R GLENN HUBBARD ANTHONY PATRICK O’BRIEN Money, Banking, and the Financial System © 2012 Pearson Education, Inc Publishing as Prentice Hall CHAPTER Determining Interest Rates LEARNING OBJECTIVES After studying this chapter, you should be able to: 4.1 Discuss the most important factors in building an investment portfolio 4.2 4.3 Use a model of demand and supply to determine market interest rates for bonds Use the bond market model to explain changes in interest rates 4.4 Use the loanable funds model to analyze the international capital market © 2012 Pearson Education, Inc Publishing as Prentice Hall CHAPTER Determining Interest Rates IF INFLATION INCREASES, ARE BONDS A GOOD INVESTMENT? •Recently, interest rates on U.S Treasury notes and corporate bonds have been falling relative to their 30-year averages •If interest rates on these securities rose back to their historical averages, holders of bonds would suffer losses •Not surprisingly, many financial advisers have warned investors that buying bonds could be risky •In this chapter, we study how investors take into account expectations of inflation, as well as other factors, such as risk and information costs, when making investment decisions •An Inside Look at Policy on page 116 discusses movements in interest rates during 2010 © 2012 Pearson Education, Inc Publishing as Prentice Hall Key Issue and Question Issue: Federal Reserve policies to combat the recession of 2007– 2009 led some economists to predict that inflation would rise and make long-term bonds a poor investment Question: How investors take into account expected inflation and other factors when making investment decisions? © 2012 Pearson Education, Inc Publishing as Prentice Hall Learning Objective Discuss the most important factors in building an investment portfolio 4.1 © 2012 Pearson Education, Inc Publishing as Prentice Hall of 56 The Determinants of Portfolio Choice The determinants of portfolio choice, sometimes referred to as determinants of asset demand, are: 1.The saver’s wealth or total amount of savings to be allocated among investments The expected rate of return from an investment compared with the expected rates of return on other investments The degree of risk in the investment compared with the degree of risk in other investments The liquidity of the investment compared with the liquidity of other investments The cost of acquiring information about the investment compared with the cost of acquiring information about other investments How to Build an Investment Portfolio © 2012 Pearson Education, Inc Publishing as Prentice Hall of 56 Wealth In general, when we view financial markets as a whole, we can assume that an increase in wealth will increase the quantity demanded for most financial assets Expected Rate of Return Expected return The return expected on an asset during a future period; also known as expected rate of return We calculate the expected return on an investment using this formula: Expected return = [(Probability of event occurring) X (Value of event 1)] + [(Probability of event occurring) X (Value of event 2)] For example, with equal probability of a rate of return of 15% or a rate of return of 5%: Expected return = (0.50)(15%) + (0.50)(5%) = 10% How to Build an Investment Portfolio © 2012 Pearson Education, Inc Publishing as Prentice Hall of 56 Risk Risk The degree of uncertainty in the return on an asset • For example, if there is a probability of 50% that a bond will have a return of 12% or a probability of 50% that the bond will have a return of 8%, then the expected return on the bond is (0.50)(12%) + (0.50)(8%) = 10% • Most investors are risk averse, which means that in choosing between two assets with the same expected returns, they would choose the asset with the lower risk For this reason, there is a trade-off between risk and return • There are also risk-loving investors who prefer to hold risky assets with the possibility of maximizing returns, and risk-neutral investors, who make their decisions on the basis of expected returns, ignoring risk How to Build an Investment Portfolio © 2012 Pearson Education, Inc Publishing as Prentice Hall of 56 Making the Connection Fear the Black Swan! • The table below illustrates the trade-off between risk and return • Investors in stocks of small companies during these years experienced the highest average returns but also accepted the most risk • Investors in U.S Treasury bills experienced the lowest average returns but also the least risk • The term black swan event refers to rare events that have a large impact on society or the economy Some economists see the financial crisis as a black swan event because before it occurred, few believed it was possible How to Build an Investment Portfolio © 2012 Pearson Education, Inc Publishing as Prentice Hall of 56 Liquidity • We saw in Chapter that liquidity is the ease with which an asset can be exchanged for money • The greater an asset’s liquidity, the more desirable the asset is to investors The Cost of Acquiring Information • All else being equal, investors will accept a lower return on an asset that has lower costs of acquiring information We can summarize our discussion of the determinants of portfolio choice by noting that desirable characteristics of a financial asset cause the quantity of the asset demanded by investors to increase, and undesirable characteristics of a financial asset cause the quantity of the asset demanded to decrease How to Build an Investment Portfolio © 2012 Pearson Education, Inc Publishing as Prentice Hall 10 of 56 Solved Problem 4.3 (continued) Why Worry About Falling Bond Prices When the Inflation Rate Is Low? Solving the Problem Step Answer part (b) by discussing the difference in the effects of actual and expected inflation on changes in bond prices Changes in bond prices result from changes in the expected rate of inflation If Tedford was correct that future inflation was going to be significantly higher, investors would be wise to sell bonds right away Waiting until the nominal interest rate had risen and bond prices had fallen would be too late to avoid the capital losses from owning bonds Step Explain why long-term bonds are a particularly bad investment if expected inflation increases An increase in expected inflation will increase the nominal interest rate on both short-term and long-term bonds The longer the maturity of a bond, the greater the change in price So, the capital losses on long-term bonds will be greater than the ones on short-term bonds The Bond Market Model and Changes in Interest Rates © 2012 Pearson Education, Inc Publishing as Prentice Hall 42 of 56 Learning Objective Use the loanable funds model to analyze the international capital market 4.4 © 2012 Pearson Education, Inc Publishing as Prentice Hall 43 of 56 In the loanable funds approach, the borrower is the buyer because the borrower purchases the use of the funds The lender is the seller because the lender provides the funds being borrowed Although the demand and supply of bonds approach and the loanable funds approach are equivalent, the loanable funds approach is more useful when looking at the flow of funds between the U.S and foreign financial markets Table 4.4 summarizes the two views of the bond market The Loanable Funds Model and the International Capital Market © 2012 Pearson Education, Inc Publishing as Prentice Hall 44 of 56 The Demand and Supply of Loanable Funds Figure 4.8 The Demand for Bonds and the Supply of Loanable Funds In panel (a), the bond demand curve, Bd, shows a negative relationship between the quantity of bonds demanded by lenders and the price of bonds, all else being equal In panel (b), the supply curve for loanable funds, Ls, shows a positive relationship between the quantity of loanable funds supplied by lenders and the interest rate, all else being equal.• The Loanable Funds Model and the International Capital Market © 2012 Pearson Education, Inc Publishing as Prentice Hall 45 of 56 The Demand and Supply of Loanable Funds Figure 4.9 The Supply of Bonds and the Demand for Loanable Funds In panel (a), the bond supply curve, Bs, shows a positive relationship between the quantity of bonds supplied by borrowers and the price of bonds, all else being equal In panel (b), the demand curve for loanable funds, Ld, shows a negative relationship between the quantity of loanable funds demanded by borrowers and the interest rate, all else being equal.• The Loanable Funds Model and the International Capital Market © 2012 Pearson Education, Inc Publishing as Prentice Hall 46 of 56 Equilibrium in the Bond Market from the Loanable Funds Perspective Figure 4.10 Equilibrium in the Market for Loanable Funds At the equilibrium interest rate, the quantity of loanable funds supplied by lenders equals the quantity of loanable funds demanded by borrowers At any interest rate below the equilibrium, there is an excess demand for loanable funds At any interest rate above equilibrium, there is an excess supply of loanable funds The behavior of lenders and borrowers pushes the interest rate to 4.2%.• The Loanable Funds Model and the International Capital Market © 2012 Pearson Education, Inc Publishing as Prentice Hall 47 of 56 The International Capital Market and the Interest Rate The foreign sector influences the domestic interest rate and the quantity of funds available in the domestic economy The loanable funds approach provides a good framework for analyzing the interaction between U.S and foreign bond markets Closed economy An economy in which households, firms, and governments not borrow or lend internationally Open economy An economy in which households, firms, and governments borrow and lend internationally The Loanable Funds Model and the International Capital Market © 2012 Pearson Education, Inc Publishing as Prentice Hall 48 of 56 Small Open Economy Small open economy An economy in which total saving is too small to affect the world real interest rate The key ideas to remember about a small economy are as follows: •The real interest rate in a small open economy is the same as the interest rate in the international capital market •If the quantity of loanable funds supplied domestically exceeds the quantity of funds demanded domestically at that interest rate, the country invests some of its loanable funds abroad •If the quantity of loanable funds demanded domestically exceeds the quantity of funds supplied domestically at that interest rate, the country finances some of its domestic borrowing needs with funds from abroad The Loanable Funds Model and the International Capital Market © 2012 Pearson Education, Inc Publishing as Prentice Hall 49 of 56 Small Open Economy Figure 4.11 Determining the Real Interest Rate in a Small Open Economy The domestic real interest rate in a small open economy is the world real interest rate, (rw), which in this case is 3%.• The Loanable Funds Model and the International Capital Market © 2012 Pearson Education, Inc Publishing as Prentice Hall 50 of 56 Large Open Economy Large open economy An economy in which shifts in domestic saving and investment are large enough to affect the world real interest rate In the case of a large open economy, we cannot assume that the domestic real interest rate is equal to the world real interest rate The Loanable Funds Model and the International Capital Market © 2012 Pearson Education, Inc Publishing as Prentice Hall 51 of 56 Figure 4.12 Determining the Real Interest Rate in a Large Open Economy Saving and investment shifts in a large open economy can affect the world real interest rate The world real interest rate adjusts to equalize desired international borrowing and desired international lending At a world real interest rate of 4%, desired international lending by the domestic economy equals desired international borrowing by the rest of the world.• The Loanable Funds Model and the International Capital Market © 2012 Pearson Education, Inc Publishing as Prentice Hall 52 of 56 Making the Connection Did a Global “Saving Glut” Cause the U.S Housing Boom? Some economists have argued that the Fed persisted in a low-interest-rate policy for too long a period, thereby fueling the housing boom Fed Chairman Ben Bernanke disagreed, arguing that “a significant increase in the global supply of saving—a global saving glut— helps to explain the relatively low level of long-term interest rates in the world today.” The Loanable Funds Model and the International Capital Market © 2012 Pearson Education, Inc Publishing as Prentice Hall 53 of 56 Answering the Key Question At the beginning of this chapter, we asked the question: “How investors take into account expected inflation and other factors when making investment decisions?” We have seen in this chapter that investors increase or decrease their demand for bonds as a result of changes in a number of factors When expected inflation increases, investors reduce their demand for bonds because, for every nominal interest rate, the higher the inflation rate, the lower the real interest rate investors will receive We have seen that increases in expected inflation lead to higher nominal interest rates and capital losses for investors who hold bonds in their portfolios © 2012 Pearson Education, Inc Publishing as Prentice Hall 54 of 56 AN INSIDE LOOK AT POLICY Investors Forecast Lower Bond Prices, Higher Interest Rates Wall Street Journal, Interest Rates Have Nowhere to Go but Up Key Points in the Article • As the U.S economy recovered from recession in 2010, analysts forecast a period of rising interest rates • Higher interest rates would damage the housing market, which had begun to recover from the recession • Analysts expected interest rate increases because the federal government was forced to sell more bonds to finance its budget deficits, and the rate of inflation was likely to increase • Because low interest rates helped to fuel the growth of stock prices, higher interest rates were likely to slow the growth of stock prices in the future • The figure in the next slide shows the impact of an increase in expected inflation on the markets for bonds and loanable funds © 2012 Pearson Education, Inc Publishing as Prentice Hall 55 of 56 AN INSIDE LOOK AT POLICY © 2012 Pearson Education, Inc Publishing as Prentice Hall 56 of 56 ... treats the funds being traded as the good, is most useful when considering how changes in the demand and supply of funds affect the interest rate Market Interest Rates and the Demand and Supply... all other factors constant, will shift the demand curve for bonds to the right As the demand curve for bonds shifts to the right, the equilibrium price of bonds rises from $960 to $980, and the. .. all other factors constant, will shift the demand curve for bonds to the left, reducing both the equilibrium price and equilibrium quantity As the demand curve for bonds shifts to the left, the