. All other
borrowers will pay a risk premium above the risk-free rate.

The risk structure of interest rates incorporates the level of credit risk, over time, attached to a
particular debt issue.

A corporation with a AA+ credit rating will pay a lower yield than a corporation with a BBB
credit rating, but both will pay a margin above the risk-free rate of the government Treasury
bond.

The yield curve evident within the financial markets for a particular security will change in
its shape and slope from time to time, in particular as business and economic conditions
change.
Essay questions
The following suggested answers incorporate the main points that should be recognised by a
student. An instructor should advise students of the depth of analysis and discussion that is
required for a particular question. For example, an undergraduate student may only be required
to briefly introduce points, explain in their own words and provide an example. On the other
4
hand, a post-graduate student may be required to provide much greater depth of analysis and
discussion.
1. Within Australia the Reserve Bank is responsible for the implementation of monetary
policy. The central banks of other developed economies also have similar responsibilities.
Briefly identify and discuss a range of issues that the Reserve Bank considers when
monitoring its current monetary policy settings. (LO 13.1)
Current monetary policy is principally directed towards containing inflation within a target range
of 2 to 3 per cent over the business cycle. In directing its policy decisions to achieve this
objective, the central bank will consider:

the underlying rate of inflation over the business cycle

the rate of employment/unemployment/employment growth

the stability of the currency—in particular relative to major trading partners

the welfare of the people

the current economic environment/business cycle

current monetary policy settings

the direction of economic growth

the impact on past monetary policy settings on current and future economic growth

time delays between a change in monetary policy settings and a change in economic growth

economic fundamentals in major trading partner countries

forecast changes in international economic growth

a wide range of economic indicators, such as housing loan approvals (discussed in question
3).
2. The macroeconomic context of interest rate determination attempts to explain the
interactions of a change in monetary policy settings with changes in interest rates. The
macroeconomic context of interest rate determination identifies three distinct effects of a
change in monetary policy.
(a) List the three effects
 Liquidity effect
5
 Income effect
 Inflation effect
(b) If the central bank tightens its monetary policy settings, describe the expected
interactions that should occur based on the three effects identified in part (a).

In order to tighten monetary policy the Reserve Bank will implement a strategy of selling
securities to the financial market; that is, it sells government paper and therefore receives
payment that reduces the amount of funds available within the financial system.

This monetary policy action of the central bank will impact upon interest rates, particularly
the overnight cash rate.
(i) Liquidity effect:

The central bank’s action of selling government securities in order to affect the money
supply will directly affect the level of liquidity in the financial system.

If the central bank sells securities into the financial system, then there will be less cash in the
system as investors pay cash to buy the securities thus reducing liquidity in the financial
system.

By tightening of liquidity, with less cash available for lending, interest rates will rise.
(ii) Income effect:

The income effect refers to the flow-on effect from the initial liquidity impact on interest
rates.

In the example, the central bank has tightened liquidity and increased interest rates. Increased
interest rates will typically reduce the levels of spending in the economy.

Reduced levels of spending will result in lower incomes in all sectors of the economy: the
household sector, the business sector and the government sector.

This occurs as employment growth slows, demand for goods and services eases and taxation
revenues to government decline.

As the rate of growth in economic activity slows, the demand for loans also slows.

The slowing in the demand for funds eventually will result in an easing in interest rates.
(iii) Inflation effect:
6

In so far as the economy was previously experiencing inflationary pressures due to high
levels of demand, now the slowing of the pace of economic activity will cause the rate of
inflation to ease.

This easing allows rates of interest to ease as well.

The nominal rate of interest is said to comprise two components, being the real rate of return
plus compensation for the expected rate of inflation.

If the rate of inflation is expected to fall, then it is expected that the nominal or market
interest rates should fall.
3. Market participants, including financial institutions, funds managers and corporations,
must understand monetary policy setting impacts on economic activity and the
business cycle. A central bank will typically implement monetary policy settings in
order to achieve certain economic outcomes over a business cycle. In order to forecast
future economic conditions and business activity, business managers therefore need to
understand the business cycle. (LO 13.1)
(a) Briefly describe the principal monetary policy objective of the Reserve Bank of
Australia.

The principal objective of current monetary policy is to implement monetary policy
initiatives that contain inflation within a target range of 2 to 3 per cent over the business
cycle.
(b) Draw a diagram and explain the structure of a business cycle over time.

The business cycle is a measure of changes in the level of economic activity in an economy
over time.

It tends to move in changing cycles of peaks and troughs.

Business cycle peak—the highest level of economic activity during a cycle.

Business cycle trough—the lowest level of economic activity during a cycle
7
Economic activity
Peak
Business cycle
Trough
Time
(c) Discuss and give examples of different economic indicators that may give an insight into
the future stages of a business cycle.

Economic indicators are constructed from a set of historic data that provide some insight into
possible future economic growth.

Leading indicators—economic variables that change before there is a change in the business
cycle.

Coincident indicators—economic variables that change at the same time as the business
cycle changes.

Lagging indicators—economic variables that change after there is a change in the business
cycle.
There is a wide range of economic indicators. Governments, central banks, corporations and
analysts will select a number of indicators that best inform them, including:

the rate of inflation over the business cycle

the rate of growth in gross domestic product

the balance of payments

credit growth and associated debt levels

the exchange rate relative to major trading partner currencies

the rate of unemployment, job vacancies and ratio of full-time and part-time employment

the balance of payments, imports and exports growth

finance for housing, residential and non-residential building approvals

economic activity and capacity utilisation

wages growth and overtime worked
8

retail sales

share price movements.
4. At a recent financial markets seminar, a participant asked the guest speaker to explain the
loanable funds approach when forecasting interest rates. (LO 13.2)
(a) Describe the basic concept of the loanable funds approach to interest rate determination.

The loanable funds approach contends that the current rate of interest is determined by the
supply of and the demand for loanable funds.

Future interest rates are therefore affected by changes in the demand and supply of loanable
funds.

Loanable funds are the flows of funds into the market for securities.
(b) Extend your answer in (a) above and draw diagrams showing the demand curve, the
supply curve and the equilibrium interest rate. With each diagram, identify and explain each
of the components that comprise the supply and the demand curves, plus discuss how the
equilibrium interest rate is derived.
Demand for loanable funds:
There are two principal components:

Business demand for funds—to finance its liquidity and capital investment requirements. The
lower the rate of interest, all else being constant, the greater will be the volume of funds
demanded. This is represented by the downward-sloping curve (labelled B). Any factors that
cause an increase (decrease) by business in its demand for funds would be represented by a
shift to the right (left) in the B curve. The curve shown represents the net business demand
for funds.

Government sector demand for funds—the total public sector borrowing requirement. This
includes the Commonwealth, States and local governments and their instrumentalities. It is
normally proposed that the public sector borrowing interest rate is independent of the market
rate of interest, and this is represented by the vertical curve labelled G. With a smaller
(larger) borrowing requirement, the G curve would be located further to the left (right) in the
diagram. The two demand curves are combined to give the total demand for loanable funds
(labelled G + B).
9
Interest
rates
Interest
rates
Interest
rates
B
G
G+B
Q
Loanable funds
Q
Loanable funds
Q
Loanable funds
Supply of loanable funds:
There are three principal components:

Savings of the household sector—the curve (S) is drawn with an upward slope on the basis of
the presumption that as interest rates increase people will save a larger proportion of their
incomes. The curve is steep because empirical evidence suggests increases in interest rates
cause only small increases in the quantity saved.

Changes in the money supply (M)—since the money supply is assumed to be independent
of the rate of interest, changes in the money supply are represented diagrammatically as a
vertical line. When M is added to the savings curve it simply changes the location of the
curve (S + M). It does not change the slope of the curve. If, for example, the Reserve Bank
increased the money supply, the S + M curve would move to the right of the S curve.

Dishoarding (D)—as interest rates increase, there is an incentive to acquire more securities in
order to obtain the increased yields that are available. In attempting to buy more securities
money is given up (or dishoarded). Dishoarding is added to the S + M curve to give the
total supply of loanable funds curve.
10
Interest
rates
Interest
rates
Interest
rates
S+M
S
S
S+M
S+M+D
Q
Q
Q
Loanable funds
Loanable funds
Loanable funds
Equilibrium in the loanable funds markets:

The equilibrium interest rate will be at the intersect of the demand and supply curves.
Interest
rates
S+M
S+M+D
Equilibrium
G+B
Loanable funds
Q
5. A problem with the loanable funds approach to explaining interest rates is that since the
supply and demand curves are interdependent a unique equilibrium rate of interest cannot
be determined. Explain and illustrate this problem by reference to the effects of:
(a) an increase in inflationary expectations using the basic Fisher effect, followed by the
non-Fisher effect.

The traditional approach to the analysis of the effects of inflation on interest rates is shown
below.

The initial equilibrium interest rate is i0, at the intersection of the original demand and supply
curves.
11

With an increase in inflationary expectations, the suppliers of funds will demand a higher
rate of interest in order to maintain the same real rate of return on their funds.
Diagrammatically, the supply curve will move vertically, by the extent of the inflationary
expectation (pe), from supply0 to supply1.

The demand for funds will also change in response to the increased inflationary expectation.
The demand curve increases, by the extent of the inflationary expectations, from demand0 to
demand1.

The demand for funds increases because businesses, in anticipating higher inflation,
recognise that they will require a greater quantity of funds merely to maintain their preinflation investment plans.

The result of the increased inflationary expectations is that interest rates will rise to the full
extent of the anticipated inflation, and the quantity of loanable funds will remain unchanged
at Q0.

This is referred to as the Fisher effect.
Interest
rate
Supply1
i1
Pe
Supply0
i0
Demand1
Q0
Demand0
Loanable funds

Q
It may be argued that non-Fisher effects will be evident, which will lower the equilibrium
interest point.

For example, increased inflation may reduce government demand for funds and the demand
curve will not move as far to the right.
12

Also the supply curve may in fact move to the right rather than the left as savings increase as
a result of higher wages and increased superannuation contributions.
(b) an expectation of a decrease in the level of economic activity. (LO13.2)

An expectation of decreased economic activity may come from the business sector.

This will result in a decrease in business demand for funds to finance investment projects due
to an anticipated fall in demand.

In a loanable funds demand and supply graph, the decrease in B would shift the demand
curve to the left, resulting in a decrease in the rate of interest.

As businesses decrease their investment in inventories and in capital equipment, they will
reduce their need to borrow and sell financial instruments to obtain funds.

As the supply of financial instruments on the market decreases, the prices of those
instruments will rise and their yields will decrease.

The higher prices on the securities (lower yields) will cause some savers to reallocate their
portfolios and sell securities; that is, hoarding will take place.

The forecast decrease in interest rates is only a temporary equilibrium.

There will be feedback mechanisms to consider in forecasting interest rate changes further
into the future.

For example, the hoarding that accompanied the initial decrease in interest rates will cease
after the desired portfolio re-allocations have been completed

With no further hoarding, interest rates may have to fall further in order to prompt even more
hoarding.

The decrease in business investment adds to the expected decrease in economic activity; as
output levels fall, there will be a decrease in savings and this will relieve some of the
downward pressure on interest rates.

In addition, the decrease in output will see a worsening in the government budget position,
with an associated increase in the government's borrowing requirement.

The depreciation of the currency that might be expected to accompany the decreased interest
rate is likely to result in increased demand for exports and a decrease in the demand for
imports. Businesses in the export-competing and import-competing sectors of the economy
13
will increase their investment, and thus increase their demand for funds. This will place some
upward pressures on interest rates.
6. Interest rates play an important role in monetary policy determinations, economic
performance and the business cycle, and the cost of funds. Financial market participants
must therefore understand the term structure of interest rates. (LO 13.3)
(a) Define in detail the term yield and explain how a yield curve is constructed.

Yield—the total return on an investment; comprising interest receipts and any capital gain or
loss.

Yield curve—a graph, at a single point in time, of yields on a specific type of security with
different terms to maturity.

For example, it is possible to plot the yield, as at today, for bank bills that have 30 days, 60
days, 90 days and 180 days to maturity.
(b) Identify three different types of yield curves. Describe each of these yield curves and
draw a fully labelled diagram of each curve.
(1) Normal/positive/upward sloping yield curve—reflects the preference for higher interest rates
if funds are invested longer-term. Short-term rates are lower than long-term rates.
Yield
Normal yield curve
Time
(2) Inverse/negative/downward sloping yield curve—illustrates that yield declines as maturity
lengthens. Short-term rates are higher than long-term rates.
14
Yield
Inverse yield curve
Time

Humped yield curve—combines the normal yield curve and the inverse yield curve and
joined by a period of a flat or horizontal yield curve.
Yield
Humped yield curve
Time
7. The expectations theory provides a foundation for our understanding of interest rate
determination. Outline the expectations theory approach to the determination of interest
rates. In your answer, explain the relationships that the theory contends will exist between
short-term and longer-term interest rates. (LO 13.3)

Expectations theory—the shape of a yield curve is a function of the current and future shortterm interest rates.

That is, the return received on a continuous series of short-term investments should be the
same as that received for a longer-term investment.

An investor will therefore be indifferent as to whether they invest for a short period or a
longer period.
15

For example, an investor has two options: (1) invest today for a one-year period at 4 per cent
per annum and reinvest the funds in 12 months time; or (2) invest the funds today for a twoyear period at 4.5 per cent per annum. The expectation theory will contend that the one-year
investment rate in 12 months time should be 5 per cent per annum (that is, 4.5% x 2 = 9% 4% = 5%)
Assumptions of the expectations theory:

There are a large number of financial investors who hold reasonably homogeneous
expectations about the future values of short-term interest rates.

There are no transaction costs, and so investors can move into and out of instruments at no
cost as they change their expectations and as they see market rates that are inconsistent with
their expectations.

There are no impediments to market rates moving to their competitive equilibrium levels.

The goal of investors is to maximise their expected rate of return, that is, if all bonds are
perfect substitutes for each other, regardless of their term to maturity, then longer-term
interest rates paid on bonds will be equal to the average of the short-term interest rates
expected to prevail over the longer-term period.
8. The shape and slope of a yield curve will change over time. The expectations theory
attempts to explain these variations in the shape and slope of the yield curve. (LO 13.3)
(a) How is the existence of a normal yield curve and an inverse yield curve explained by
the theory?

A normal yield curve will result from expectations that future short-term rates will be higher
than current short-term rates.

An inverse yield curve will result if the market expects future short-term rates to be lower
than current short-term rates.
(b) Having regard to your answer in (a) above, briefly explain why the slope of a yield
curve might vary.
Normal yield curve:
16

The central bank may reduce short-term rates, but since the market believes that future shortterm rates will be higher than current short-term rates, longer-term rates will not fall as far as
the policy-induced cut in short-term rates.

Therefore the yield curve will be upward-sloping.

That is, if E1i1 > 0i1, then the yield curve will be normal.
Inverse yield curve:

Even though the central bank may increase rates at the short end of the yield curve to achieve
its monetary policy objectives, market participants expect that once those objectives have
been achieved, short-term rates will be lowered again.

In this circumstance, long-term rates will not rise to the same extent as the policy-induced
change in short-term rates, and therefore the yield curve will slope downwards.
9. The segmented markets theory extends our understanding of factors that influence the
determination of interest rates. (LO 13.3)
(a) Identify and explain two assumptions of the expectations approach that are challenged
by the segmented markets approach to interest rate determination.
The segmented markets theory rejects two expectation theory assumptions:
(1) All bonds are perfect substitutes for one another.
(2) Investors are indifferent between holding instruments with a short term to maturity and
holding instruments with a long term to maturity.

Securities in different maturity ranges—for example, a 1 to 3 year range versus a 9 to 10 year
range—are not viewed by various market participants as being perfect substitutes for one
another.

Whereas bonds with a very short tem to maturity may well be close substitutes for each
other, and likewise for bonds with long terms to maturity, a one-month-to-maturity bond is
unlikely to be seen as a close substitute for a 10-year bond.

Some market participants have a preference for short-dated securities, and others have a
preference for longer-term maturities.

That is, different investors have preferences for different segments of the market.
17

The particular preferences are motivated out of a desire by the various participants to reduce
the riskiness of their portfolios.

Investors will seek to minimise their exposure to fluctuations in the prices and yields
associated with their assets and liabilities by matching the cash flows and maturities of their
assets and liabilities.

For example, life offices have mainly long-term liabilities and therefore tend to hold more
longer-term assets.

The implication of the segmented markets approach is that it is the relative demands for and
supplies of securities in the various maturity ranges that determine yields.

The shape and slope of the yield curve are determined by the relative demand and supply
conditions that exist along the maturity spectrum.
(b) It may be argued that the segmented markets approach is negated by modern risk
management practices, arbitrage and speculation. Explain what is meant by this assertion.

The segmented markets approach emphasises the risk management motivation of market
participants.

That is, the matching of cash flows and maturities of assets and liabilities in order to
minimise associated risk exposures.

By implication, this approach would cause discontinuities in a yield curve, thus exposing
significant speculation and arbitrage opportunities.

Arbitrageurs, who are indifferent about the maturity of the bonds they hold, will sell and buy
to take advantage of the discontinuities along the yield curve.

Their actions will smooth out the yield curve; that is, remove the segmentation distortions.

Therefore, it may be reasonable to argue that certain investors do have segment preferences
along a yield curve, but those preferences are balanced by investors with different
preferences: arbitrageurs and speculators.
10. If financial market participants considered that anticipated inflation would rise
significantly in the future, what effect would you expect this forecast to have on the slope of
a normal yield curve? Why? (LO 13.3)

A normal yield curve is upward sloping.
18

Yields on a particular security are higher as the term to maturity increases.
Yield %
Normal yield curve
Time

The nominal interest rate (yield) on an investment mainly incorporates a component for the
real rate of interest and a component for anticipated inflation.

Therefore, all other impacts being equal, an anticipation of an increase in inflation over time
should push up nominal interest rates further out on the maturity spectrum.

As indicated in the graph below, the slope of the yield curve will become steeper.
Yield %
Inflation
Time
11. The liquidity premium theory seeks to extend our understanding of the expectations
theory and the determination of interest rates. (LO 13.3)
(a) Outline the principal contention of the liquidity premium theory.

A criticism of the pure expectations approach is its assumption that investors are indifferent
as to whether they hold long-term or short-term bonds.

There is one important characteristic that distinguishes short-term and longer-term securities
that may result in a violation of the assumption of indifference.
19

Longer-term-to-maturity bonds are susceptible to a greater risk of larger price fluctuations
than are shorter-term instruments.

Given the greater price risk associated with longer-term securities, it may be hypothesised
that investors require a premium if they are to be enticed away from the shorter end of the
maturity spectrum.

If this is the case, then the expectations hypothesis explanation of the level of longer-term
rates may be presented as being approximately:.
0i2
= (0i1 + E1i1 ) + L
2

Where L is the liquidity premium that is demanded in order to hold the higher risk, longerterm security.

The size of L is likely to increase the longer the term to maturity of the particular instrument.

The effect of the liquidity premium on the expectations hypothesis is shown below:
Yield %
observed yield curve
liquidity premium
expectations yield curve
Time
(b) How does the historic prevalence of a normal yield curve provide indirect evidence of
the existence of a liquidity premium?

Support for the addition of the liquidity premium to the expectations hypothesis is derived
from observations of the shape of the yield curve over time.

The positive or upward-sloping curve is labelled as the ‘normal’ yield curve.

The normal yield curve is typically the shape most frequently observed over the years.

The combination of the expectations theory and the liquidity premium explains the observed
dominance of the normal curve.
20

At times, even though the pure expectations outcome is an inverse curve, when the liquidity
premium is added to the curve it results in a positive or normal curve.

At other times, the slope of an inverse yield curve will become flatter as a result of the effect
of the liquidity premium; that is, the inverse curve will move upward.
(c) Does the existence of an inverse yield curve indicate a violation of the liquidity premium
contention?

No, an inverse yield curve is still possible.

In this instance, the downward slope of the inverse yield curve will be reduced by the
liquidity premium effect. That is, the yield curve will become flatter, but still retain an
inverse slope.
Yield %
observed yield curve
liquidity premium
expectations yield curve
Time
12. The daily financial press regularly report data released on current economic variables
and provide expert analysis on the forecast impact of changes in these variables on the
future direction of interest rates. Market participants, including policy makers, regulators
and corporate managers also actively monitor changes in economic variables and interest
rates. Within this context, why is it important for market participants to understand the
term structure of interest rates? Provide examples in your response. (LO 13.3)

The term structure of interest rates represents the relationship of yield to the term to maturity
on a particular security such as Treasury bonds.

Yield is expressed at a given point in time where there is constant risk, the same security, but
a varying period to maturity.
21

Yield curves may be categorised as normal, inverse and flat. The shape and slope of each of
these types of curves provides information to the market.

Under the pure expectations theory, a normal yield curve implies that future short-term
interest rates are expected to be higher than current short-term rates. On the opposite side, an
inverse yield curve implies that future short-term interest rates are expected to be lower than
current short-term rates.

If the term structure of interest rates within the market are correct and in equilibrium, then
the shape and slope of the yield curve provides some very important indicators to market
participants:

Borrowers—assists borrowers to make informed decisions on the future direction of their
borrowing costs. The borrower may be able to restructure or reschedule their existing
funding arrangements to take advantage of expected movements in interest rates. New
borrowing issues may be brought forward, or alternatively delayed, depending on the
forecast future movement in interest rates. Decisions may also be made on the maturity
structure of existing and new funding arrangements.

Investors—will consider the term structure of interest rates in forecasting the future direction
of interest rates. This will influence their investment acquisition and disposal strategies; for
example, an investor with a portfolio of bonds may determine to sell the bonds if an interest
rate rise is forecast so as to avoid the price risk that prevails if yields increased.

Financial institutions—are particularly concerned with current and future interest rates. The
price of most financial institution products is based on an interest rate. Therefore any
movement in rates will have a direct impact on the institutions’ net interest margins.
Institutions will implement strategies to restructure their existing asset portfolios, together
with their liability commitments (gap management). Institutions will set the pricing of their
borrowing and lending products based on their interpretation of the future movement in
interest rates.

Government and Reserve Bank—government will analyse the term structure of interest rates,
having regard to its economic, social and political objectives. These will be supported by the
determination and implementation of monetary policy by the Reserve Bank in order to
achieve its objectives of full employment, stability of the currency and maintenance of the
welfare of the people of Australia. To this end, monetary policy is currently directed towards
22
achieving an underlying inflation rate of 2 to 3 per cent over a business cycle. The level of
anticipated inflation will affect the slope or steepness of the yield curve. If inflation is
expected to remain relatively low, then the slope of the yield curve should remain relatively
flat.
13. A group of university students are asked to investigate interest rates on debt securities
issued in the financial markets. They soon discover that many interest rates exist. The
students are then asked to explain:
(a) the term 'risk-free rate of interest'

The risk-free rate of interest is a return (yield) earned with certainty of payment; that is, there
is no risk of default by the issuer.

Within the Australian markets, the Treasury bond, issued by the Commonwealth
government, is adopted as a proxy for the risk-free rate of return.

The Treasury bond is accepted as being risk-free in that it is presumed that the government is
able to meet its monetary commitments.
(b) why the existence of the risk-free rate of interest is important when examining the level
of interest rates generally in the financial markets. (LO 13.4)

The importance of the risk-free rate of return is that it is the basis upon which other financial
assets are priced.

Securities that have a higher degree of risk attached to them are priced at a margin above the
risk-free rate.

Therefore, the Treasury bond becomes the benchmark upon which interest rates on other
securities with similar maturities are established.

The risk-free rate of interest is applied in a number of important pricing models, including
the options pricing model developed by Black & Scholes, and the Capital Asset Pricing
Model.

The following graph demonstrates the role of the Treasury bond as the risk-free rate.
Debentures are priced above the Treasury bond rate, but unsecured notes are further priced
above the debenture rate. This reflects the relative risk of each of the securities.
23
Yield %
Unsecured notes
Risk premium
Debentures
Risk premium
Treasury bonds
Time (years)
14. The lending manager at a commercial bank is asked to explain to a corporate borrower
what the bank’s policy is in relation to risk premiums on corporate loans. (LO 13.4)
(a) Discuss the concept of a risk premium and the effect that a risk premium will have on
the yield curve for a corporate borrower.

Risk premiums will be applied to corporate borrowers relative to the risk-free rate, being the
Treasury bond yield for the similar term to maturity.

Underlying the risk premium charged against a particular corporate borrower will be a range
of operational and financial variables, however, the basic measure will be the level of
perceived credit or default risk.

That is, what is the probability that a borrower will be able to meet its future on-going cash
flow commitments when they are due; in particular, repay its debt commitments and remain a
financially viable corporation.

The level of the risk premium will impact the cost of funds and the level of profitability of a
corporation.

A standard measure of risk used in the international corporate debt market is a credit rating
given by a recognised credit rating agency such as Standard and Poor’s.

The higher the credit rating, the lower is the risk premium and the cost of borrowing.

Usually for domestic lending, a commercial bank will conduct its own assessment of the
level of credit risk associated with a local corporate borrower.
(b) Is it inevitable that the risk premium for a corporate borrower will be constant
throughout the maturity spectrum? Explain your response.
24

While conceptually it is possible for a risk premium attached to a particular corporate
borrower to be constant over the maturity spectrum, it is more likely that the risk premium
may vary.

One set of conditions under which a widening risk premium gap may occur is if the corporate
borrower has been a highly successful corporation, but its future is somewhat uncertain.

For example, this could occur if the corporation's main products are towards the end of the
product life cycle, and the company has not devoted sufficient resources to the research and
development of a new product or production technique that will maintain its competitive
advantage.

The increasing gap could also open up if the company has recently been involved in a
takeover or merger, the likely commercial success of which has not been clearly established
by lenders.

In both cases, there is a low risk of default on the near-to-maturity instruments, but greater
uncertainty about the company's performance further into the future.

It is also possible that the yield curve for a higher-risk borrower may show a narrowing of the
risk premium gap as the term to maturity increases.

Such an outcome could result from a concern that, in the current business environment, the
company may have difficulty in redeeming the soon-to-mature instruments, but market
participants believe that if the company survives the near-term, then its prospects are
relatively good.

Another example may be a company that is involved in a reasonably speculative exploration
activity, or the development of a new technology, or an attempt to convert a laboratory
discovery into a commercial product. Near-term risk is high, but if successful the longer-term
risk premium will fall.
Extended learning question
15. This question requires calculations relating to the yield curve and the expectations
theory. (LO 13.5)
(a) If an investor possesses the following information, and expectations on Treasury bond
yields are:
0i1
= 4.25% p.a.
25
E1i1 = 5.20% p.a.
calculate the yield on a two-year bond (0i2) that would result in the investor being
indifferent between placing funds in a one-year bond now, to be followed by a one-year
bond in a year’s time, or placing the funds in a two-year bond now.
(1)
Calculation using arithmetic average:
0i2
=
(0i1 + E1i1 )
2
=
4.25 + 5.20
2
=
(2)
4.725 %
Calculation using geometric average:
0i2
=
[( 1 + 0i1 ) ( 1 + E1i1 )] 0.5 – 1
=
[( 1.0425 ) ( 1.0520 )] 0.5 – 1
=
[ 1.09671 ] 0.5 – 1
=
4.723923 %
(b) You are given the following data:
0i1
= 4.00% p.a.
E1i1 = 5.00% p.a.
E2i1 = 5.75% p.a.
E3i1 = 6.20% p.a.
On the basis of the expectations theory of the yield curve, complete the following:
(1) Calculate the 0i2, 0i3 and 0i4 rates.
formula: 0in = [(1 + 0i1) (1 + E1i1) (1 + E2i1) ... (1 + En - 1i1)]1/n – 1
(i)
0i2
= [(1 + 0.04) (1 + 0.05)]1/2 – 1
= 4.498804%
(ii)
0i3
= [(1 + 0.04) (1 + 0.05) (1 + 0.0575]1/3 – 1
= 4.914216%
26
(iii)
0i4
= [(1 + 0.04) (1 + 0.05) (1 + 0.0575) (1 + 0.0620]1/4 – 1
= 5.234195%
(2) Explain what is meant by implicit forward rates of interest.
On the basis of the expectations theory, a yield curve provides information regarding market
participant’s future on-balance expectations concerning a large range of future interest rates.
That is, implicit in the yield curve there are indicators, or information, on a series of expectations
about future interest rates.
(3) List the full range of one-year implicit rates of interest that could be calculated on the
basis of the yield curve data that provide the current rates on bonds with one, two and
three years to maturity.
Yield %
0
1
2
3
Years
0i1
0i2
Actual rates
0i3
1i1
1i2
Implicit rates
2i1
Implicit interest rates that could be calculated on the basis of the above yield curve are 1i1 , 1i2
and 2i1.
27
(4) Given the following yield curve data, calculate the 2i2, 1i2 and 3i1 implicit rates:
0i1
= 4.30% p.a.
0i2
= 5.15% p.a.
0i3
= 5.80% p.a.
0i4
= 6.25% p.a.
Yield %
0
1
0i1
2
3
4
Years
4.30%
0i2
5.15%
0i3
Actual rates
5.80%
0i4
6.25%
1i1
1i2
1i3
Implicit rates
2i1
2i1
3i1
formula:
where:
n = the number of periods until the future rate starts
k = the number of periods over which the future rate applies
28
(i)
calculate 2i2
where: n = 2; k = 2
= [(1 + 0.0625)4]0.5 –1
[(1 + 0.0515)2]
= 7.361507%
(ii)
calculate 1i2
where: n = 1; k = 2
= [(1 + 0.0580)3]0.5 –1
[(1 + 0.0430)1]
= 6.558070%
(iii)
calculate 3i1
where: n = 3; k = 1
= [(1 + 0.0625)4]1/1 –1
[ (1 + 0.0580)3]
= 5.135093%
FINANCIAL NEWS CASE STUDY
Chapter 13 considered the macroeconomic context, the loanable funds approach and the main
theories that explain the determination of interest rates. Also, as discussed in both Chapters 12
and 13, the central bank has an important impact on interest rates through the implementation of
monetary policy.
The following article recognises that current economic conditions and monetary policy settings
should significantly change in the near future and this will have an impact on the level of interest
rates.
Next year could be even tougher for fixed-income investors, with long-dated bond prices likely to
be driven down by foreign central bank policies.
29
During 2013, the performance of all asset classes and the weakness in the Australian dollar was
heavily influenced by the actions of the US Federal Reserve, with its $US85 billion ($93 billion)
in monthly bond purchases underpinning financial markets and helping restore confidence in
United States-denominated assets.
While fixed-income managers are divided on whether the Fed will start reducing its bond
purchases as early as next week, most agree yields will track higher in the months ahead,
sending bond prices down.
'Given the uncertainty of tapering, I think it is going to be a tough year for investors in 2014,
much harder than 2013,' Kapstream Capital managing director Kumar Palghat said.
He added the better returns of around 5 per cent will be in corporate bonds, infrastructure bonds
and asset-backed securities.
'The removal of tapering could imply that the cost of borrowing for the US government goes up,'
he said.
'Yields on five- and 10-year bonds in the US will rise in 2014 because the largest buyer (the
Federal Reserve) will no longer be buying bonds.'
Yields, which move inversely to price, on comparable Australian bonds are also expected to
follow US Treasuries higher – even if the Reserve Bank of Australia decides to keep the local
cash rate on hold at 2.5 per cent.
30
Typically, shorter-dated bonds reflect future interest rate expectations. 'In Australia, it is notable
that the bond market is already repricing to an improved economic outlook and we expect to see
this continue,' he said.
UBS strategist Mike Schumacher said politics, economic growth and inflation, which typically
influence bond market returns, would still take a back seat in the year ahead because of the
sheer scale of Fed stimulus and interest rates decisions to come.
'Bond yields are likely to trend higher next year in all major markets, with Australia being no
exception,' said Steven Mansell, Citi head of G10 rates strategy for Asia Pacific.
SOURCE: Bianca Hartge-Hazelman, Tough time for bonds in 2014, Smart Investor, 12 December 2013
DISCUSSION POINTS

The article contends that long-dated bond prices are likely to be driven down by
foreign central bank policies during 2014. Discuss the relationship between bond prices
and the monetary policy initiatives of central banks.
As mentioned in the article and in the text book, there is an inverse relationship between the
price of existing (fixed interest) bonds and changes in market interest rates.
The monetary policy initiatives of a central bank will change the level of interest rates. If a
central bank decides to tighten monetary policy, then interest rates across the maturity
spectrum will progressively rise; on the other hand, if monetary policy is loosened, then
interest rates are expected to fall.
At the time of this article, a very loose monetary policy in the USA has seen interest rates at
very low levels, but it is expected that as the USA economy improves monetary policy will
tighten thus pushing up interest rates. This will mean that the prices of existing bonds in the
USA will fall.
31
However, the article also contends that yields on bonds in Australia and other major markets
may well rise in response to the rise in forecast interest rates in the USA; that is, yields will
increase (without any monetary policy action by an overseas country’s central bank) in order
to encourage fixed interest investors to continue to buy those bonds rather than moving a
large part of their bond portfolios into the US bond market

The article refers specifically to the stimulus package initiatives of the Federal Reserve
in the United States. Why and how did the Federal Reserve implement the stimulus
package?
In 2009, at the height of the global financial crisis, the US Federal Reserve implemented an
economic stimulus package, often referred to as quantitative easing. Quantitative easing
(QE) has moved through three phases during which the Fed bought over US$4 trillion worth
of securities from the market.
QE3 saw the Fed buying US$85 each month from the market. Essentially, the Fed was
pumping US$85 billion into the economy each month. As at July 2014 this had tapered to
US$35 billion per month as the Fed winds back its stimulus package.
At the time of this article, it appears that the Fed plans to end its economic stimulus plan by
the end of October 2014.
The QE stimulus package was designed to put money into the financial system in order to
encourage bank lending to the corporate sector, which in turn would stimulate economic
growth and lower the very high unemployment rate.

Tapering of the Federal Reserve stimulus package is forecast to begin in 2014. What
does this mean and how will the ongoing tapering of the above stimulus package
impact interest rates in the debt markets?
Tapering refers to the gradual reduction of the QE3 economic stimulus being conducted by
the Federal Reserve Bank in the USA.
As mentioned above, as at July 2014, the Fed had reduced its monthly US$85 billion
stimulus package down the US$35 billion each month. Unless economic conditions
deteriorate in the US the Fed proposes to finish QE3 by the end of October 2014.
As noted in the article, the slowdown in QE3 has begun to push yields up on longer-term
32
fixed interest securities. As QE3 winds down fully, it is to be expected that yields will rise
further.
The rise in interest rates should flow through to interest rates throughout the maturity
spectrum.
True/False questions
1. T Initially, an easing of monetary policy will result in a fall in interest rates, but as
economic activity increases, the income and inflation effects are likely to result in an
increase in interest rates.
2. F Economic indicators such as the level of employment provide market participants with
clear and certain indication as to the future direction of economic activity and growth.
3. F A coincident economic indicator is one that might be used to indicate the future direction
in which the economy is headed.
4. T In the loanable funds approach to interest rates, the demand for funds originates from the
business sector and the government sector.
5. T The supply of loanable funds is derived from the savings of the household sector, changes
in the money supply and dishoarding.
6. F An increase in the money supply would permanently shift the supply curve of loanable
funds to the right.
7. T Dishoarding is generally more evident when interest rates in the market have increased.
8. F The government sector demand curve in the loanable funds approach is downward
sloping, with the slope changing in response to the size of government expenditures.
9. T With the loanable funds approach to interest rate determination, the demand and supply
curves are not independent of each other; therefore it is not possible to accurately determine
a unique equilibrium interest rate.
10. F Applying the non-Fisher outcome to the loanable funds approach, an increase in
inflationary expectations will result in an increase in interest rates equal to the increase in
inflationary expectations.
11. F The long-term yield curve is a single curve at a point in time that shows the various
interest rates for different terms to maturity on all fixed-interest securities issued by
33
governments and corporations.
12. T When the central bank implements tight monetary policy, an inverse yield curve should
occur as short-term interest rates will be higher than longer-term interest rates.
13. F The various theories of interest rate determination are independent of each other and
market participants usually adopt one theory when analysing interest rates.
14. T Under the expectations theory of the yield curve, longer-term interest rates are a function
of the current short-term interest rate and forecast future short-term interest rates that will
exist over the longer term.
15. F Using the expectations approach, a bank is offering a one-year term deposit interest rate
of 4.75 per cent per annum, and a two-year rate of 5.25 per cent per annum. Therefore an
investor should expect that in 12 months’ time the new one-year interest rate will have
increased to 5.25 per cent per annum.
16. T Under the segmented markets approach to explaining the yield curve, an increase in the
supply of short-term instruments and an equal reduction in the supply of long-term
instruments would cause the short end of the yield curve to rise and the long end to fall.
17. T The liquidity premium theory suggests that investors will demand a higher rate of interest
to induce them to buy long-term instruments so that they will be compensated for increased
risk and loss of liquidity.
18. F The existence of an inverse yield curve indicates that investors are not demanding a
liquidity premium in periods of tight monetary policy.
19. T The risk structure of interest rates includes a margin for default or credit risk for each
corporate debt issuer. A corporation with a AA– credit rating will pay a lower risk premium
than a corporation with a BBB+ credit rating.
20. F The risk-free rate of interest is the yield paid on longer-term securities issued by corporate
borrowers that have an investment-grade credit rating.
34