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Money Credit and the Determination of Interest Rates

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					    Chapter   2

 Money, Credit,
    and the
Determination of
 Interest Rates
         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
    The General Level of
      Interest Rates
 Interest rate on an instrument reflects
  general market rates and the risk of the
  specific instrument
 Equation of Exchange MV = PT
      M = money supply
      V = stable velocity of circulation
      P = passive price level
      T = stable volume of trade
   Fisher Equation      i=r+p
       Determining Interest
             Rates
   LIQUIDITY EFFECT
    – 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
     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
     Risks In Real Estate
           Finance
   MARKETABILITY RISK
     – Risk that the asset doesn’t trade in a large,
       organized market
   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
         The Yield Curve
   Relates maturity and yield at the same point
    in time
   Explaining the structure of the yield curve:
    – Liquidity Premium Theory
    – Market Segmentation Theory
    – Expectations Theory – the long-term rate for some
      period is the average of the short-term rates over
      that period
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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posted:11/8/2012
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