04_the behavior of interest rates

Chapter4ThebehaviorofInterestRatesU.S.RealandNominalInterestRatesChapterPreview•Inthischapter,weexaminetheforcesthemoveinterestratesandthetheoriesbehindthosemovements.•Interestrateinnegativelyrelatedtobondprice•Topicsinclude:–DeterminingAssetDemand–SupplyandDemandintheBondMarket–ChangesinEquilibriumInterestRatesCopyright©2009PearsonPrenticeHall.Allrightsreserved.4-3DeterminantsofAssetDemand•Anassetisapieceofpropertythatisastoreofvalue.Facingthequestionofwhethertobuyandholdanassetorwhethertobuyoneassetratherthananother,anindividualmustconsiderthefollowingfactors:1.Wealth,thetotalresourcesownedbytheindividual,includingallassets2.Expectedreturn(thereturnexpectedoverthenextperiod)ononeassetrelativetoalternativeassets3.Risk(thedegreeofuncertaintyassociatedwiththereturn)ononeassetrelativetoalternativeassets4.Liquidity(theeaseandspeedwithwhichanassetcanbeturnedintocash)relativetoalternativeassetsCopyright©2009PearsonPrenticeHall.Allrightsreserved.4-4Wealth•Wealth:•Resourcesavailable•Holdingeverythingelseconstant,anincreaseinwealthraisesthequantitydemandedofanassetExpectedReturnExpectedreturn•weightedaverage•Possiblereturn•equation1:EXAMPLE1:WhatistheexpectedreturnonanExxon-Mobilbondifthereturnis12%two-thirdsofthetimeand8%one-thirdofthetime?Copyright©2009PearsonPrenticeHall.Allrightsreserved.4-6nneRETpRETpRETpRET...2211Solutiontoe.g.1SolutionTheexpectedreturnis10.68%.Re=p1R1+p2R2wherep1=probabilityofoccurrenceofreturn1=2/3=.67R1=returninstate1=12%=0.12p2=probabilityofoccurrencereturn2=1/3=.33R2=returninstate2=8%=0.08ThusRe=(.67)(0.12)+(.33)(0.08)=0.1068=10.68%Risk•Riskwillaffectthedemandoftheasset•Standarddeviation,ameasureofrisk•Equation2:2222211)(...)()(enneeRETRETpRETRETpRETRETpEXAMPLE2:Considerthefollowingtwocompaniesandtheirforecastedreturnsfortheupcomingyear:Copyright©2009PearsonPrenticeHall.Allrightsreserved.4-9Fly-by-NightFeet-on-the-GroundProbability50%100%Return15%10%Probability50%Return5%Outcome1Outcome2EXAMPLE2:•WhatisthestandarddeviationofthereturnsontheFly-by-NightAirlinesstockandFeet-on-the-GroundBusCompany,withthereturnoutcomesandprobabilitiesdescribedabove?Ofthesetwostocks,whichisriskier?Copyright©2009PearsonPrenticeHall.Allrightsreserved.4-10Solutiontoe.g.2•Solution–Fly-by-NightAirlineshasastandarddeviationofreturnsof5%.Copyright©2009PearsonPrenticeHall.Allrightsreserved.4-11•Feet-on-the-GroundBusCompanyhasastandarddeviationofreturnsof0%.Copyright©2009PearsonPrenticeHall.Allrightsreserved.4-12Solutiontoe.g.2•astandarddeviationofreturns–Fly-by-NightAirlines5%;–Feet-on-the-GroundBusCompany0%•riskier–Clearly,Fly-by-NightAirlines–higher•Arisk-averseperson–prefersstockintheFeet-on-the-Ground(thesurething)toFly-by-Nightstock(theriskierasset),eventhoughthestockshavethesameexpectedreturn,10%.–ariskpreferrerorrisklover.–Weassumepeoplearerisk-averse,especiallyintheirfinancialdecisionsCopyright©2009PearsonPrenticeHall.Allrightsreserved.4-13Solutiontoe.g.2Liquidity•Quicklyconvertedtocash•Withoutlargecost•Themoreliquidanassetisrelativetoalternativeassets,holdingeverythingelseunchanged,themoredesirableitis,andthegreaterwillbethequantitydemandedDeterminantsofAssetDemand(2)•Thequantitydemandedofanassetdiffersbyfactor.1.Wealth:Holdingeverythingelseconstant,anincreaseinwealthraisesthequantitydemandedofanasset2.Expectedreturn:Anincreaseinanasset’sexpectedreturnrelativetothatofanalternativeasset,holdingeverythingelseunchanged,raisesthequantitydemandedoftheasset3.Risk:Holdingeverythingelseconstant,ifanasset’sriskrisesrelativetothatofalternativeassets,itsquantitydemandedwillfall4.Liquidity:Themoreliquidanassetisrelativetoalternativeassets,holdingeverythingelseunchanged,themoredesirableitis,andthegreaterwillbethequantitydemandedCopyright©2009PearsonPrenticeHall.Allrightsreserved.4-15DeterminantsofAssetDemand(3)Copyright©2009PearsonPrenticeHall.Allrightsreserved.4-16BenefitsofDiversification1.Diversificationalmostalwaysbeneficialtorisk-averseinvestor2.Lessreturnsofsecuritiesmovetogether,greaterisriskreductionfromdiversificationCopyright©2003PearsonEducation,Inc.Slide4–17Supply&DemandintheBondMarketCopyright©2009PearsonPrenticeHall.Allrightsreserved.4-18•howinterestratesaredetermined–fromademandandsupplyperspective.•Keepinmindthattheseforcesactdifferentlyindifferentbondmarkets.•corporatebondmarket•mortgagemarket.•Assume:asifthereisoneinterestratefortheentireeconomy.Target•Changesinexpectedinflation•BusinesscycleexpansionorrecessionTheDemandCurveCopyright©2009PearsonPrenticeHall.Allrightsreserved.4-20Let’sstartwiththedemandcurve.Let’sconsideraone-yeardiscountbondwithafacevalueof$1,000.Inthiscase,thereturnonthisbondisentirelydeterminedbyitsprice.Thereturnis,then,thebond’syieldtomaturity.DerivationofDemandCurveCopyright©2009PearsonPrenticeHall.Allrightsreserved.4-21PointB:ifthebondwassellingfor$900.iReFPPP$950i$1000$950$950.0535.3%Bd100P$900i$1000$900$900.11111.1%Bd200PointA:ifthebondwassellingfor$950.DerivationofDemandCurveCopyright©2009PearsonPrenticeHall.Allrightsreserved.4-22Howdoweknowth