Copyright © 2004 by Thomson Southwestern All rights reserved. 8-1 Interest Rates, Exchange Rates and Inflation Theories and Forecasting Chapter 8

Copyright © 2004 by Thomson Southwestern All rights reserved.

8-1

Interest Rates, Exchange Rates and Inflation Theories and Forecasting

Chapter 8


8-2

Part A: Theories of Interest Rates

Interest Rates • A change causes an automatic market repricing

of all fixed interest obligations• Are altered as a major instrument of monetary

policy by central banks to direct the economy• Can be very volatile

Foreign Exchange Rates• A change alters international flows of both

goods and capital• Can be very volatile


8-3

Theories Are Important to Managers

Many decisions made on the basis of forecasts

Need to understand assumptions underlying forecasts and data

Need to understand the reasons why the assumptions are made


8-4

A Historical Look at Interest Rates

See Figures 8.1 and 8.2, pages 268-269Interest Rates Are Constantly Changing and

Have Been Particularly Volatile in Recent Decades.

Interest Rates Generally Fall During Recessions

Interest Rates Incorporate the Real Rate of Interest


8-5

The General Level of Interest Rates

Standard conventions1. Models focus on the determination of the

equilibrium interest rate◦ Economy is rarely in equilibrium◦ Assumption is made that economy is always

moving toward equilibrium2. Models use simplifying assumptions and hope

that critical factors are not omitted3. Focus is on the rate of interest not differences

in rates among various securities


8-6

Loanable Funds TheoryInterest rates are determined by supply and

demand of funds for investmentAssumes open and competitive money and

capital marketsUseful for forecastingMarket participant are borrowers and lenders

• Households or Consumers• Businesses• Governments• The Central Bank• The Foreign Sector


8-7

Households as Suppliers

Time preference for consumptionReward for saving is necessaryCash balances may be held due to

• Transactions demand• Precautionary demand• Speculative demand

Savings necessary due to future needs(e.g. illness, college fund, retirement)


8-8

Business as Suppliers

More often demandersSupply from business affected by

• Available funds◦ Depreciation◦ Retained earnings

• Investment options (real and financial)• Nature of the business• Management philosophy


8-9

Other Supply Factors

The Money Supply• Changed by Federal Reserve System policy• An increase in the money supply increases

funds available for investmentThe Foreign Sector

• Funds are also supplied from participants in other countries

• Supply is affected by interest rates & economic growth in the two countries and other factors

Governments


8-10

The Demand for Loanable Funds

Businesses and households will demand less funds at higher interest rates

Demand by governments is inelastic with respect to interest rates and due to budget deficits

Demand by the foreign sector is due to• Same factors affecting domestic units• Differences in U.S. rates and rates abroad


8-11

Loanable Funds ($)

Inte

rest

Rat

e (%

)

0

(Household + Business +M + Foreign)

SLF

Loanable Funds ($)

SUPPLY OF LOANABLE FUNDS

The supply of loanable funds increases as the expected interest rate increases.

0

(Business +Government + Foreign)

DLFIn

tere

st R

ate

(%)

DEMAND FOR LOANABLE FUNDS

The demand for loanable funds decreases as the expected interest rate increases.


8-12

I*

SLF

DLF

Q*

Loanable Funds ($)

Inte

rest

Rat

e (%

)

0

EQUILIBRIUM RATE OF INTERESTThe equilibrium level of interest rates is the rate at which the quantity of loanable funds demanded equals the quantity of loanable funds supplied.


8-13

Loanable Funds Theory and Interest Rate Forecasting

Changes in Supply or Demand can be caused by• Government Fiscal Policy (determined by

Congress)◦ Federal Budget Deficit◦ Taxation

• Government Monetary Policy (determined by the Federal Reserve System

Supply and demand determine the equilibrium interest rate (price) and equilibrium loanable funds (quantity)


8-14

I'

Inte

rest

Rat

e (%

)

I*

Loanable Funds ($)0

SLF

DLF

DLF'

Higher DLF

0

Inte

rest

Rat

e (%

)

I*

I'

Loanable Funds ($)

SLF

DLF

DLF'

Lower DLF

SHIFTS IN THE DEMAND CURVE AND CHANGES IN THE EQUILIBRIUM RATE OF INTEREST

If the demand for loanable funds increases, the equilibrium interest rate will increase.If the demand for loanable funds decreases, the equilibrium interest rate will fall.


8-15

Inflation and New Financial Innovations Due to Inflation

Variable rate loansVariable rate depositsAdjustable-rate bonds and mortgagesZero-coupon bondsInterest rate swapsInflation-adjusted Treasury securitiesInflation futures contractsOther derivatives


8-16

The Fisher Effect

Explains the relationship between • The nominal interest rate,• The real interest rate, and • Expected inflation

Inflation affects real purchasing power.Investors will demand a higher interest rate

(an inflation premium) for expected lost purchasing power over the period of an investment.


8-17

The Fisher Effect(1 + iN) = (1 + iR)(1 + Expected Inflation Rate)

iN = [(1+iR) )(1 + Expected Inflation Rate)] – 1

where iN is the nominal interest rate demanded

iR is the real rate of return desired

If the real rate of return desired is 2% and expected inflation is 12%, then the nominal rate demanded is:

(1.02)(1.12) - 1 = .1424 or 14.24%


8-18

The real ex post return that investors actually get is given by:

iR = [( + iN)/(1 + Actual Inflation Rate)] – 1

If inflation turned out to be 12%, and the nominal rate was 14.2%, the real ex post return would be:

(1.142)/(1.12) - 1 = .02 or 2%

Real Ex Post Return


8-19

The Fisher effect approximation formula eliminates the cross-products.

iN = iR + Expected Inflation

iR = iN – Expected Inflation

or iN = 2% + 12% = 14%The Fisher effect assumes that the iR remains unchanged.Changes in nominal interest rates are driven by changes in expected inflation.

Expected Inflation Drives Changes in Nominal Interest Rates


8-20

Expected Inflation and the Loanable Funds Theory

Loanable Funds ($)Q*0

iR

iN

Interest Rate (%)

E(INFL)

SLF

SLF”

DLF”

DLF”

Panel B: Inflationary Expectations and the Real Rate of Interest Panel A: Inflation and the

Equilibrium Rate of Interest

Q0

iR’

iR

Interest Rate (%)

SLF

SLF”

DLF”

Q’Loanable Funds ($)


8-21

Evaluation of the Fisher EffectThe theory is based on

• ex ante real rates• ex ante expected inflation

These are not observable, resulting in measurement problems in testing the theory.

Ex post real rates are not stable which suggests that inflationary expectations by investors were consistently incorrect.


8-22

Further Evaluation of the Fisher Theory

Historical RelationshipsMeasurement Problems

• Historical Ex Post Analysis• Interest Rate Behavior Adjustments for

Deflation?Adjusting for the Tax EffectAccuracy of Interest Rate ForecastingProfessional Forecasts Based on the Loanable

Funds Theory


8-23

Adjusting for the Tax EffectIncome taxes are levied on nominal rather than on

real returns. • This suggests that changes in nominal yields will

actually be greater than that predicted by Fisher to compensate for the tax on the inflation premiums.

The nominal rate adjusting for tax effects isiN = [(1 + iR)(1 + Before-Tax Inflation Premium)] – 1where iN= the nominal return before taxes

iR = the real rate expected before taxes


8-24

Calculating Effective Annual Yields on Money Market Securities

Money Market Securities• Maturity less than one year• Generally sold at a discount• Maximum maturity is 360 days• If the yield is calculated in a 365 day year (to

compare yields with capital market securities, it is the coupon equivalent yield

• If the yield is calculated in a 360 day year, it is the bank discount yield


8-25

Coupon Equivalent Yield on Money Market Securities

n

y 365P

P - )(Por Par 0

01

where:P0 = the initial amount investedPar = the par value at maturityP1 = price received if sold before maturityn = the number of days until maturity or sold


8-26

Effective Annual Yield

The equation implicitly assumes that any money received will be reinvested at the given annual rate during the year, resulting in a higher effective rate of return at the end of the year. Hence, y* will be greater than y.

3651*

0

Par (or P ) 1P

ny


8-27

Bank Discount Yield

The yield on money market securities is quoted as a percentage of par. Thus, discount yield (d) will always be lower than the annual yield (y) or the effective annual rate (y*).

0

0

Par - P 360P

dn


8-28

The purchase price of money market securities is found by:

01- (d n)P Par

360

Purchase Price of Money Market Securities


8-29

Find the price, the coupon equivalent yield and the effective annual yield for a 91-day T-bill with a discount yield of 4.425%.

Purchase price of the T-bill

3601)(.04425)(91100% P0 98.8% of par

The price that must be paid for the T-bill with a par value of $10,000 would be $9,888.10.


8-30

Coupon equivalent (annual) yield for the T-bill

91

365%881.98

%881.98%100y 0.04539 or 4.539%

The effective annual yield for the T-bill

1

%881.98%100 91

365

*y .04618 or 4.618%

Yield Calculations


8-31

Differences in Yields for Money Market Securities

Calculating Yields for Negotiable CDs and Fed Funds

1d nP Amount Invested 1360

where:P1 = the amount received at maturity, equal to interest earned at the quoted rate plus the principal or amount investedd = the quoted rate


8-32

Find the effective annual yield on a 180-day CD with a face value of $1 million and a coupon rate of 3.5%.

Amount received at maturity

360)180)(035(.1 million 1$P1 $1.0175 million

The effective annual yield on the CD

180

365*

10175.1y .03581 or 3.581%


8-33

Differences in Yields for Money Market Securities

Default riskLiquidity

Influenced by the size of the secondary market for the particular security.

Denomination sizeMaturity


8-34

Part B: Currency Exchange RatesCompanies doing business in more than one

country face exchange rate riskThe risk that money will be lost solely through

variations in the exchange rate of the two currencies

Direct exchange rate – U.S. dollars per unit of foreign currency

Indirect exchange rate – units of foreign currency per U.S. dollar

Spot rate – rate for immediate currency exchange

Forward rate – rate for an exchange on a future date agreed upon today


8-35

Theories of Exchange Rate Determination

Supply and Demand for Goods and ServicesFloating Exchange Rates as Adjusters for

International Monetary Surpluses and Deficits

Relative Inflation RatesPurchasing Power Parity Theorem

Relative Interest RatesInterest Rate Parity Theorem


8-36

Theories of Exchange Rate Determination

Controlling Inflation for the Euro• Politics Changing the Fiscal Rules

Underpinning the Euro• A Complex Puzzle• The Role of Expectations

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Copyright © 2004 by Thomson Southwestern All rights reserved. 8-1 Interest Rates, Exchange Rates and Inflation Theories and Forecasting Chapter 8