Chapter 2 Money, Credit, and the Determination of Interest Rates

Chapter 2 Learning Objectives n Understand how the supply and demand for money and credit affect (and are affected by) the economy and the general level of interest rates n Understand how yields on individual debt instruments are determined n Understand why securities of different maturities may have different yields

The General Level of Interest Rates n Interest rate on an instrument reflects general market rates and the risk of the specific instrument n Equation of ExchangeMV = PT M = money supply V = stable velocity of circulation P = passive price level T = stable volume of trade n Fisher Equationi = r + p

Determining Interest Rates n LIQUIDITY EFFECT –Money supply goes up –Demand for bonds goes up –Interest rates go down n INCOME EFFECT –Income goes up –Demand for credit goes up –Interest rates go up

Risks In Real Estate Finance n DEFAULT RISK –Risk that the borrower will not repay the mortgage per the contract n CALLABILITY RISK –Borrower may repay the debt before maturity n MATURITY RISK –Other things held constant, the longer the maturity the greater the change in value for a given change in interest rates

Risks In Real Estate Finance n MARKETABILITY RISK –Risk that the asset doesn’t trade in a large, organized market n INFLATION RISK –Risk in loss of purchasing power n INTEREST RATE RISK –Risk of loss due to changes in market interest rates –Fixed-income assets are most susceptible

The Yield Curve n Relates maturity and yield at the same point in time n Explaining the structure of the yield curve: –Liquidity Premium Theory –Market Segmentation Theory –Expectations Theory – the long-term rate for some period is the average of the short-term rates over that period

Explaining the Yield Curve n LIQUIDITY PREMIUM –Premium paid for liquidity n SEGMENTED MARKETS –Market divided into distinct segments n EXPECTATIONS THEORY –Current rates are the average of expected future rates –The current two-year rate is the average of the current one-year rate and the one-year rate a year from now