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1、Chapter 4 Why Do Interest Rates Change?Determinants of Asset Demand Wealth Expected Returns Risk Liquidity Summary Supply and Demand in the Bond Market Demand Curve Supply Curve Market Equilibrium Supply and Demand Analysis Changes in Equilibrium Interest Rates Shifts in the Demand for Bonds Shifts
2、in the Supply of Bonds Case:Changes in the Equilibrium Interest Rate Due to Expected Inflation:The Fisher Effect Case:Changes in the Interest Rate Due to a Business Cycle Expansion Case:Explaining Low Japanese Interest Rates Case:Reading the Wall Street Journal:The“Credit Markets”Column The Wall Str
3、eet Journal:Following the News:The“Credit Markets”Column The Practicing Manager:Profiting from Interest-Rate Forecasts The Wall Street Journal:Following the News:Forecasting Interest Rates Appendix 1:Models of Asset Pricing Appendix 2:Applying the Asset Market Approach to a Commodity Market:The Case
4、 of Gold Appendix 3:Loanable Funds Framework Appendix 4:Supply and Demand in the Market for Money:The Liquidity Preference Framework As is clear in the Preface to the textbook,I believe that financial markets and institutions is taught effectively by emphasizing a few analytic principles and then ap
5、plying them over and over again to the subject matter of this exciting field.Chapter 4 introduces one of these basic principles:the determinants of asset demand.It indicates that there are four primary factors that influence peoples decisions to hold assets:wealth,expected returns,risk,and liquidity
6、.The simple idea that these four factors explain the demand for assets is,in fact,an extremely powerful one.It is used continually throughout the study of financial markets and institutions and makes it much easier for the student to understand how interest rates are determined,how financial institu
7、tions manage their assets and liabilities,why financial innovation takes place,how prices are determined in the stock market and the foreign exchange market.Chapter 4 Why Do Interest Rates Change?17 One teaching device that I have found helps students develop their intuition is the use of summary ta
8、bles,such as Table 1,in class.I use the blackboard to write a list of changes in variables that affect the demand for an asset and then ask students to fill in the table by reasoning how demand responds to each change.This exercise gives them good practice in developing their analytic abilities.I us
9、e this device continually throughout my course and in this book,as is evidenced from similar summary tables in later chapters.I recommend this approach highly.The rest of Chapter 4 lays out a partial equilibrium approach to the determination of interest rates using the supply and demand in the bond
10、market.An important feature of the analysis in this chapter is that supply and demand is always done in terms of stocks of assets,not in terms of flows.Recent literature in the professional journals almost always analyzes the determination of prices in financial markets with an asset-market approach
11、:that is,stocks of assets are emphasized rather than flows.The reason for this is that keeping track of stocks of assets is easier than dealing with flows.Correctly conducting analysis in terms of flows is very tricky,for example,when we encounter inflation.Thus there are two reasons for using a sto
12、ck approach rather than a flow approach:(1)it is easier,and(2)it is more consistent with modern treatment of asset markets by financial economists.Another important feature of this chapter is that it lays out supply and demand analysis of the bond market at a similar level to that found in principle
13、s of economics textbooks.The ceteris paribus derivations of supply and demand curves with numerical examples are presented,the concept of equilibrium is carefully developed,the factors that shift the supply and demand curves are outlined,and the distinction between movements along a demand or supply
14、 curve and shifts in the curve is clearly drawn.My feeling is that the step-by-step treatment in this chapter is worthwhile because supply and demand analysis is such a basic tool throughout the study of financial markets and institutions.I have found that even those students who have had excellent
15、training in earlier courses find that this chapter provides a valuable review of supply and demand analysis.An additional innovative feature of the book that first appears in this chapter are the special applications,“Case:the Wall Street Journal.”These cases show students how the analytical framewo
16、rk in the book can be used directly to understand the daily columns in the United States leading financial newspaper.The students particularly like the case on reading the credit markets column because it shows them that the concepts developed in the chapter are actually used in the real world.In te
17、aching my class,I bring the previous days Wall Street Journal columns into class and then use them to conduct a case discussion along the lines of the“Case:the Wall Street Journal“in the text.My students very much like the resulting case discussions and have told me that they are better than case di
18、scussions in other classes because the material is so current.The Practicing Manager application at the end of the chapter shows how interest rate forecasts can be used by managers of financial institutions to increase profits.This application shows students how the analysis they have learned is use
19、ful in the real world.This chapter has an extensive set of appendices on the web to enhance its material.Appendix 1 provides models of asset pricing in case and instructor wants to make use of the capital asset pricing model or the arbitrage pricing model in this course.Appendix 2 shows how the anal
20、ysis developed in the chapter can be applied to understanding how any assets price is determined.Students particularly like the application to the gold market because this commodity piques almost everybodys interest.Appendix 3 provides an another interpretation of the supply and demand analysis for
21、bonds using a different terminology involving the supply and demand for loanable funds.Appendix 4 provides an alternative approach to interest rate determination developed by John Maynard Keynes,known as the liquidity preference framework.18 Mishkin/Eakins Financial Markets and Institutions,Sixth Ed
22、ition 1.a.Less,because your wealth has declined;b.more,because its relative expected return has risen;c.less,because it has become less liquid relative to bonds;d.less,because its expected return has fallen relative to gold;e.more,because it has become less risky relative to bonds.2.a.More,because y
23、our wealth has increased;b.more,because it has become more liquid;c.less,because its expected return has fallen relative to Polaroid stock;d.more,because it has become less risky relative to stocks;e.less,because its expected return has fallen.3.True,because the benefits to diversification are great
24、er for a person who cares more about reducing risk.4.Purchasing shares in the pharmaceutical company is more likely to reduce my overall risk because the correlation of returns on my investment in a football team with the returns on the pharmaceutical company shares should be low.By contrast,the cor
25、relation of returns on an investment in a football team and an investment in a basketball team are probably pretty high,so in this case there would be little risk reduction if I invested in both.5.True,because for a risk averse person,more risk,a lower expected return and less liquidity make a secur
26、ity less desirable.6.When the Fed sells bonds to the public,it increases the supply of bonds,thus shifting the supply curve Bs to the right.The result is that the intersection of the supply and demand curves Bs and Bd occurs at a lower equilibrium bond price and thus a higher equilibrium interest ra
27、te,and the interest rate rises.7.When the economy booms,the demand for bonds increases:the publics income and wealth rises while the supply of bonds also increases,because firms have more attractive investment opportunities.Both the supply and demand curves(Bd and Bs)shift to the right,but as is ind
28、icated in the text,the demand curve probably shifts less than the supply curve so the equilibrium interest rate rises.Similarly,when the economy enters a recession,both the supply and demand curves shift to the left,but the demand curve shifts less than the supply curve so that the bond price rises
29、and the interest rate falls.The conclusion is that bond prices fall and interest rates rise during booms and fall during recessions:that is,interest rates are procyclical.8.Interest rates fall.The increased volatility of gold prices makes bonds relatively less risky relative to gold and causes the d
30、emand for bonds to increase.The demand curve,Bd,shifts to the right and the equilibrium bond price rises and the interest rate falls.9.Interest rates would rise.A sudden increase in peoples expectations of future real estate prices raises the expected return on real estate relative to bonds,so the d
31、emand for bonds falls.The demand curve Bd shifts to the left,and the equilibrium bond price falls,so the interest rate rises.Chapter 4 Why Do Interest Rates Change?19 10.Interest rates might rise.The large federal deficits require the Treasury to issue more bonds;thus the supply of bonds increases.T
32、he supply curve,Bs,shifts to the right and the equilibrium bond price falls and the interest rate rises.Some economists believe that when the Treasury issues more bonds,the demand for bonds increases because the issue of bonds increases the publics wealth.In this case,the demand curve,Bd,also shifts
33、 to the right,and it is no longer clear that the equilibrium bond price or interest rate will rise.Thus there is some ambiguity in the answer to this question.11.The increased riskiness of bonds lowers the demand for bonds.The demand curve shifts to the left and the equilibrium bond price falls and
34、the interest rate rises.12.The increased riskiness of bonds lowers the demand for bonds.The demand curve Bd shifts to the left,the equilibrium bond price falls and the interest rate rises.13.Yes,interest rates will rise.The lower commission on stocks makes them more liquid than bonds,and the demand
35、for bonds will fall.The demand curve Bd will therefore shift to the left,and the equilibrium bond price falls and the interest rate will rise.14 If the public believes the presidents program will be successful,interest rates will fall.The presidents announcement will lower expected inflation so that
36、 the expected return on goods decreases relative to bonds.The demand for bonds increases and the demand curve,Bd,shifts to the right.For a given nominal interest rate,the lower expected inflation means that the real interest rate has risen,raising the cost of borrowing so that the supply of bonds fa
37、lls.The resulting leftward shift of the supply curve,Bs,and the rightward shift of the demand curve,Bd,causes the equilibrium bond price to rise and the interest rate to fall.15.The interest rate on the AT&T bonds will rise.Because people now expect interest rates to rise,the expected return on long
38、-term bonds such as the 188s of 2022 will fall,and the demand for these bonds will decline.The demand curve Bd will therefore shift to the left,and the equilibrium bond price falls and the interest rate will rise.16.Interest rates will rise.The expected increase in stock prices raises the expected r
39、eturn on stocks relative to bonds and so the demand for bonds falls.The demand curve,Bd,shift to the left and the equilibrium bond price falls and the interest rate rises.17.Interest rates will rise.When bond prices become volatile and bonds become riskier,the demand for bonds will fall.The demand c
40、urve Bd will shift to the left,and the equilibrium bond price falls and the interest rate will rise.1.You own a$1,000-par zero-coupon bond that has 5 years of remaining maturity.You plan on selling the bond in one year,and believe that the required yield next year will have the following probability
41、 distribution:Probability Required Yield 0.1 6.60%0.2 6.75%0.4 7.00%0.2 7.20%0.1 7.45%a.What is your expected price when you sell the bond?b.What is the standard deviation?20 Mishkin/Eakins Financial Markets and Institutions,Sixth Edition Solution:Probability Required Yield Price Prob Price Prob (Pr
42、ice Exp.Price)2 0.1 6.60%$774.41$77.44 12.84776241 0.2 6.75%$770.07$154.01 9.775668131 0.4 7.00%$762.90$305.16 0.013017512 0.2 7.20%$757.22$151.44 6.862609541 0.1 7.45%$750.02$75.02 16.5903224$763.07 46.08937999 The expected price is$763.07.The variance is$46.09,or a standard deviation of$6.79.2.Con
43、sider a$1,000-par junk bond paying a 12%annual coupon.The issuing company has 20%chance of defaulting this year;in which case,the bond would not pay anything.If the company survives the first year,paying the annual coupon payment,it then has a 25%chance of defaulting in the second year.If the compan
44、y defaults in the second year,neither the final coupon payment nor par value of the bond will be paid.What price must investors pay for this bond to expect a 10%yield to maturity?At that price,what is the expected holding period return?Standard deviation of returns?Assume that periodic cash flows ar
45、e reinvested at 10%.Solution:The expected cash flow at t1 0.20(0)0.80(120)96 The expected cash flow at t2 0.25(0)0.75(1,120)840 The price today should be:0296840781.491.101.10P At the end of two years,the following cash flows and probabilities exist:Probability Final Cash Flow Holding Period Return
46、Prob HPR Prob (HPR Exp.HPR)2 0.2$0.00 100.00%20.00%19.80%0.2$132.00 83.11%16.62%13.65%0.6$1,252.00 60.21%36.12%22.11%0.50%55.56%The expected holding period return is almost zero(0.5%).The standard deviation is roughly 74.5%the square root of 55.56%.3.Last month,corporations supplied$250 billion in b
47、onds to investors at an average market rate of 11.8%.This month,an additional$25 billion in bonds became available,and market rates increased to 12.2%.Assuming a Loanable Funds Framework for interest rates,and that the demand curve remained constant,derive a linear equation for the demand for bonds,
48、using prices instead of interest rates.Solution:First,translated the interest rates into prices.100011.8%,or894.454PiPP Chapter 4 Why Do Interest Rates Change?21 100012.2%,or891.266PiPP We know two points on the demand curve:P 891.266,Q 275 P 894.454,Q 250 So,the slope 891.266894.4540.12755275250PQ
49、Using the point-slope form of the line,Price 0.12755 Quantity Constant.We can substitute in either point to determine the constant.Lets use the first point:891.266 0.12755 275 constant,or constant 856.189 Finally,we have:Bd:Price 0.12755 Quantity 856.189 4.An economist has estimated that,near the po
50、int of equilibrium,the demand curve and supply curve for bonds can be estimated using the following equations:Bd:Price 2 Quantity9405 Bs:Price Quantity 500 a.What is the expected equilibrium price and quantity of bonds in this market?b.Given your answer to part a.,which is the expected interest rate