BA 580-Interest RatesBA 580-Interest Rates

Breaking Down Market Breaking Down Market Influences on RatesInfluences on Rates

Influences on RatesInfluences on Rates

Factors that influence all rates as well Factors that influence all rates as well as account for differences in ratesas account for differences in rates– InflationInflation– Market forces on supply and demand for Market forces on supply and demand for

loans (price of borrowing-lending)loans (price of borrowing-lending)Income growth & expectations (consumption; Income growth & expectations (consumption; business investment decisions)business investment decisions)

RiskRisk

Time Time

Inflation & Rates: Why Connected?Inflation & Rates: Why Connected?

Inflation = change in purchasing power of $Inflation = change in purchasing power of $– With 5% inflation for 1 year, lender receives With 5% inflation for 1 year, lender receives

dollars worth $9500 on a 1-year $10,000 notedollars worth $9500 on a 1-year $10,000 note

Nominal rates made up of price for Nominal rates made up of price for borrowing (real rate) plus premium for borrowing (real rate) plus premium for expected inflation expected inflation – R = r + PR = r + Pee – Implies 1:1 relationship between R and PImplies 1:1 relationship between R and Pee

– ““Money Center” banks estimate PMoney Center” banks estimate Pee

– Bond buyers/sellers incorporate formal & informalBond buyers/sellers incorporate formal & informal– Estimates by surveys of experts, guesses based Estimates by surveys of experts, guesses based

on recent history, or stat models e.g.on recent history, or stat models e.g.PI = 1 + 0.4*infl(-1 month) + 0.2*(-2 months) + 0.15*(-3 PI = 1 + 0.4*infl(-1 month) + 0.2*(-2 months) + 0.15*(-3 months)months)

Evidence on Inflation & Evidence on Inflation & RatesRates

Regression EvidenceRegression Evidence

R-Square indicates the % of R-Square indicates the % of the changes in the given the changes in the given rate that can be attributed rate that can be attributed to predicted inflationto predicted inflation

Slope indicates whether the Slope indicates whether the relationship is 1:1 – e.g.relationship is 1:1 – e.g.

0.95 means that the T-bill 0.95 means that the T-bill rate goes up about .95% rate goes up about .95% for each 1% increase in for each 1% increase in predicted inflationpredicted inflation

Rate= constant + slope*Predicted InflationRate Slope R-SquareRFFUNDS 1.17 0.51RTB3m 0.95 0.49RCPR1M 1.01 0.41RTB1Y 1.00 0.48RTB10Y 0.77 0.37RAAA 0.71 0.33RBBB 0.80 0.33

Differences in Rates Due to InflationDifferences in Rates Due to Inflation

Predicted inflation more closely Predicted inflation more closely related to and closer to 1:1 for related to and closer to 1:1 for short term ratesshort term rates

Predicted Monthly Inflation & Rates (Fed Funds; 30-year Mortagage) 1960-2004

Market Influences on Real RatesMarket Influences on Real Rates(Economy-Wide Level)(Economy-Wide Level)

Analytics: risk; income growth; timeAnalytics: risk; income growth; time– Income growth influences demand & supplyIncome growth influences demand & supply– Timing of income growth influence a keyTiming of income growth influence a key– Measuring economy wide riskMeasuring economy wide risk

Bbb Rate – Aaa RateBbb Rate – Aaa Rate

0.0

0.5

1.0

1.5

2.0

2.5

3.0

-1

0

1

2

3

4

5

6

7

60 65 70 75 80 85 90 95 00

Risk Premium Real GDP Growth (smoothed)

Risk Premium (Moody's Aaa - Bbb Rates) & Real GDP Growth

Real Rate MovementsReal Rate Movements

Real 10-year T-Bond Rate MovementsReal 10-year T-Bond Rate Movements– Monthly data 1960-2004Monthly data 1960-2004

TB10 Rate = 0.03* above avg. (3.1%) growthTB10 Rate = 0.03* above avg. (3.1%) growth+ 0.5*(Bbb – Aaa rate)+ 0.5*(Bbb – Aaa rate)

Implies 1% additional growth raises TB10 by 3 basis ptsImplies 1% additional growth raises TB10 by 3 basis ptsImplies 1% additional risk premium raises TB10 by 5 basis Implies 1% additional risk premium raises TB10 by 5 basis

ptspts

Market Influences on Real RatesMarket Influences on Real Rates(Individual Business Loan Level)(Individual Business Loan Level)

Analytics: income potential (profitability) Analytics: income potential (profitability) and risk measuresand risk measures– Profitability (Past-expected Return on Assets)Profitability (Past-expected Return on Assets)– RiskRisk

Default-Credit (Debt/Equity, …)Default-Credit (Debt/Equity, …)Liquidity (ST assets/ST liabilities, …)Liquidity (ST assets/ST liabilities, …)Term (length of loan)Term (length of loan)

MethodsMethods– Simple: use thresholdsSimple: use thresholds– Complex: use “scoring” or “likelihood” Complex: use “scoring” or “likelihood”

producing statistical methods such as producing statistical methods such as regression, discriminant analysis, …regression, discriminant analysis, …

Why Rates DifferWhy Rates Differ

Law of One PriceLaw of One Price– Resale not limited by law or productResale not limited by law or product– Price Market A = Price Market B + cost differencePrice Market A = Price Market B + cost difference– Implies demand differences are not sufficient to sustain Implies demand differences are not sufficient to sustain

price differences; cost difference (transport; storage; … price differences; cost difference (transport; storage; … and and riskrisk))

SF Fed Article link explains non-risk cost SF Fed Article link explains non-risk cost differentialsdifferentials

Loans of similar nature (risk) and time are very, Loans of similar nature (risk) and time are very, very closely related (see irates.xls)very closely related (see irates.xls)

Because Time (term of loan) is closely intertwined Because Time (term of loan) is closely intertwined with risk, it is a key reason that rates differ with risk, it is a key reason that rates differ

Time & Rate DifferencesTime & Rate Differences

R(short) = R(long) + cost differencesR(short) = R(long) + cost differencesWhat costs/risks differ or may differ depending What costs/risks differ or may differ depending on length of the loan?on length of the loan?– Inflation Inflation – Income growthIncome growth

Yield Curve – graph of rates over timeYield Curve – graph of rates over time– Typically graphing loans that are similar except with Typically graphing loans that are similar except with

regard to length such as Treasury Yield Curve, regard to length such as Treasury Yield Curve, Corporate Aaa Yield Curve, …Corporate Aaa Yield Curve, …

Yield Curve Shape Changes with changes in Yield Curve Shape Changes with changes in views about future inflation & income growthviews about future inflation & income growth

Digging Into the Yield CurveDigging Into the Yield Curve

““Normal” Yield Curve – about a 2% Normal” Yield Curve – about a 2% difference in 3-month & 10-year T-ratesdifference in 3-month & 10-year T-rates

Higher Inflation Expected Near Term?Higher Inflation Expected Near Term?– Flatter or even negative Yield CurveFlatter or even negative Yield Curve

Lower Income growth expected near Lower Income growth expected near term?term?– Flatter or even negative Yield curveFlatter or even negative Yield curve

See website links (Living Yield Curve; See website links (Living Yield Curve; NY Fed for examples and current NY Fed for examples and current situation)situation)

Digging into Yield Curve (con’t)Digging into Yield Curve (con’t)

Difficulties in Interpreting Yield CurveDifficulties in Interpreting Yield Curve– Separating Inflation from other InfluencesSeparating Inflation from other Influences– Expectations are not always correctExpectations are not always correct

Inflation-Indexed Treasury Securities Inflation-Indexed Treasury Securities (TIPS) as way to separate out inflation part (TIPS) as way to separate out inflation part of Yield Curveof Yield Curve– See forwardyields.xls for exampleSee forwardyields.xls for example