AP/ECON 3430 3.0 A MONETARY ECONOMICS I: FINANCIAL MARKETS AND INSTITUTIONS Fall 2016 Topic 6: Interest Rates Session 6A&B Course Director: Prof. Brenda Spotton Visano © Brenda Spotton Visano 2016

Agenda (6A & 6B) Review Bond Demand/Supply  Price of Bond Theories of Interest Rates What is “the” interest rate? Interest Rates, Bond Yields, Bond Market Prices Yield Curve Term Structure of Interest Rates What explains the different levels and variations of interest rates over time? Predicting Future Interest Rates

Review of Bond Basics - Demand Lenders demand bonds as a vehicle for storing value over time, as savings Everything else equal, Bond Demand will be greater the… lower the price of the bond ↔ higher the rate of return on the bond lower the risk of repayment lower the rate of return on substitute investment/lending opportunities

Review of Bond Basics - Supply Borrowers supply bonds as a vehicle for financing economic investment Everything else equal, Bond Supply will be greater the… Higher the price of the bond ↔ Lower the rate of return on the bond Higher the rate of return on the economic investment being financed by the bond issue Higher the rate to be paid on substitute borrowing options

Comparative Statics What do you predict will happen to the Price of Bonds in today if Business becomes more profitable? We expect interest rates to rise in 1 year’s time? Government of Canada pays off a large portion of the national debt? Bank of Canada pursues expansionary monetary policy?

Interest Rates What is “interest”? = premium on present goods over future goods = usury? = price of loanable funds? (I. Fisher) OR = the opportunity cost of liquidity? (J.M. Keynes)

Interest as the Price of Loanable Funds (Irving Fisher, 1930) Demand for Loanable Funds (Uses): by whom? For what? Marginal Efficiency of Capital (Investment) Supply of Loanable Funds (Sources): by whom? Why? Rate of time preference (psychological propensity to save)

Interest as the Reward for Parting with Liquidity (J.M. Keynes, 1936) Given a decision to save out of income, there is a second question: Why hold wealth in liquid financial instruments? Precautionary motive Transactions motive Speculative motive

Variations in Interest Rates Theories of Interest explain a level of interest rates But why are there so many different interest rates at any one time? Stylized Facts of Interest Rates: Short and Long rates tend to move together Short rates are more volatile than Long rates Long rates tend to be higher than Short rates

Interest Rate and Bond Yield Interest rate = real interest rate + expected inflation rate Real rate of interest = Nominal interest rate – actual inflation Coupon payment = coupon (interest) rate x Face (or Par) Value of Bond Bond Yield = Coupon payment + Capital gain/loss as % of Market Price Compare with vocabulary re: Earnings Yield = Earnings per share = Dividend/Market Price of Stock

Bond Yield Yield includes both the Coupon (“interest”) rate and an adjustment to the rate of return for capital gain/loss in the difference between the Face Value and the Current Market Price Example: Risk free Bond with face value of $1000, Coupon Rate = 10%, term to maturity = 1 year, Market Price* = “109” **Convention: Bond prices are quoted as a percentage of the bond's par or face value and exclude accrued interest; e.g. if a nominal fixed coupon bond is quoted as 109, then the price of that bond is 109% or 1.09 times the value of the bond at maturity. What is the interest income? What is the total income? What is the net rate of return?

Recent Government of Canada Bond Issue Auction Date: 2016.10.12 Term to Maturity: 2Y Date of Maturity: 2018.11.01 Coupon Rate*: 1.000 Average Price**: 99.576 Average Yield: 0.61% *Fixed Coupon Rate paid semi-annually on a Face Value of $1000 **Convention (again): Bond prices are quoted as a percentage of the bond's par or face value and exclude accrued interest; e.g. if a nominal fixed coupon bond is quoted as 99.776, then the price of that bond is 99.776% or 0.99776 times the value of the bond at maturity.

Government of Canada Benchmark Bond Yields Term (years) Maturity Date Yield @ 2Oct14 2 2016 1.00% 3 2017 1.50% 5 2019 1.75% 7 2021 3.25% 10 2024 2.50% 30 2045 3.50%

Government of Canada Benchmark Bond Yields Bank of Canada, October 12, 2016 as at 12Oct16 2 year 2018 0.61% 3-year 2019 0.61% 5-year 2021 0.76% 7-year 2023 0.92% 10-year 2026 1.20% Long 2045 1.84%

Consider… Bond A: term to maturity = 1 year; yield = 1%; default-risk free Bond B: term to maturity = 2 years; yield = 2.5%; default-risk free You have funds available to lend out for 2 year period; which bond do you prefer to buy today? Why or under what conditions?

Term Structure of Interest Rates With everything else (?) equal what explains the variation in interest rates on bonds that differ only in term to maturity? Are debts of different maturities substitutable? Market Segmentation (no substitution) Liquidity Preference (limited substitution) Expectations Theory (perfect substitution)

Flip it Around… Recent Canadian yields on government debt (again) Overnight rate = 0.50% 3-month T-Bills = 0.49% 2-year GofC Bonds = 0.61% 10-year GofC Bonds = 1.20% What might bond traders be expecting to happen to short term rates in 10 years time?