1. BA 580-Interest Rates Breaking Down Market Influences on Rates

2. Influences on Rates Factors that influence all rates as well as account for differences in rates –Inflation –Market forces on supply and demand for loans (price of borrowing-lending) Income growth & expectations (consumption; business investment decisions) RiskTime

3. Inflation & Rates: Why Connected? Inflation = change in purchasing power of $ –With 5% inflation for 1 year, lender receives dollars worth $9500 on a 1-year $10,000 note Nominal rates made up of price for borrowing (real rate) plus premium for expected inflation –R = r + P e –Implies 1:1 relationship between R and P e –“Money Center” banks estimate P e –Bond buyers/sellers incorporate formal & informal –Estimates by surveys of experts, guesses based on recent history, or stat models e.g. PI = 1 + 0.4*infl(-1 month) + 0.2*(-2 months) + 0.15*(-3 months)

4. Evidence on Inflation & Rates Regression Evidence R-Square indicates the % of the changes in the given rate that can be attributed to predicted inflation Slope indicates whether the relationship is 1:1 – e.g. 0.95 means that the T-bill rate goes up about.95% for each 1% increase in predicted inflation

5. Differences in Rates Due to Inflation Predicted inflation more closely related to and closer to 1:1 for short term rates

6. Market Influences on Real Rates (Economy-Wide Level) Analytics: risk; income growth; time –Income growth influences demand & supply –Timing of income growth influence a key –Measuring economy wide risk Bbb Rate – Aaa Rate

7. Real Rate Movements Real 10-year T-Bond Rate Movements –Monthly data 1960-2004 TB10 Rate = 0.03* above avg. (3.1%) growth + 0.5*(Bbb – Aaa rate) Implies 1% additional growth raises TB10 by 3 basis pts Implies 1% additional risk premium raises TB10 by 5 basis pts

8. Market Influences on Real Rates (Individual Business Loan Level) Analytics: income potential (profitability) and risk measures –Profitability (Past-expected Return on Assets) –Risk Default-Credit (Debt/Equity, …) Liquidity (ST assets/ST liabilities, …) Term (length of loan) Methods –Simple: use thresholds –Complex: use “scoring” or “likelihood” producing statistical methods such as regression, discriminant analysis, …

9. Why Rates Differ Law of One Price –Resale not limited by law or product –Price Market A = Price Market B + cost difference –Implies demand differences are not sufficient to sustain price differences; cost difference (transport; storage; … and risk) SF Fed Article link explains non-risk cost differentials Loans of similar nature (risk) and time are very, very closely related (see irates.xls) Because Time (term of loan) is closely intertwined with risk, it is a key reason that rates differ

10. Time & Rate Differences R(short) = R(long) + cost differences What costs/risks differ or may differ depending on length of the loan? –Inflation –Income growth Yield Curve – graph of rates over time –Typically graphing loans that are similar except with regard to length such as Treasury Yield Curve, Corporate Aaa Yield Curve, … Yield Curve Shape Changes with changes in views about future inflation & income growth

11. Digging Into the Yield Curve “Normal” Yield Curve – about a 2% difference in 3-month & 10-year T-rates Higher Inflation Expected Near Term? –Flatter or even negative Yield Curve Lower Income growth expected near term? –Flatter or even negative Yield curve See website links (Living Yield Curve; NY Fed for examples and current situation)

12. Digging into Yield Curve (con’t) Difficulties in Interpreting Yield Curve –Separating Inflation from other Influences –Expectations are not always correct Inflation-Indexed Treasury Securities (TIPS) as way to separate out inflation part of Yield Curve –See forwardyields.xls for example