VIEWS: 2,272 PAGES: 41 CATEGORY: Business POSTED ON: 11/14/2010
Historical Savings Account Interest Rates document sample
Interest Rates Fin 200 Drake Fin 200 DRAKE UNIVERSITY Drake The Cost of Money DRAKE UNIVERSITY Fin 200 The interest rate is the price paid to borrow debt capital (the required return of the bondholder). Likewise equity holders expect a return (the required return of the shareholder). What impacts the level of interest rates? Production Opportunities Time Preference for Consumption Risk Inflation Drake Review of Key Factors Impacting DRAKE UNIVERSITY Interest Rate Volatility Fin 200 Federal Reserve and Monetary Policy Discount Window Reserve Requirements Open Market Operations Review of Key Factors Drake Impacting DRAKE UNIVERSITY Fin 200 Interest Rate Volatility Fisher model of the Savings Market Two main participants: Households and Business Households supply excess funds to Businesses who are short of funds. Loanable funds theory expands this to allow individuals, business and governments to both borrow and save. The Saving or supply of funds is upward sloping (saving increases as interest rates increase) The investment or demand for funds is downward sloping (demand for funds decease as interest rates increase) Drake Saving and Investment DRAKE UNIVERSITY Decisions Fin 200 Saving Decision Marginal Rate of Time Preference Trading current consumption for future consumption Expected Inflation Income and wealth effects Generally higher income – save more Federal Government Money supply decisions Business Decisions Short term temporary excess cash. Foreign Investment Drake Borrowing Decisions DRAKE UNIVERSITY Fin 200 Borrowing Decision Marginal Productivity of Capital Expected Inflation Other Drake Equilibrium in the Market DRAKE UNIVERSITY Fin 200 Interest Rate S D Dollars Drake Equilibrium in the Market DRAKE UNIVERSITY Fin 200 Original Equilibrium Decrease in Income S S’ S D D Increase in Marg. Prod Cap Increase in Inflation Exp. S’ S S D’ D’ D D Drake Multiple Markets DRAKE UNIVERSITY Fin 200 The market for investment capital is not one single demand and supply relationship. It can be thought of as being separated by the amount of risk in the borrowing (the chance that the firm will repay the debt) and the length of time for the debt (bond). The different markets are interrelated. If the risk free cost of borrowing increases, the rate paid on more risky borrowing also increases. Generally the higher the risk, the higher the return. Drake Differences in Return DRAKE UNIVERSITY Fin 200 The differences in return paid between two different types of borrowing (low risk corporate vs. high risk corporate with the same maturity for example) is the risk premium or yield spread. Drake Yield Spreads and Risk Premiums DRAKE UNIVERSITY Fin 200 Yield Spreads and Risk Premiums The difference in required return between two assets, the difference in required return represents the difference in risk. Often bonds that are the same except for the possibility of default are compared, implying that the yield spread is a measure of the default risk Drake Long Term Average Yearly Yields DRAKE UNIVERSITY Over Time (Moody’s) Fin 200 18 16 14 12 (%) 10 8 6 4 1980 1985 1990 1995 2000 Aaa Aa A Baa Bond Ratings and Average Drake Yield Spreads vs. US Treasuries DRAKE UNIVERSITY Fin 200 (long term bonds) Rating Spread Rating Spread AAA .20% B+ 2.5% AA .50% B 3.25% A+ .80% B- 4.25% A 1.0% CCC 5.00% A- 1.25% CC 6.00% BBB 1.5% C 7.5% BB 2.0% D 10.0% Drake Yield Spread Monthly Data DRAKE UNIVERSITY Jan 1919 – June 2004 (Moodys) Fin 200 20 18 16 14 12 % 10 8 6 4 2 0 9/8/1913 1/24/1941 6/11/1968 10/28/1995 Aaa Baa Date Drake Yield Spreads 1994 - 2003 DRAKE UNIVERSITY Fin 200 10 6 9 Yield 5 8 7 4 6 AAA 5 BBB 3 Treas 4 AAA-Treas Spread BBB-Treas 2 3 2 1 1 0 0 Jan-94 Nov-94 Sep-95 Jul-96 May-97 Mar-98 Jan-99 Nov-99 Sep-00 Jul-01 May-02 Mar-03 Date Drake Impact of Maturity DRAKE UNIVERSITY Fin 200 It is often the case that the return on similar assets that differ only in their maturity differ also have a interconnected relationship. Usually the long term asset has a higher return than the short term asset. However this is not always the case. Drake General Model of Interest Rates DRAKE UNIVERSITY Fin 200 The relationship between assets of different riskiness and maturity can be broken down into a very general idea. The return paid on an asset that matures I t years, rt should be thought of being a combination of its riskiness and maturity compared to a risk free asset. Drake Quoted Interest Rate DRAKE UNIVERSITY Fin 200 The quoted interest rate is then equal to a base rate, the real risk free rate of interest, plus premiums that account for differences in maturity and riskiness. Drake The quoted rate DRAKE UNIVERSITY Fin 200 r = r*+ IP + DRP + LP + MRP Where: r* = The real risk free rate of interest IP = The inflation premium DRP =The default risk premium LP = The liquidity premium MRP = the Market Risk Premium Drake The real risk free rate of interest DRAKE UNIVERSITY Fin 200 r* is the rate that would be paid on an asset with zero default risk, and an expected interest rate of zero. It is the actual increase in purchasing power you should expect to receive. It depends on the productivity of the borrowers assets and the marginal time preference mentioned earlier. Drake Nominal Risk Free Rate and DRAKE UNIVERSITY the Inflation Premium Fin 200 The nominal, or risk free rate of interest is then the real rate plus a premium (IP) added to account for expected inflation in the future. rRF = r*+ IP Ideally the premium should be based upon expected inflation over the life of the security. Usually these are based on historical rates of inflation and the current economy. Drake The other premiums DRAKE UNIVERSITY Fin 200 DFR = The extra return associated with a higher chance of default (BBB corporate bonds vs. treasury bonds for example) LP = Liquidity Premium The extra return associated with the market for an asset being less liquid making it harder to sell the asset for cash Drake The other premiums DRAKE UNIVERSITY Fin 200 MRP = Market Risk Premium A longer term bond has higher interest rate risk (TVM says the impact of a change in interest rates will be larger on a cash flow received further in the future). Therefore, the longer the maturity of the bond the higher the quoted interest rate. Drake Yield Curves DRAKE UNIVERSITY Fin 200 Graph of maturity (horizontal axis) vs. yield (vertical axis) for a group of bonds with similar risk. Often represented using US gov’t bonds, it is usually upward sloping, implying that the longer the commitment the higher the required return for the investor (the higher the opportunity cost of capital). Drake Recent Yield Curve DRAKE UNIVERSITY Fin 200 0.055 0.053 0.051 0.049 0.047 Yield 0.045 0.043 0.041 12/30/2005 1/31/2006 2/28/2006 3/31/2006 0.039 4/28/2006 5/31/2006 6/30/2006 0.037 Maturity (Years) 0.035 0.00 5.00 10.00 15.00 20.00 Drake Long Term vs. Short Term Interest DRAKE UNIVERSITY rates Fin 200 0.09 Downward Sloping 0.08 Yield Curves 0.07 0.06 0.05 0.04 Yield 0.03 0.02 0.01 3-mo 6-mo 10-yr 20-yr Date 0 12/8/1989 9/3/1992 5/31/1995 2/24/1998 11/20/2000 8/17/2003 5/13/2006 Drake Why does the Yield Curve DRAKE UNIVERSITY usually slope upwards? Fin 200 Three things are observed empirically concerning the yield curve: 1. Rates across different maturities move together 2. More likely to slope upwards when short term rates are historically low, sometimes slope downward when short term rates are historically high 3. The yield curve usually slope upward Drake Three Explanations of the Yield DRAKE UNIVERSITY Curve Fin 200 The Expectations Hypothesis Segmented Markets Theory Preferred Habitat Theory Drake Expectations Hypothesis DRAKE UNIVERSITY Fin 200 Long term rates are a representation of the short term interest rates investors expect to receive in the future Assumes that bonds of different maturities are perfect substitutes In other words, the expected return from holding a one year bond today and a one year bond next year is the same as buying a two year bond today. Drake Expectations Hypothesis DRAKE UNIVERSITY Fin 200 Let Rt = today’s time t interest rate on a one period bond Ret+1 = expected interest rate on a one period bond in the next period R2t = today’s (time t) yearly interest rate on the two period bond Drake The One Period Return Twice DRAKE UNIVERSITY Fin 200 If the strategy of buying an one period bond in two consecutive years is followed the return is: (1+Rit)(1+Ret+1) – 1 which reduces to Rt+Ret+1 (Rt)(Ret+1) can be dropped Drake The 2 Period Return DRAKE UNIVERSITY Fin 200 If the strategy of investing in the two period bond is followed the return is: (1+R2t)(1+R2t) - 1 = 1+2R2t+(R2t)2 - 1 This simplifies to 2R2t (R2t)2 is small enough it can be dropped. Drake Set the two equal to each other DRAKE UNIVERSITY Fin 200 2R2t = Rt+Ret+1 R2t = (Rt+Ret+1)/2 In other words, the two period interest rate is the average of the two one period rates Drake Expectations Hypothesis DRAKE UNIVERSITY Fin 200 When the yield curve is upward sloping it is expected that short term rates will be increasing (the average future short term rate is above the current short term rate). Likewise when the average yield curve is downward sloping the average of the future short term rates is below the current rate. (Fact 2) As short term rates increase the long term rate will also increase. (Fact 1) This however does not explain Fact 3 Drake Segmented Markets Theory DRAKE UNIVERSITY Fin 200 Interest Rates for each maturity are determined by the supply and demand for bonds at each maturity. Different maturity bonds are not perfect substitutes for each other. Longer term bonds have a higher interest rate risk (and associated Market Risk Premium), therefore they should have a higher return Implies the yield curve usually slopes up. Drake Preferred Habitat Theory DRAKE UNIVERSITY Fin 200 Combines the other two – The interest rate on the long term bond will equal an average of the short term rates, plus a liquidity premium and market risk premium, that responds to the supply and demand for that bond. In other words the bonds are substitutes, but savers might have a preference for one maturity over another (they are not perfect substitutes) Drake Preferred Habitat Theory DRAKE UNIVERSITY Fin 200 The long term rate should include a premium associated with them. To attract savers who prefer a shorter maturity, the long term bond will need to pay an additional amount (or market risk and liquidity premiums). Thus according to the theory a rise in short term rates still causes a rise in the average of the future short term rates. Therefore the long and short rates move together (Fact 1). Drake Preferred Habitat Theory DRAKE UNIVERSITY Fin 200 The explanation of Fact 2 from the expectations hypothesis still works. In the case of a downward sloping yield curve, the term premium (interest rate risk) must not be large enough to compensate for the currently high short term rates (Current high inflation with an expectation of a decrease in inflation). Since the demand for the short term bonds will increase, the yield on them should fall in the future. Drake Preferred Habitat Theory DRAKE UNIVERSITY Fin 200 Fact three is explained since it will be unusual for the term premium to be so small that the yield curve slopes down. Drake Predicting Future Short Term DRAKE UNIVERSITY Interest Rates Movements Fin 200 Steep Yield Curves Short term interest rates are expected to increase Flat Yield Curves Short term interest rates are expected to decrease slightly Downward sloping Yield Curves Short term interest rates are expected to decrease. Drake Changes in the Yield Curve DRAKE UNIVERSITY Fin 200 These ideas can also be used to analyze changes in the shape of the yield curve. As the yield curve starts to become more steep it indicates that the average future short term rate is starting to increase. The current short term rate is to low. A shift in the Yield curve that remains approximately the same slope is indicating that future expectations about both short term and long term rates are moving together (the real rate of interest is increasing and not just short term rates are changing)