POOJA KARVAT

A21

NAITIK MODI
PANKAJ SHARMA

A25
A43

SHAILESH BAJAJ
BHAVIN VYAS

PG66
A60

SHUBHANGI SHRINIVASAN

B53

Objectives
Explain The Concepts, Like Pure And Gross Interest Rates, Bond Price Etc

Summarise The Important Theories Of Term Structure Of

Interest Rates Identify The Factors Influencing Market Interest Rates Describe The Effects Of Changes In Interest Rates

Introduction Types Real vs. Nominal Yield Curve

Interest Rates

What do we call the price, or cost, of debt capital?

The interest rate What do we call the price, or cost, of equity capital?
Required Dividend Capital return = yield + gain

Introduction Types Real vs. Nominal Yield Curve

Types Of Interest Rates

Simple & Compound Fixed & Floating

Pure Interest Rate

Gross Interest Rate

Payment For Risk Payment For Inconvenience Payment For Management

Payment For Exclusive Use Of Money

Introduction Types Real vs. Nominal Yield Curve

Real And Nominal Interest Rates

Introduction Types Real vs. Nominal Yield Curve

Real And Nominal Interest Rates

Nominal Interest Rate = Real Interest Rate + Expected Inflation Where Nominal Rate Is Advertised Market Rate Real Rate Is Extra Purchasing Power Lender Demands Of Borrower.

Real And Nominal Interest Rates

a) In zero inflation world, if M&Ms cost $1.00 and you lend $10.00, youre lending 10 bags of M&Ms b) If you want a real return of 10%, you need 11 bags so you charge 10% interest and get $11.00 back c) If inflation is 20%, then you need $1.20 x 11 = $13.20 back to buy 11 bags and get your 10% real return. This means you must charge a nominal rate of 32% d) 32% = 10% + 20% + 2% Nominal real expected Rate = rate + inflation + real rate inflation Conclusion Two fundamental determinants of interest rates are strength of economy expected (not past) inflation

Introduction Types Real vs. Nominal Yield Curve

What four factors affect the level of interest rates?

Production opportunities Time preferences for consumption Risk Expected inflation

Introduction Types Real vs. Nominal Yield Curve

Determinants of Interest Rates

R = r* + IP + DRP + LP + MRP

R = required return on a debt security r* = real risk-free rate of interest IP = inflation premium

DRP = default risk premium

LP = liquidity premium MRP = maturity risk premium

Introduction Types Real vs. Nominal Yield Curve

Fishers Classical Approach

Fisher Effect: creating to much money causes more money chasing some amount of goods. So, price of goods goes up. But if price increases cause inflation, interest rates will rise!

So, Money Inflation Interest Rates

Fisher Equation : i = real rate + expected inflation

Introduction Types Real vs. Nominal Yield Curve

Fishers Classical Approach

Supply of Savings Marginal rate of time preference Income Reward for saving Demand for Borrowed Resources Marginal productivity of capital Rate of interest Equilibrium Rate of Interest

Introduction Types Real vs. Nominal Yield Curve

Fishers Law
Nominal Rate of Interest (i) Real Rate of Interest (r) Premium for Expected Inflation (p) Fishers Law (1 + i) = (1 + r)(1 + p) or i=r+p

Changes in

e :

the Fisher Effect

If e 1. Relative RETe , Bd shifts in to left 2. Bs , Bs shifts out to right 3. P , i

INTEREST RATE MECHANICS

Bond prices and interest rates move in opposite directions
If bond prices rise, interest rates on those bonds fall.

If bond prices fall, interest rates on those bonds rise. Q. If interest rates equal 10%, what would you pay for a zero coupon bond that pays $100 one year from now? A. About $91 (because your interest income would be $9 and $9/91 as about 10%).

Q. If interest rates equal 1%, what would you pay for the same bond? A. About $99 So, Interest Rate 10% 1% Price $91 $99

INTEREST RATE MECHANICS

Suppose you have a 4% bond with
Face Value Coupon $100 $4

If it sells for $100, its current return is 4% ($4/$100). Now suppose interest rates in the economy go up to 8%! Would someone pay you $100 for this bond? No, because if Price = $100 and coupon = $4, the return is 4%, not 8%. What would someone pay? About $96.00 because

$4 coupon $4 capital gain $96

(about ) 8%

Discount vs. Yield Suppose you pay $90 for one year T-bill that returns $100 face value in one year.

Interest $10 Yield (roughly) 11% Price $90

But the amount below face that the bill sold for (i.e. its Discount price) is Amt Below Face $10 Discount 10% Face Value $100

Determinants of Asset Demand

Supply and Demand Analysis of the Bond Market

Market Equilibrium 1. Occurs when B = B , at P* = $850, i* = 17.6% 2. When P = $950, i = 5.3%, B > d B (excess supply): P to P*, i to i* 3. When P = $750, i = 33.0, B > s B (excess demand): P to P*, i to i*
d s d s

Shifts in the Bond Demand Curve

1. Wealth

Factors that Shift the Bond Demand Curve

A. Economy grows, wealth , Bd , Bd shifts out to right

2. Expected Return
A. i in future, Re for long-term bonds , Bd shifts out to right B. e , Relative Re , Bd shifts out to right C. Expected return relative to other assests , Bd , Bd shifts out to right

3. Risk
A. Risk of bonds , Bd , Bd shifts out to right B. Risk of other assets , Bd , Bd shifts out to right

4. Liquidity
A. Liquidity of Bonds , Bd , Bd shifts out to right B. Liquidity of other assets , Bd , Bd shifts out to right

Shifts in the Bond Supply Curve

1. Profitability of Investment Opportunities Business cycle expansion, investment opportunities , Bs , Bs shifts out to right 2. Expected Inflation e , Bs , Bs shifts out to right 3. Government Activities Deficits , Bs , Bs shifts out to right

Factors that Shift the Bond Supply Curve

1. Profitability of Investments
A. Profitability , Bs , Bs shifts out to right

2. Expected Inflation
A. i , Bs , Bs shifts out to right

3. Government Deficit
A. Government Deficit Increases , Bs , Bs shifts out to right

Introduction Types Real vs. Nominal Yield Curve

BOND PRICE AND YIELD TO MATURITY

Internal Factors :
Business risk Financial Risk External Factors : Purchasing Power Risk Real Return/Nominal Return Market Risk

Yield Spread

Introduction Types Real vs. Nominal Yield Curve

BOND PRICE AND YIELD TO MATURITY

Real Return/Nominal Return

Assume That A Saving Deposit Earns A Nominal Interest Rate Of 5% During One-year Period. Thus, If Rs. 100 Are Deposited, It Would Grow To 100 (1 + 0.05) = Rs 105

Inflation @ 5%
100 (1.0 + 0.05/ 1.0 + 0.05) = Rs. 100

What is the term structure of interest rates? What is a yield curve?

Term Structure: The Relationship Between Interest Rates (Or Yields) And Maturities.

A Graph Of The Term Structure Is Called The Yield Curve.

Yield Curve Construction

Step 1:Find the average expected inflation rate over Years 1 to n:

INFL
IPn =
t 1

Suppose, that inflation is expected to be 5% next year, 6% the following year, and 8% thereafter.
IP1 = 5%/1.0 = 5.00%. IP10 = [5 + 6 + 8(8)]/10 = 7.50%.

IP20 = [5 + 6 + 8(18)]/20 = 7.75%.

Step 2: Find MRP Based on This Equation: MRPt = 0.1%(t 1).

MRP1 MRP10 MRP20 = 0.1% x 0 = 0.1% x 9 = 0.1% x 19 = 0.0%. = 0.9%. = 1.9%.

Step 3: Add the IPs and MRPs to k*:

kRFt = k* + IPt + MRPt .

kRF= Quoted market interest rate on treasury securities.

Assume k* = 3%:

kRF1 = 3.0% + 5.0% + 0.0% = 8.0%. kRF10 = 3.0% + 7.5% + 0.9% = 11.4%. kRF20 = 3.00% + 7.75% + 1.90% = 12.65%.

Hypothetical Treasury Yield Curve

Interest Rate (%)
15
Maturity risk premium

1 yr 10 yr 20 yr

8.0% 11.4% 12.65%

10

Inflation premium

5
Real risk-free rate

0 1 10

Years to Maturity
20

Factors that Shift Supply Curve for Bonds Measures Of Money Supply

M1, M2, M3 and M4. Controlling Inflation In order to control the money supply, regulators have to decide which particular measure of the money supply to target .

Factors that Shift Supply Curve for Bonds M1

One Measure Of The Money Supply That Includes All Coins Currency Held By The Public + Travelers Cheque + Checking Account Balances + New Account Transfers Service Accounts

M1 consists of the most highly liquid assets. That is, M1 includes all forms of assets that are easily exchangeable as payment for goods and services. It consists of coin and currency in circulation, traveler's checks, demand deposits, and other checkable deposits

Factors that Shift Supply Curve for Bonds M2

M1

Savings And Small Time Deposits Overnight Repos At Commercial Banks

Non-institutional Money Market Accounts

M2 is a broader measure of money than M1. It includes all of M1, the most liquid assets, and a collection of additional assets that are

slightly less liquid. These additional assets include savings

accounts, money market deposit accounts, small time deposits and retail money market mutual funds.

Factors that Shift Supply Curve for Bonds M3

M2

Plus Large Time Deposits

Institutional Money Market Institutions

M3 is an even broader definition of the money supply, including M2 and other assets even less liquid than M2. As the number gets larger, 1 2 3, the assets included become less and less liquid.

Factors that Shift Supply Curve for Bonds M4 M3

Total Post Office Deposits

FIXED RATE MORTGAGE

DEFINITIONS
LOAN The act of lending; a grant of the temporary use of something: the loan of a book. Something lent or furnished on condition of being returned, a sum of money lent at interest: a $5000 loan at 10 percent interest for 2 years. MORTGAGE Conveyance of the conditional right of ownership (lien) on an asset or property by its owner (the mortgagor) to a lender (the mortgagee) as security for a loan.

TYPES OF MORTGAGE
The 2 basic types are: 1) Fixed rate mortgage (FRM). 2) Adjustable rate mortgage (ARM) (also known as Floating Rate or Variable Rate Mortgage). Combinations of fixed and floating rate are also available.

FIXED RATE MORTGAGE

A fixed rate mortgage (FRM) is a mortgage loan where the interest rate on the note remains the same through the entire term of the loan, as opposed to loans where the interest rate may adjust or float.

DETERMINANTS OF MORTGAGE INTEREST RATES

MORTGAGE INTEREST RATES ARE BASED ON A DERIVED DEMAND -- THE DEMAND FOR HOUSING AND SUPPLY SIDE FACTORS. NOMINAL INTEREST RATE (Contract Rate). The nominal interest rate is simply the interest rate stated on the loan or investment

agreement.
REAL INTEREST RATE.

An interest rate that has been adjusted to remove the effects of inflation to reflect the real
cost of funds to the borrower, and the real yield to the lender. REAL INTEREST RATE = NOMINAL INTEREST RATE INFLATION.

DETERMINANTS OF MORTGAGE INTEREST RATES

Interest Rate Risk. Default Risk. Prepayment Risk.

MORTGAGE PAYMENT PATTERNS

Constant Amortization Mortgage (CAM)

Constant Payment Mortgage (CPM)

Graduated Payment Mortgage (GPM)

Constant Amortization Mortgage (CAM)

Amortization - the process of loan repayment over

time.
Constant amortization of principal.

Interest computed on Outstanding Loan Balance (OLB).

Changing monthly payments.

Monthly payment = Constant amortization of

principal + interest due on OLB.

EXAMPLE

$100,000 LOAN, 10% INTEREST, 30 YEARS (360 PAYMENTS) MONTH 1 PAYMENT = 100,000/360 = 277.78 +100,000(.10/12)= 833.33 = $1,111.11 MONTH 2 PAYMENT = 277.78 + ((100,000-277.78)(.10/12) = 277.78 + 827.69 = $1,105.47

Constant Payment Mortgage (CPM)

Monthly payment is constant over life of loan Portion of payment that is principal versus interest changes every month Easier to qualify than CAM because initial payment is low Monthly payment = original loan amt*[r/1-(1+r)^(-n)] where, r interest rate n total number of installments.

EXAMPLE

$100,000 LOAN, 10% INTEREST, 30 YEARS (360 PAYMENTS) Monthly payment = 100000*[(0.10/12)/1-(1+0.10/12)^(-360)] = $877.57

CAM V/S CPM

Graduated Payment Mortgage (GPM)

low initial monthly payments which gradually increase over a specified time frame. For those who cannot afford large payments initially, but can realistically expect to do better financially in the future. For example, a borrower may have a 30-year graduated payment mortgage with monthly payments that increase by 7 % every year for five years. At the end of five years, the increment stops. The borrower would then pay this new increased amount monthly for the rest of the 25-year loan term.

CAM V/S CPM V/S GPM

Term structure
Liquidity preference theory

THE TERM STRUCTURE OF INTEREST RATES

Expectations theory
Market segmentations theory

The term structure of interest rates or the yield curve compares the interest rates on securities ,assuming all the characteristics except maturity are the same There are two types of yield curves Normal yield curve Inverted yield curve

Term structure
Liquidity preference theory Liquidity preference theory

TERM STRUCTURE OF INTEREST RATES

Expectations theory
Market segmentations theory

YIELD TO MATURITY

YIELD TO MATURITY

TIME TO MATURITY NORMAL YIELD CURVE

TIME TO MATURITY

INVERTED YIELD CURVE

Liquidity Term preference structuretheory

Liquidity preference Motives theory

LIQUIDITY PREFERENCE THEORY OF INTEREST

M Liquidity Expectations preference theory curve Liquidity trap Market segmentations theory

People prefer absolute liquidity to other forms of wealth in the short run Determination of interest rate is dependent upon the demand for and supply of money in the economy

Liquidity preference Peoples fondness for cash or liquid money

Liquidity preference theory Liquidity preference theory Motives Motives M Liquiditypreference preference curve Liquidity curve

MOTIVES

Liquidity trap The liquidity trap Transaction motive Demand for liquid money to carry out day-to-day transactions Factors Income earned Time period between the successive receipts of income Spending habits T=f(i) Precautionary motive Demand for liquidity to safeguard their future Factors Size of the income Nature of the people P=f(i) T+P=M1f(i)

Liquiditypreference preference theory Liquidity theory Motives Motives M Liquiditypreference preference curve Liquidity curve

MOTIVES

Liquidity trap The liquidity trap

Speculative motive Stocking cash to take the advantage of the changes in price levels of securities and bonds Interest rate differs inversely with the liquidity preference for speculative motives M2=f(int) The liquidity preference curve

Liquidity preference theory Motives M Liquidity preference curve Liquidity trap

THE LIQUIDITY PREFERENCE CURVE

i Rate Of Interest a i1 b lpc

O
S0 S1 S2

Demand for money for Speculative Motive

Liquidity preference theory Motives M Liquidity preference curve Liquidity trap THE LIQUIDITY TRAP

There is certain limit below which the interest rate cannot fall
The portion where the interest rate remains same even if there is increase in supply of money The rate of interest cannot be zero AD=M1+M2

Liquidity preference theory Liquidity preference theory Money supply Money supply M Determination

MONEY SUPPLY
S

Rate Of Interest

S The Supply Curve

Liquiditypreference preference theory Liquidity theory Money supply Money supply M Determination

DETERMINATION OF INTEREST RATE

S

a Rate Of Interest i1 i i2 b e b1 a1 lpc

S Demand and Supply of Money

Liquiditypreference preference theory Liquidity theory Money supply Money supply M Determination

SHIFT IN LIQUIDITY PREFERENCE CURVE

Rate Of Interest

i1 i i2

e1 e e2 lpc1 lpc

lpc2 o s
Demand and Supply of Money

Theory
Equilibrium
Mathematical Equation Construction of Yield Curve

Unbiased expectations theory

The markets current expectations of future short term rates.

Eg:- Investor having 5 year horizon Current 5 year bond or Five successive 1 year bond In Mathematical Equation, each interest rate has two subscripts. Period in which the security is bought. Maturity on the security. Eg:- 1R5, 2ER1

Theory

Equilibrium
Mathematical Equation Construction of Yield Curve

Unbiased expectations theory

Return on bonds having long term maturity = return on successive bonds of

short term maturity. If not there exists an arbitrage opportunity.

EG:Conclusion: Rising curve Constant curve Falling curve

Theory Equilibrium Mathematical Equation

Construction of Yield Curve

Unbiased expectations theory

Theory says that current long term interest rates are the averages of current &
expected future short term rates. Mathematical equation:
1RN
1RN

= [1R1+E(2r1)+E(3r1)+E(Nr1)]/N

= Actual N period rate today

N = Term to maturity
1R1

= Actual current 1 year rate today

Theory Equilibrium Mathematical Equation

Construction of Yield Curve

Unbiased expectations theory

1R1

= 1.94%, E(2r1)= 3.00%, E(3r1) = 3.74%, E(4r1) = 4.10%

1RN

= [1R1+E(2r1)+E(3r1)+E(Nr1)]/N

Theory
Yield curve

Market segmentation theory

Individual investors & financial institutions have different maturity preference. Relationship between short & long term rates are independent.

Securities having different maturities are not considered as substitutes.

Demand & supply are determined by nature of their liability. For eg: Insurance firms, Banks, etc.

Hence demand supply of each of this segment helps determine the interest
rate in each of this segment.

Theory

Yield curve

Market segmentation theory

Upward sloping curve.

Downward sloping curve.

Forecast interest rates

Forecast recessions

Uses of The Term Structure

Investment and financing decisions

The market provides a consensus forecast of expected future interest rates Short term or long term

Forecast interest rates

Forecast recessions

Uses of The Term Structure

Investment and financing decisions

Flat or inverted yield curves have been a good predictor of

recessions.

Forecast interest rates

Forecast recessions

Uses of The Term Structure

Investment and financing decisions

Lenders/borrowers attempt to time investment / financing

based on expectations shown by the yield curve.

FACTORS AFFECTING INTEREST RATES

Economic Conditions Expected Rate of Inflation Savings by Individuals

Continued
Monetary Policy Bank Rate
Open Market Operations

Cash Reserve Ratio

Supply of Money