chapter 2 money, credit, and the determination of interest rates © oncourse learning
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Chapter 2
Money, Credit, and the Determination of Interest Rates
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Chapter 2 Learning Objectives Understand how the supply and demand for money
and credit affect (and are affected by) the economy and the general level of interest rates
Understand how yields on individual debt instruments are determined
Understand why securities of different maturities may have different yields
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The General Level of Interest Rates Assume that only one type of credit instrument exists (e.g. a bond)
The bond is riskless
No inflation expectation
The price of the bond is inversely related to and determined by the market-required yield
Market value of the bonds can be defined in terms of either their price or their yield.
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The General Level of Interest Rates Interest rate on an instrument reflects general market rates and the risk of the
specific instrument
Transition mechanism of money and interest rates: Money supply → economy → inflation → inflationary expectations → credit markets → interest
rates
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The General Level of Interest Rates Equation of Exchange MV = PT
M = money supply V = velocity of circulation (the average number of
time$1 turns over in 1 year) P = general price level T = the volume of trade
Monetary theory of inflation The greater the rate of growth in money, the grater the rate
of inflation
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The Fisher Equation The inflation rate plays an important role in the
determination of market rates Fisher equation: I = r + p
I – the equilibrium nominal rate of interest observed in the credit market
r – the real interest rate P – the expected inflation over the maturity of the
instrument
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The Relationship between Inflation and T-Bill Yield
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The Gibson Paradox An increase in money supply leads to increases in
demand for bonds and goods and services, resulting in upward pressure on bond prices, forcing interest rates down.
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Liquidity, Income and Price-Anticipation Effects
Liquidity effect (short-run) Money supply goes up
Demand for bonds goes up
Interest rates go down
Income effect Income goes up
Demand for credit goes up
Interest rates go up
Price anticipation effect Future expected inflation
Decrease in supply of credit
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Liquidity, Income and Price-Anticipation Effects
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Risks In Real Estate Finance
Default risk Risk that the borrower will not repay the mortgage per the contract
Callability risk Borrower may repay the debt before maturity
Maturity risk Other things held constant, the longer the maturity the greater the change in value for a
given change in interest rates
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Risks In Real Estate Finance
Marketability risk Risk that the asset doesn’t trade in a large, organized market I = r + p + k, where k is risk premium associated with noninflationary risks
Inflation risk Risk in loss of purchasing power
Interest rate risk Risk of loss due to changes in market interest rates Fixed-income assets are most susceptible
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Description of Agency Ratings
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Income Tax Considerations Municipal bonds – issued by government jurisdictions
other than the federal government Interest from municipal bonds is tax free The tax-free nature of these instruments implies that
investors will receive lower return on these bonds MY = TY(1 – T)
where MY is the yield on a municipal bond, TY is the taxable yield on a comparable non-municipal bond, T is the investor’s tax rate.
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The Yield Curve
Relates maturity and yield at the same point in time
Theories explaining the structure of the yield curve: Liquidity Premium Theory
Long-term rates tend to be higher that short-term rates
Market Segmentation Theory
There are two (or more) markets for securities of different maturities
Assumes that investors will not change their preferences as a result of yield discrepancies
Expectations Theory
The long-term rate for some period is the average of the short-term rates over that period
Upward-sloping (downward-sloping) curves indicate that market participants expect rates to rise (fall) in the future.
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Yield Curve
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Explaining the Yield Curve
Liquidity premium Premium paid for liquidity
Segmented markets Market divided into distinct segments
Expectations theory Current rates are the average of expected future rates
The current two-year rate is the average of the current one-year rate and the one-year rate a year from now
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Examples of Yield Curves
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