1. 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

2. 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

3. 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

4. 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

5. 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?

6. 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)

7. 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)

8. 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

9. 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

10. 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

11. 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?

12. Recent Government of Canada Bond Issue
Auction Date:
Term to Maturity: 2Y
Date of Maturity:
Coupon Rate*: 1.000
Average Price**:
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 , then the price of that bond is % or  times the value of the bond at maturity.

13. Government of Canada Benchmark Bond Yields
Term (years) Maturity Date 2Oct14 % % % % % %

14. Government of Canada Benchmark Bond Yields Bank of Canada, October 12, 2016
as at 12Oct16
2 year %
3-year %
5-year %
7-year %
10-year %
Long %

15. 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?

16. 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)

17. 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?