Viney - Financial Markets and Institutions

8/10/2019 Viney - Financial Markets and Institutions

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Week 41

Week Four

Market participants and reasons for trading

Price behaviour The impact of maturity date

The risk and term structures of interest rates

Trading strategies and rate forecasting Viney Chapter 13


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Week 42

Learning Objectives

Explain the reasons for a change in the

Central Bank interest rate policy Describe how changes in official interest

rates affect the rest of the economy

Describe how a yield curve is constructed

Explain the theories that describe how a yieldcurve obtains its shape


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Week 43

Introduction

In most developed economies monetary

policy actions are directed at influencinginterest rates

By understanding what motivates a centralbank in its implementation of interest rates

policy Financial market participants can anticipate

changes in interest rate policy

Lenders and borrowers can make better-informed

decisions


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Week 44

RBA Responsibilities

"It is the duty of the Reserve Bank Board, within the limits of itspowers, to ensure that the monetary and banking policy of theBank is directed to the greatest advantage of the people of

Australia and that the powers of the Bank ... are exercised insuch a manner as, in the opinion of the Reserve Bank Board,will best contribute to:

(a) the stability of the currency of Australia;(b) the maintenance of full employment in Australia; and(c) the economic prosperity and welfare of the people of

Australia." Source http://www.rba.gov.au/MonetaryPolicy/about_monetary_policy.html Monetary policy seeks to achieve this over the medium term,

and subject to that, encourage strong and sustainable growth inthe long-term.
http://www.rba.gov.au/MonetaryPolicy/about_monetary_policy.htmlhttp://www.rba.gov.au/MonetaryPolicy/about_monetary_policy.html


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Week 45

Macroeconomic Context of

Interest Rate Determination

A central bank may increase interest rates if

there is Inflation above three per cent (in Australia)

Excessive growth in GDP

A large deficit in the balance of payments

Rapid growth in credit and debt levels Excessive downward pressure on the domestic

currency


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Week 46

Macroeconomic Context of Interest

Rate Determination (cont.)

An expected increase in interest rates (i.e.tightening of monetary policy) will

Eventually increase long-term rates (if it has notalready done so).

Slow consumer spending Reducing inflation and demand for imports


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Week 47



Effects of changes in interest rates Economic indicators provide market participants

with insight into possible future economic growthand the likelihood of central bank intervention


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Week 48



Economic indicators Leading indicators (Examples??)

Economic series that tend to rise or fall in advance ofthe rest of the economy.

Coincident indicators (Examples ??)

Economic series that change at the same time as therest of the economy.

Lagging indicators (Examples??) Economic series that change after the rest of the

economy.


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Week 49



Economic indicators (cont.)

Difficulties exist with Knowing the extent of the timing lead or lag of such

indicators

Consistently performing indicators e.g. rates of growth inmoney measures were once lead indicators and are now

lagging indicators


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Week 410

So Which Indicators Should you

Watch?

CPI

Unemployment Retail sales

Home sales

New car sales Surveysconsumer or business sentiment,

business investment plans and expectations


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Week 411

Term & Risk Structure of Rates

Definition: the term structure of interest ratesis thespread of yields of a security with a given issuer

across different maturities of that security Known as a YIELD CURVE

Definition: the risk structure of interest ratesis thespread of yields on securities with the same maturityacross different issuers at that maturity


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Week 412

Term Structure of Interest Rates

The yield curve is a chart showing theschedule of yields for various maturities of asecurity


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Week 413

Term Structure - continued

Two basic types of yield curve:normal - upward sloping


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Week 414


inverse - downward sloping


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Week 415


The gap between the yield curves on two securitiesindicates their different credit risk


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Week 416


The term structure affects borrowing and investingstrategies

Example : an investor decides to purchase bondsover a 10-year horizon. From the last chart thechoices include:

1. Buy a single 10-yr bond at 6%

2. Buy a 5-yr bond at 7% then another 5-yr bond3. Buy a 2-yr bond at 8% then four 2-yr bonds

4. Buy a 15-yr bond at 7% and sell after 10 years


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Week 417


The term structure can be used to lock infuture interest rates

Definition: the forward rate is an interest ratewhich is fixed for a future transaction

By a correct combination of spot transactionswe can fix a forward interest rate today


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Week 418


Example: a company knows it will need to borrow$104,000 for a term of one year in exactly twelve

months time and wishes to fix the interest rate inadvance

Solution: assuming the yield curve on the next slidethe forward rate is secured by:

1. borrowing for 2 years at 5%, and

2. investing the proceeds for 1 year at 4%


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Week 419



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Week 420


Example continued: the cash flow from the

borrowing is $110,250/(1.05)

2

= $100,000and the company then invests this at 4% togive $100,000(1.04) = $104,000 in 12months

The net ratio is $110,250/$104,000 = 1.0601.That is, the company has secured a 1-yearforward rate of 6.01%.

We observe that (1.0601)1= (1.05)2/(1.04)1


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Week 421


Generalising from the above example: the

forward interest rate rx.yon a security thatcommences in year x and matures in year ycan be found by combining spot rates:

(rx,y)1= (1 + r0,y)

y / (1 + r0,x)x

E.g. if the 3-year spot is 6% and 2-year spotis 5% then (1+r2,3)

1= (1.06)3 / (1.05)2 =1.0803


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Week 422

Term Structure

Theories : PET

Pure Expectations Theory (PET) says the shape ofthe yield curve is determined solely by market

interest rate expectations Assumptions:

- no transactions costs

- investors view securities with different

maturities as perfect substitutes- long dated securities carry same risk as short

dated securities


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Week 423

Theories of the Term Structure

PET continued

Implications of PET:

upward sloping yield curve always means themarket expects rising future rates

investing a single n-year bond will yield thesame return as n 1-year bonds

observed forward rates equal (unobservable)expected future spot rates

the term structure embodies predictions of

future spot rates


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Week 424


PET continued

Empirical evidence:

PET explains the phenomenon ofinverse yield curves

The role of expectations helps explain

volatility in yield curves The yield curve can often predict the

economic cycle


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Week 425

Term Structure

Theories : LPT

Liquidity Premium Theory (LPT) sayscompensation is included in longer termyields to reward investors for tying theirmoney up for extended periods

Longer dated bonds therefore contain a riskpremium

E.g: if the expected future rate is 6% and therisk premium is 1%, the forward rate is 7%


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Week 426


LPT continued

Implications of LPT:

the yield curve should slope upwards moreoften than downwards

investing in consecutive short term bonds willnot provide same return as investing in a

single long term bond implied forward rates are greater than

expected future spot rates

the term structure cannot tell us much


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Week 427

Term Structure

Theories : SMT

Segmented Markets Theory (SMT) says themarkets for different maturities of a securityare segmented so that the yield on eachmaturity is determined by supply anddemand in that maturity band

Bond markets are seen as dominated bylarge institutional players with preferences forcertain maturities


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Week 428


SMT continued

Implications of Segmented Markets Theory

An upward sloping yield curve is due toexcess demand for short term securitiesand/or excess supply of long term ones

The yield curve contains no informationabout the markets expectations


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Week 429

Term Structure

Theories : PHT

Preferred Habitat Theory (PHT) combinesPET, LPT and SMT

Investors have a preferred habitat (SMT),demand a premium to move out of this

maturity (LPT) and base their decisions onexpected future spot rates (PET)


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Week 430

Risk Structure of Interest Rates

The yield spread is the gap between theyields on two securities with the samematurity but different issuers

Three factors influence the yield spread:

Credit risk

Liquidity Supply of securities


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Week 431

Risk Structure - continued

Credit risk is the risk that a borrower will notrepay the interest and/or principal on a debt.

Also known as default risk.

CGS are regarded by the market as havingzero default risk

Private sector bonds have non-zero defaultrisk, reflected in a risk premium over CGS


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Week 432

Risk Structure - continued

Credit Ratings measure the likelihood ofdefault and are made by an independent

rating agency Ratings are based on factors such as the

issuers financial accounts, managementquality and strategic direction

Ratings allow the market to price paper forcredit risk


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Week 433

Risk structure - continued


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Week 434


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Week 435


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Week 436

Conclusion

This lecture has covered

The role of the Central Bank in the interest ratemarkets

The factors that influence the Central Bank

Term structure of interest ratesyield curve

Risk structure of interest rates.


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W k 437

Week Five

The roles of government in the financialmarkets

Reasons for borrowing by government.

The dual role of the central bank - monetarymanagement and financial stability.

The implementation of monetary policy. The relationship between the central bank

and government

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Viney - Financial Markets and Institutions