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

Chapter 2 Learning Objectives Understand how the supply and demand for money and credit affect (and are affected by) the economy and the general level of interest rates Understand how the supply and demand for money and credit affect (and are affected by) the economy and the general level of interest rates Understand how yields on individual debt instruments are determined Understand how yields on individual debt instruments are determined Understand why securities of different maturities may have different yields Understand why securities of different maturities may have different yields 2-1

Determining Interest Rates LIQUIDITY EFFECT LIQUIDITY EFFECT Money supply goes up Money supply goes up Demand for bonds goes up Demand for bonds goes up Interest rates go down Interest rates go down INCOME EFFECT INCOME EFFECT Income goes up Income goes up Demand for credit goes up Demand for credit goes up Interest rates go up Interest rates go up 2-2

Yield Curves LIQUIDITY PREMIUM LIQUIDITY PREMIUM Premium paid for liquidity Premium paid for liquidity SEGMENTED MARKETS SEGMENTED MARKETS Market divided into distinct segments Market divided into distinct segments EXPECTATIONS THEORY EXPECTATIONS THEORY Current rates are the average of expected future rates 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 The current two-year rate is the average of the current one-year rate and the one-year rate a year from now 2-3

The General Level of Interest Rates Interest rate on an instrument reflects general market rates and the risk of the specific instrument Interest rate on an instrument reflects general market rates and the risk of the specific instrument Equation of ExchangeMV = PT Equation of ExchangeMV = PT M = money supply M = money supply V = stable velocity of circulation V = stable velocity of circulation P = passive price level P = passive price level T = stable volume of trade T = stable volume of trade Fisher Equationi = r + p Fisher Equationi = r + p 2-4

Risks In Real Estate Finance DEFAULT RISK DEFAULT RISK Risk that the borrower will not repay the mortgage per the contract Risk that the borrower will not repay the mortgage per the contract CALLABILITY RISK CALLABILITY RISK Borrower may repay the debt before maturity Borrower may repay the debt before maturity MATURITY RISK MATURITY RISK Other things held constant, the longer the maturity the greater the change in value for a given change in interest rates Other things held constant, the longer the maturity the greater the change in value for a given change in interest rates 2-5

Risks In Real Estate Finance MARKETABILITY RISK MARKETABILITY RISK Risk that the asset doesn’t trade in a large, organized market Risk that the asset doesn’t trade in a large, organized market INFLATION RISK INFLATION RISK Risk in loss of purchasing power Risk in loss of purchasing power INTEREST RATE RISK INTEREST RATE RISK Risk of loss due to changes in market interest rates Risk of loss due to changes in market interest rates Fixed-income assets are most susceptible Fixed-income assets are most susceptible 2-6

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