Week 4
Interest Rate
Determination
C H A P T E R 13
Short vs Long term debt
instruments
Short-term Debt
Long –term Debt
◦ Trade credit
◦ Term loans or fully drawn advances
◦ Bank overdrafts
◦ Mortgage finance
◦ Commercial bills
◦ Leasing
◦ Promissory notes
◦ Debentures, unsecured notes and
subordinated debt
◦ Negotiable certificates of deposit
◦ Inventory finance, accounts receivable,
financing and factoring
Learning Objectives – Interest
Rate Determination
1. Interest rate determination approach
a) the macroeconomic context of interest rate determination
b) the loanable funds approach to interest rate determination
2. The Yield curve
a) Defining the yield curves
b) term structures of interest rates
I.
expectations theory
II.
segmented markets theory and
III.
liquidity premium theory
c) Risk structure
LO1. Interest rate determination
1.Macroeconomic context
In most developed economies monetary policy actions are directed at influencing interest rates
By understanding what motivates a central bank in its implementation of interest rates policy:
◦ financial market participants can anticipate changes in a government’s interest rate policy
◦ lenders and borrowers can make better-informed decisions
Macroeconomic context of interest
rate determination (cont.)
A central bank may increase interest rates if there is:
◦ inflation above target range
◦ excessive growth in GDP
◦ a large deficit in the balance of payments
◦ rapid growth in credit and debt levels
◦ excessive ‘downward’ pressure on FX markets
Macroeconomic context of interest
rate determination (cont.)
An increase in interest rates (i.e. tightening of monetary
policy) will:
◦ eventually increase long-term rates
◦ slow consumer spending
◦ reducing inflation and demand for imports
◦ decrease the size of the current account
◦ possibly attract foreign investment, causing the domestic currency to
appreciate
Macroeconomic context of interest
rate determination (cont.)
Three effects of changes in interest rates
1.
Liquidity effect
◦ The effect of the RBA’s market operations on the money supply and system liquidity
◦ E.g. RBA increases rates (i.e. tightens monetary policy) by selling CGSs
2.
Income effect
◦ A flow-on effect from the liquidity effect
◦ If interest rates rise, economic activity will slow, allowing rates to ease
◦ Increased rates reduce spending levels and income levels
3.
Inflation effect
◦ As the rate of growth in economic activity slows, demand for loans also slows
◦ This results in an easing of the rate of inflation
Macroeconomic context of interest
rate determination (cont.)
(cont.)
Macroeconomic context of interest
rate determination (cont.)
Liquidity, income and inflation effects of changes in interest rates
(cont.)
◦ It is difficult to forecast the extent of liquidity, income and inflation effects on
changes in interest rates
◦ Particularly when the business cycle is about to change, i.e. is at a peak or trough
◦ Economic indicators provide an insight into possible future economic growth and the
likelihood of central bank intervention
(cont.)
Macroeconomic context of interest
rate determination (cont.)
Economic indicators
◦ Leading indicators
◦ Economic variables that change before 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 the business cycle changes
(cont.)
2.Loanable funds approach to
interest rate determination
The loanable funds (LF) approach
◦ LF are the funds available in the financial system for lending
◦ Assumes a downward-sloping demand curve and an upward-sloping supply curve in
the loanable funds market; i.e.:
◦ as interest rates rise demand falls
◦ as interest rates rise supply increases
(cont.)
Loanable funds approach
to interest rate determination
Demand for loanable funds
◦ Two sectors
1.Business demand for funds (B)
◦ Short-term working capital
◦ Longer-term capital investment
2.Government demand for funds (G)
◦ Finance budget deficits and intra-year liquidity
◦ Demand for loanable funds (B + G)
(cont.)
Loanable funds approach to
interest rate determination (cont.)
(cont.)
Loanable funds approach to
interest rate determination
Supply of loanable funds
◦ Comprises three principal sources
1.Savings of household sector (S)
2.Changes in money supply (M)
3.Dishoarding (D)
◦ Hoarding is the proportion of total savings in economy held as currency
◦ Dishoarding occurs (i.e. currency holdings decrease) as interest rates rise and
more securities are purchased for the higher yield available
(cont.)
Loanable funds approach to
interest rate determination (cont.)
(cont.)
Loanable funds approach to
interest rate determination
Equilibrium in the LF market
◦ Equilibrium rate is i0
◦ E is a temporary equilibrium because the supply and demand curves
are not independent
◦ The level of dishoarding will change
◦ The money supply is unlikely to increase proportionately in subsequent
periods
◦ A change in business and/or government demand
(cont.)
Loanable funds approach to
interest rate determination
Impact of disturbances on rates
◦ Expected increase in economic activity
◦ Initial effect is that businesses sell securities, yields increase (price decreases), dishoarding occurs
◦ Inflationary expectations
◦ The demand curve shifts to the right and the supply curve shifts to the left, resulting in higher interest
rates and unchanged equilibrium quantity
LO2 : a)Yields - Term structure of
interest rates
Yield is the total return on an investment, comprising interest received and any capital
gain (or loss)
Yield curve is a graph, at a point in time, of yields on an identical security with different
terms to maturity
(cont.)
Bloomberg Market Concepts
What’s a YIELD CURVE?
◦ The yield curve represents the cost of borrowing for various loan lengths
Yield curve
◦ X-axis - maturity
◦ Y-axis - yield
Why normally upward sloping?
◦ Yield curves are naturally upwardly sloping due to elevated risk of long-term lending
Bloomberg Market Concepts
What’s ‘Term Premium’?
What’s spread?
The difference between the corporate yield and the benchmark yield
What does it mean when a company’s corporate spread tightens?
◦ The company’s bonds are outperforming the benchmark yield
Corporate bonds are priced using a spread off the government yield curve so the yield curve
indirectly regulates company funding
Term structure of interest rates
(cont.)
b)Term structure of interest rates
Differently shaped yield curves are evident from time to time
◦ Normal or positive yield curve
◦ Longer term interest rates are higher than shorter term rates
◦ Inverse or negative yield curve
◦ Short-term interest rates are higher than longer term rates
◦ Humped yield curve
◦ Shape of yield curve changes over time from normal to inverse
(cont.)
Term structure of interest rates
The fact that the shape of the yield curve changes over time suggests that
monetary policy interest rate changes are not the only factor affecting interest
rates
Three theories have been advanced to explain the shape of the yield curve:
1.
Expectations theory
2.
Market segmentation theory
3.
Liquidity premium theory
1. Expectations theory
The current short-term interest rate and expectations about future short-term interest
rates are used to explain the shape and changes in shape of the yield curve
Longer term rates will be equal to the average of the short-term rates expected over
the period
The theory is based on assumptions, e.g.:
◦ Large number of investors with reasonably homogenous expectations
◦ No transactions costs and no impediments to interest rates moving to their competitive
equilibrium levels
◦ Investors aim to maximise returns and view all bonds as perfect substitutes regardless of
term to maturity
Expectations theory (cont.)
Example: The rate on a one-year instrument is 7% per annum. The investor expects to
obtain 9% per annum on a one-year investment starting in one year’s time. What is the
current two-year rate?
(cont.)
Expectations theory (cont.)
Explanation for the shape of yield curves
◦ Inverse yield curve
◦ Will result if the market expects future short-term rates to be lower than current short-term rates
◦ Normal yield curve
◦ Will result from expectations that future short-term rates will be higher than current short-term rates
◦ Humped yield curve
◦ Investors expect short-term rates to rise in the future but to fall in subsequent periods
2. Segmented markets theory
Assumes that securities in different maturity ranges are viewed by market
participants as imperfect substitutes (i.e. investors will operate within some
preferred maturity range)
◦ Rejects two assumptions of the expectations theory
◦ Preferences of participants are motivated by reducing the risk of their portfolios; i.e. minimising
exposure to fluctuations in prices and yields
The shape and slope of the yield curve are determined by the relative
demand and supply of securities along the maturity spectrum
Segmented markets theory (cont.)
Central bank sales of short term securities
Segmented market
theory - Inverse Yield
curve
(cont.)
Segmented markets theory (cont.)
Central bank sales of long-term securities
Segmented Market
Theory – Normal
Yield curve
(cont.)
Segmented markets theory (cont.)
If the central bank increases the average maturity of bonds by purchasing
short-term bonds and selling long-term bonds
◦ Segmented markets theory suggests:
◦ short-term yields decrease and long-term yields increase
◦ although financial system liquidity is unchanged, economic activity is affected because areas of
expenditure sensitive to:
◦ short-term interest rates will expand
◦ long-term interest rates will contract
◦ Expectations theory suggests:
◦ no effect on expectations about future short-term interest rates, and therefore no effect on the economy
Expectations approach versus segmented markets approach
Segmented markets theory ignores:
◦ arbitrage opportunities
◦ without their participation, the extreme segmentation theory would facilitate discontinuities in
the yield curve
◦ speculative profit
◦ speculators’ trading actions are dictated by expectations
3. Liquidity premium theory
Assumes investors prefer shorter term instruments, which have
greater liquidity and less maturity and interest rate risk and,
therefore, require compensation for investing longer term
This compensation is called ‘liquidity premium’
Liquidity premium theory (cont.)
The liquidity premium can be included in the expectations theory equation
◦ L is the size of the liquidity premium
 i +E i + L 
i =  0 1 11 
02
2
(cont.)
Liquidity premium theory (cont.)
(cont.)
c. Risk structure of interest rates
Default risk is the risk that the borrower (i.e. issuer) will fail to meet its
interest payment obligations
Commonwealth government bonds are assumed to have zero default risk
◦ As they are risk-free, they offer a risk-free rate of return
Some borrowers may have greater risk of default (i.e. state government or
private sector firms)
Investors will require compensation for bearing the extra default risk
Risk structure of interest rates
(cont.)
(cont.)
Bloomberg Market Concepts
What determines the LHS of the yield curve i.e. short-term yield drivers?
Central bank determining the short term rate
What determines the RHS of the yield curve i.e. long-term yield drivers?
◦ BELIEFS
◦ Interest rate forecasts
◦ Long-term GDP growth estimates
◦ Demographics
◦ Demand for long-term borrowing
◦ Supply of long-term lending
◦ Inflation expectations
Bloomberg Market Concept
What is a sign of accelerating economy? Steep yield curve
What does the inverted yield curve imply? Sign of a recession
The yield curve acts as an economic indicator!!
EQUITY MARKET 1
(Chapter 4)
KEYWORD: OWNERSHIP
O W N E R S H I P I N W H AT ?
C O R P O R AT I O N S … .
SHAREHOLDERS –
Learning
objectives
1. CORPORATION
2. EXCHANGES
Corporations
Share market
• A formal exchange facilitating the issue, buying and selling of equity securities
• i.e. Primary market and Secondary market
Publicly listed corporation
• A company whose shares are quoted and traded on a formal stock exchange
Ordinary share
• The principal form of equity issued by a corporation, which bestows a claim to residual cash
flows and ownership and voting rights
41
Corporations
The corporation differs from other business forms
• Ownership claims are widespread and easily transferable
• Owners (shareholders) do not affect the day-to-day affairs of the company
• Shareholders’ liability is limited to:
• the issue price of shares of a limited liability company
• any partly paid portion of shares of a no-liability company
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Advantages of the corporate form
Can obtain large amounts of finance at a relatively cheaper cost
Separation of ownership and control facilitates:
• appointment of specialised management
• greater effectiveness in the planning and implementation of strategic decisions
‘Perpetual succession’—the corporate form is unaffected by
changes in management or ownership
The corporate form is suited to large-scale operations
43
Disadvantages of the corporate form
• Main disadvantage arises from the separation of ownership and control
• Agency problem - Conflict of interest between owners (principals) and managers
(agents)
• Management may try to run business for their own benefit, rather than that of
shareholders, i.e. maximise shareholder value (share price)
• Factors moderating conflict of interest between owners and managers
• Investors’ ability to sell shares in a corporation, causing the share price to fall
• Dismissal from the board at AGM by shareholders
• Threat of takeover and loss of employment
• Use of performance incentives, such as share options
• More rigorous corporate governance
44
Evidence of advantage of Corporations
• Following the GFC, many corporations were forced to raise additional
capital through the stock market
• This was to ‘sure up’ their balance sheets during the tough economic
environment that followed the crisis
• The advantage of the corporate form is highlighted by such behaviour
• Smaller firms are not able to access capital as easily and would normally
be expected to pay a higher rate of return
45
Roles of stock exchange
Various roles of a stock exchange are considered:
• Primary market role
• Secondary market role
• Managed Product role
• Derivative market role
• Interest rate market role
• Trading and settlement roles
• Information role
• Regulatory role
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