Description
theories related to determinants of interest rates, Fishers theory, Laon-able funds theory, Keynes – Liquidity Preference Theory, expectations theory, liquidity theory, preferred habitat theory.
Determination of Interest Rates
Theories
• Fishers Theory
– Interest rate is determined by the interaction between SAVERS willingness to save and BORROWERS demand for investment • Savers : – Marginal rate of time preference – Income – Reward for saving • Investors – For gain – Marginal productivity of Capital – Investment only when marginal productivity >or = interest rate • Interest function of propensity to save & technology
Theories
• Loan-able funds theory
– Supply
• Loan-able funds
– Function of » Interest Rates » Expectation of inflation rate
– Demand
• From government (generally inelastic) • Others - function of interest rate
Theories
• Keynes – Liquidity Preference Theory
– Changes in the MONEY SUPPLY can affect the level of interest rates through the
– LIQUIDITY EFFECT, – INCOME EFFECT and – PRICE EXPECTATION EFFECT.
• Their relative magnitudes depend upon the LEVEL OF ECONOMIC ACTIVITY at the time of change in Money Supply
Interest Rates in a Financial System
• In every economy there is not one interest rate but a structure of interest rates • All rates are tracked as a “Spread” above a “Bench Mark Rate” • The generally accepted bench mark rate , globally, is the yield on US Treasuries • Base Interest Rate = • yield on US Treasuries + » Expected rate of inflation • Risk Premium is the yield spread between a nontreasury and a comparable on-the-run treasury
Yield Curve - Term Structure of Interest Rates
• Relationship between yield and maturity of bonds of the same credit quality • Most commonly used – Treasury yield curve • Yield curve based on observed yields (YTM) of Treasuries -(easily available) • Using the method of “Boot Strapping” we can get the yield curve for Treasury “Zeroes” or the “Spot Rates” • Value of a Bond can be got by discounting the cash flows with the corresponding spot rate for that period
Shape of the Yield Curve
• “Normal” (Upward sloping)
– Flat ,
– “Inverted” (Downward Sloping)
Yield Curve Theories (do they predict future rates)
• Expectations Theory
– Forward rates are perfect predictors of future interest rates – When interest rates are expected to rise:
• Investors will wait and meanwhile park their funds in Short Term • Speculators will sell bonds and park the liquidity in Short Term • Borrowers rush to borrow • => upward sloping yield curve
Yield Curve Theories (2)
• Liquidity Theory
– Forward rates are the sum of expected future rates and a risk premium that increases for more distant future rates and hence rises with maturity of a bond – Presumes that all lenders do not have maturity preferences
Yield Curve Theories (3)
• Preferred Habitat Theory
– Each lenders / borrowers has a preferred maturity – Therefore the Supply and Demand for different maturities are different – SS / DD in each of this “habitats” determines the interest rate for different maturities – One has to induce lenders / borrowers out of their “habitat” with inducements (premium/discount)
Yield Curve Theories (4)
• Market Segments
• A variation of the habitat theory with the rider that no inducement will make the lender/borrower to move out of his habitat
» Insurance companies » Primary dealers » Infrastructure companies
Indian Scene
• Bench Mark Rates
– – – – – Bank Rate, RBI Repo / Reverse Repo MIBOR / MIBID G-Sec Yields Bench Mark / Popular Securities Banks’ Bench-Mark PLR (Short Term & Mid Term)
• • • • •
RBI auctions, Market Stabilization Bonds LAF - Data RBI’s OMO Ways and Means Advances of RBI to GOI Statements by RBI officials
Indian Scene
• Huge Govt borrowings • Efficacy of RBI intervention
• RBI willing to borrow
– But reluctant to lend ?
• RBI’s preoccupation with the Re/Dollar rate
• Sterilization
• Shortage G-Secs holding of RBI
• Efficiency of the money market • Ban on Short Sales of G-Secs • Market Preferences –
• Absence of term borrowings / lendings
Indian Scene
• Market infrastructure
– – – – – NDS (Negotiated Dealing System) RTGS (Real Time Gross Settlement) CCIL CFMS (Centralized Fund Mgmnt System) INFINET
• Trading of G-Secs on the NSE • Interest Rate Derivatives
doc_363814188.pptx
theories related to determinants of interest rates, Fishers theory, Laon-able funds theory, Keynes – Liquidity Preference Theory, expectations theory, liquidity theory, preferred habitat theory.
Determination of Interest Rates
Theories
• Fishers Theory
– Interest rate is determined by the interaction between SAVERS willingness to save and BORROWERS demand for investment • Savers : – Marginal rate of time preference – Income – Reward for saving • Investors – For gain – Marginal productivity of Capital – Investment only when marginal productivity >or = interest rate • Interest function of propensity to save & technology
Theories
• Loan-able funds theory
– Supply
• Loan-able funds
– Function of » Interest Rates » Expectation of inflation rate
– Demand
• From government (generally inelastic) • Others - function of interest rate
Theories
• Keynes – Liquidity Preference Theory
– Changes in the MONEY SUPPLY can affect the level of interest rates through the
– LIQUIDITY EFFECT, – INCOME EFFECT and – PRICE EXPECTATION EFFECT.
• Their relative magnitudes depend upon the LEVEL OF ECONOMIC ACTIVITY at the time of change in Money Supply
Interest Rates in a Financial System
• In every economy there is not one interest rate but a structure of interest rates • All rates are tracked as a “Spread” above a “Bench Mark Rate” • The generally accepted bench mark rate , globally, is the yield on US Treasuries • Base Interest Rate = • yield on US Treasuries + » Expected rate of inflation • Risk Premium is the yield spread between a nontreasury and a comparable on-the-run treasury
Yield Curve - Term Structure of Interest Rates
• Relationship between yield and maturity of bonds of the same credit quality • Most commonly used – Treasury yield curve • Yield curve based on observed yields (YTM) of Treasuries -(easily available) • Using the method of “Boot Strapping” we can get the yield curve for Treasury “Zeroes” or the “Spot Rates” • Value of a Bond can be got by discounting the cash flows with the corresponding spot rate for that period
Shape of the Yield Curve
• “Normal” (Upward sloping)
– Flat ,
– “Inverted” (Downward Sloping)
Yield Curve Theories (do they predict future rates)
• Expectations Theory
– Forward rates are perfect predictors of future interest rates – When interest rates are expected to rise:
• Investors will wait and meanwhile park their funds in Short Term • Speculators will sell bonds and park the liquidity in Short Term • Borrowers rush to borrow • => upward sloping yield curve
Yield Curve Theories (2)
• Liquidity Theory
– Forward rates are the sum of expected future rates and a risk premium that increases for more distant future rates and hence rises with maturity of a bond – Presumes that all lenders do not have maturity preferences
Yield Curve Theories (3)
• Preferred Habitat Theory
– Each lenders / borrowers has a preferred maturity – Therefore the Supply and Demand for different maturities are different – SS / DD in each of this “habitats” determines the interest rate for different maturities – One has to induce lenders / borrowers out of their “habitat” with inducements (premium/discount)
Yield Curve Theories (4)
• Market Segments
• A variation of the habitat theory with the rider that no inducement will make the lender/borrower to move out of his habitat
» Insurance companies » Primary dealers » Infrastructure companies
Indian Scene
• Bench Mark Rates
– – – – – Bank Rate, RBI Repo / Reverse Repo MIBOR / MIBID G-Sec Yields Bench Mark / Popular Securities Banks’ Bench-Mark PLR (Short Term & Mid Term)
• • • • •
RBI auctions, Market Stabilization Bonds LAF - Data RBI’s OMO Ways and Means Advances of RBI to GOI Statements by RBI officials
Indian Scene
• Huge Govt borrowings • Efficacy of RBI intervention
• RBI willing to borrow
– But reluctant to lend ?
• RBI’s preoccupation with the Re/Dollar rate
• Sterilization
• Shortage G-Secs holding of RBI
• Efficiency of the money market • Ban on Short Sales of G-Secs • Market Preferences –
• Absence of term borrowings / lendings
Indian Scene
• Market infrastructure
– – – – – NDS (Negotiated Dealing System) RTGS (Real Time Gross Settlement) CCIL CFMS (Centralized Fund Mgmnt System) INFINET
• Trading of G-Secs on the NSE • Interest Rate Derivatives
doc_363814188.pptx