Chapter 4
Why Do Interest Rates
Change?
Chapter Preview

Interest rates might fluctuate time and time
and affect business activities. We will
examine the forces that move interest rates
and the theories behind those movements.
Topics include:

Determining Asset Demand

Supply and Demand in the Bond Market

Changes in Equilibrium Interest Rates
2
4.1 Determinants of Asset Demand


An asset is a piece of property that is
a store of value.
Facing the question of whether to
buy and hold an asset or whether to
buy one asset rather than another,
an individual must consider the
following factors:
Wealth, expected return, risk and
liquidity
3
4.1.1 Wealth (财富)


Wealth, the total resources
owned by the individual,
including all assets;
The effect of changes in wealth:
Other things being equal, an
increase in wealth raises the
quantity demanded of an asset.
4
4.1.2 Expected Return (预期收益)


Expected return: the return expected over the
next period, on one asset relative to
alternative assets;
The expected return on an asset is the
weighted average of all possible returns,
where the weights are the probabilities of
occurrence (发生事件) of that return:
Re = p1R1 + p2R2,
Where
p1 = probability of occurrence of return 1; R1 = return in state 1
p2 = probability of occurrence return 2; R2 = return in state 2
5
4.1.2.1 EXAMPLE 1: Expected Return
(P72)
What is the expected return on the Mobil Oil bond if the return
is 12% two-thirds of the time and 8% one-third of the time?
Solution
The expected return is 10.68%.
Re = p1R1 + p2R2， where
p1 = probability of occurrence of return 1
= 2/3
=
.67
R1 = return in state 1
= 12% =
0.12
p2 = probability of occurrence return 2
= 1/3
=
.33
R2 = return in state 2
= 8%
=
0.08
Thus
Re = (.67)(0.12) + (.33)(0.08) = 0.1068 = 10.68%
6
4.1.2.2 Effect of changes in expected
return

An increase in an asset’s expected
return relative to that of an alternative
asset, holding everything else
unchanged, raises the quantity
demanded of the asset.
7
4.1.3 Risk



Risk: the degree of uncertainty
associated with the return on one asset
relative to alternative assets;
In finance, we use standard deviation of
return as a measure of risk;
The formula for the standard deviation
is shown as on P73
8
4.1.3.1 EXAMPLE 2: Standard Deviation
(a)


What is the standard deviation of the returns
on the Fly-by-Night Airlines stock and Feeton-the Ground Bus Company, with the same
return outcomes and probabilities described
as on P73?
Of these two stocks, which is riskier?
9
4.1.3.2 EXAMPLE 2: Standard Deviation
(b)

Solution
 Fly-by-Night Airlines has a standard deviation of returns of
5%.
10
4.1.3.3 EXAMPLE 2: Standard Deviation
(c)

Feet-on-the-Ground Bus Company has a standard
deviation of returns of 0%.
11
4.1.3.4 EXAMPLE 2: Standard Deviation
(d)


Fly-by-Night Airlines has a standard deviation of
returns of 5%; Feet-on-the-Ground Bus Company
has a standard deviation of returns of 0%
Clearly, Fly-by-Night Airlines is a riskier stock
because its standard deviation of returns of 5% is
higher than the zero standard deviation of returns
for Feet-on-the-Ground Bus Company, which has a
certain return.
12
4.1.3.5 Conclusion on the above example



A risk-averse （厌恶风险） person prefers stock in
the Feet-on-the-Ground (the sure thing) to Fly-byNight stock (the riskier asset), even though the
stocks have the same expected return, 10%.
By contrast, a person who prefers risk is a risk lover.
Most people are risk-averse, especially in their
financial decisions.
13
4.1.3.6 Effect of changes in risk
Holding everything else constant,
if an asset’s risk rises relative to
that of alternative assets, its
quantity demanded will fall.
14
4.1.4 Liquidity



Liquidity: the ease and speed with which
an asset can be turned into cash,
relative to alternative assets;
Effect of changes in liquidity: The more
liquid an asset is relative to alternative
assets, holding everything else
unchanged, the more desirable it is, and
the greater will be the quantity
demanded.
Government bond VS company bond
15
4.1.5 Determinants of Asset Demand
16
4.2 Supply and demand in the bond
market



We want to study the interest-rate
determination by examining the supply of
and demand for bonds;
Since interest rates on different markets
tend to move together, we first of all study
by supposing that there is only one type of
securities and a single interest rate in the
entire economy.
In next chapter, we will discuss why
interest rates on different securities differ.
17
4.2.1 Derivation of Demand Curve (look
at Figure 1 on P77)
For one-year discount bonds (no coupon, face value
$1000):
iR 
e
Point A:
Point B:
P  $950
P  $900
i
i
F  P 
P
$1000  $950 
$950
$1000  $900 
$900
 .053  5.3%
 .111  11.1%
Bd  100
Bd  200
18
4.2.1.1 Derivation of Demand Curve

Point C: P = $850 i = 17.6% Bd = 300

Point D: P = $800 i = 25.0% Bd = 400

Point E: P = $750 i = 33.0% Bd = 500

Demand Curve is Bd in Figure 1 which
connects points A, B, C, D, E.

Has usual downward slope
19
4.2.1.2 Supply and Demand Analysis
of the Bond Market
Figure 4.1 Supply and Demand for Bonds
20
4.2.2 Derivation of Supply Curve

Point F:
P = $750
i = 33.0%
Bs = 100

Point G: P = $800
i = 25.0%
Bs = 200

Point C: P = $850
i = 17.6%
Bs = 300

Point H: P = $900
i = 11.1%
Bs = 400

Point I:
i = 5.3%
Bs = 500

Supply Curve is Bs that connects points F, G, C, H, I,
and has upward slope: the higher the interest rate,
the less willingness to issue new bonds.
P = $950
21
4.2.3 Market Equilibrium
1.
Occurs when Bd = Bs, at P* = 850, i*
= 17.6%
2.
When P = $950, i = 5.3%, Bs > Bd
(excess supply): P  to P*, i  to i*
3.
When P = $750, i = 33.0, Bd > Bs
(excess demand): P  to P*, i  to i*
22
4.2.4 Market Demand Conditions
Market equilibrium occurs when the amount that
people are willing to buy (demand) equals the
amount that people are willing to sell (supply) at a
given price
Excess supply occurs when the amount that
people are willing to sell (supply) is greater than the
amount people are willing to buy (demand) at a
given price
Excess demand occurs when the amount that
people are willing to buy (demand) is greater than
the amount that people are willing to sell (supply) at
a given price.
23
4.2.5 Loanable (可贷出的)Funds
Terminology
1.
Demand for
bonds = supply of
loanable funds
2.
Supply of
bonds = demand for
loanable funds
3.
Therefore we can
use the Figure 4.2 to
express interest
rates value in the
usual direction.
Figure 4.2 A Comparison of Terminology: Loanable
Funds and Supply and Demand for Bonds
24
4.3 Changes in Equilibrium Interest Rates

It is important to distinct between
movements along a demand (or
supply) curve and a shifts in a
demand (or supply) curve.
25
4.3.1 Movement along the demand curve

When quantity demanded changes as a
result of a change in the price of the bond, we
have a movement along the demand curve,
e.g., from Point A to B;
26
4.3.2 Shift in the demand curve

When quantity demanded changes at each
given price of the bond in response to a
change in some other factor besides the
bond’s price or interest rate, we have a shift
in the demand curve, e.g. B d to B d .
1
2
27
4.3.3 Shifts in the Demand Curve
Figure 4.3 Shifts in the Demand Curve for Bonds
28
4.3.4.1 How Factors Shift the Demand
Curve - Wealth
Wealth

Economy , wealth , Bd , Bd shifts out to right,
and the vice versa.
29
4.3.4.2 How Factors Shift the Demand
Curve – Expected return
Expected Return
1.


i  in future, Re for long-term bonds , Bd shifts
out to right
πe , relative Re , Bd shifts out to right
30
4.3.4.3 How Factors Shift the Demand
Curve - Risk
Risk


Risk of bonds , Bd , Bd shifts out to right
Risk of other assets , Bd , Bd shifts out to
right
31
4.3.4.4 How Factors Shift the Demand
Curve - Liquidity
Liquidity


Liquidity of bonds , Bd , Bd shifts out to right
Liquidity of other assets , Bd ,Bd shifts out to
right
32
4.3.4.5
Factors
That
Shift
Demand
Curve
4.3.5.1 Summary of Shifts
in the Demand for Bonds (1)
1.
Wealth: in a business cycle expansion with
growing wealth, the demand for bonds rises,
conversely, in a recession, when income and
wealth are falling, the demand for bonds falls
2.
Expected returns: higher expected interest rates
in the future decrease the demand for long-term
bonds, conversely, lower expected interest rates in
the future increase the demand for long-term
bonds
34
4.3.5.1 Summary of Shifts
in the Demand for Bonds (1)
3.
4.
Risk: an increase in the riskiness of bonds causes
the demand for bonds to fall, conversely, an
increase in the riskiness of alternative assets (like
stocks) causes the demand for bonds
to rise
Liquidity: increased liquidity of the bond market
results in an increased demand for bonds,
conversely, increased liquidity of alternative asset
markets (like the stock market) lowers the demand
for bonds
35
4.3.6 Changes in Supply
Certain factors can cause the supply curve for
bonds to shift:
 Expected profitability of investment
opportunities;
 Expected inflation;
 Government activities.
36
4.3.6.1 Shifts in the Supply Curve
Figure 4.4 Shift in the Supply Curve for Bonds
37
4.3.6.2.1 Factors that shift supply curveProfitability
Profitability of Investment Opportunities

Business cycle expansion, investment
opportunities , Bs , Bs shifts out to right
In a business cycle expansion, the supply of bonds
increases, conversely, in a recession, when
there are far fewer expected profitable
investment opportunities, the supply of bonds
falls
38
4.3.6.2.2 Factors that shift supply curveExpected Inflation
Expected Inflation

πe , Bs , Bs shifts out
to right
An increase in expected inflation causes the supply of
bonds to increase
39
4.3.6.2.3 Factors that shift supply curveGovernment Activity
Government Activities

Deficits , Bs , Bs shifts out to right
Higher government deficits increase the
supply of bonds, conversely, government
surpluses decrease the supply of bonds
40
4.3.6.2.4 Factors That Shift Supply Curve
(Table 3)
41
4.4 Fisher Effect and Business cycle


Fisher Effect
Business cycle
42
4.4.1 Changes in expected inflationπe
If πe 
1.
2.
3.
Relative
Re ,
Bd shifts
in
to left
Bs , Bs
shifts out
to right
P , i 
Figure 4.5 Response to a Change in Expected Inflation
43
4.4.2 Fisher Effect



Our analysis on demand and supply
has brought an important observation:
when expected inflation rises, interest
rates will rise.
This observation was firstly pointed
out by Irving Fisher, and therefore
called Fisher Effect.
Irving Fisher, famous
economist( (1867-1947)
44
4.4.3 Evidence on the Fisher Effect
in the United States
Figure 4.6 Expected Inflation and Interest Rates (Three-Month Treasury Bills), 1953–2004
45
4.4.4 Summary of the Fisher Effect
1.
If expected inflation rises from 5% to 10%, the expected
return on bonds relative to real assets falls and, as a result,
the demand for bonds falls
2.
The rise in expected inflation also means that the real cost
of borrowing has declined, causing the quantity of bonds
supplied to increase
3.
When the demand for bonds falls and the quantity of bonds
supplied increases, the equilibrium bond
price falls
4.
Since the bond price is negatively related to the interest
rate, this means that the interest rate will rise
46
4.4.5 Business Cycle Expansion
1.
2.
3.
Wealth , Bd ,
Bd shifts out to
right
Investment , Bs
, Bs shifts right
If Bs shifts more
than Bd then P ,
i
Figure 4.7 Response to a Business
Cycle Expansion
47
4.4.6 Evidence on Business Cycles
and Interest Rates
Figure 4.8 Business Cycle and Interest Rates (Three-Month Treasury Bills), 1951–2004
48
4.4.7 Business cycle and Interest rates


Interest rates rise during business
expansions;
Interest rates fall during contractions (as
shown in the shaded areas indicating
periods of recession in Figure 4.8)
49
4.5 Profiting from Interest-Rate Forecasts

Methods for forecasting
1.
2.
Supply and demand for bonds: use Flow of
Funds Accounts and judgment
Econometric Models: large in scale, use
interlocking equations that assume past
financial relationships will hold in the future
50
4.6 Profiting from Interest-Rate Forecasts

Make decisions about assets to hold
1.
2.

Forecast i , buy long bonds
Forecast i , buy short bonds
Make decisions about how to borrow
1.
2.
Forecast i , borrow short
Forecast i , borrow long
51
Chapter Summary

Determining Asset Demand: We examined
the forces that affect the demand and supply
of assets.

Supply and Demand in the Bond Market: We
examine those forces in the context of bonds,
and examined the impact on interest rates.
52
Chapter Summary (cont.)

Changes in Equilibrium Interest Rates: We
further examined the dynamics of changes in
supply and demand in the bond market, and
the corresponding effect on bond prices and
interest rates.
53