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Published byBarnaby Murphy Modified over 9 years ago
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BA 580-Interest Rates Breaking Down Market Influences on Rates
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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
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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)
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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
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Differences in Rates Due to Inflation Predicted inflation more closely related to and closer to 1:1 for short term rates
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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
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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
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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, …
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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
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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
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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)
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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
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