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WHY DO INTEREST

RATES CHANGE?
Chapter 4
Preview
We will look at the forces that move interest rates
Asset Demand

Supply and Demand in the Bond Market

Changes in Equilibrium Interest Rates


DETERMINANTS OF
ASSET DEMAND
Determinants of Asset Demand
An asset is a piece of property that is a store of value
In determining whether to buy or sell and asset and
determining which asset to buy, we consider:
1.Wealth - the total resources owned by an individual,
including all assets
2.Expected return - the return expected on one asset
relative to alternative assets
3.Risk - the degree of uncertainty associated with the
return on one asset relative to alternative assets
4.Liquidity - the ease and speed with which an asset
can be turned into cash relative to alternative assets
Wealth
In general, as wealth increases, we have more resources
to purchase assets, thus demand increases

Holding everything else constant, an increase in


wealth raises the quantity demanded of an asset
Expected Return
We know that the return on an asset measures how much
we gain from holding an asset
The expected return is a weighted average of all
possible returns, where the weights are the probability of
the return
In other words,

= 1 1 + 2 2 +. . +

Re=expected return
n = number of possible outcomes(returns)
Ri = return in the ith state
Pi = probability of the occurrence of the return Ri
Expected Return
What is the expected return on Exxon-Mobil if the
return is 12% two-thirds of the time and 8% one-third
of the time?

= 1 1 + 2 2 +. . +

Expected Return = 10.68%

An increase in an assets expected return relative


to other assets, raises the quantity demanded of
the asset
Risk
Not surprisingly, holding everything else constant,
if an assets risk rises relative to other assets, its
quantity demanded will fall

How do we measure Risk?


We can measure risk by calculating the standard
deviation of the returns
The greater the standard deviation, the more risky an
asset is

= = 1 1 2 + 2 2 2 + 2
Risk
Consider the following two companies and their
forecasted returns for the upcoming year

Which Company is more Risky?

Standard Deviation 5% 0%
Standard Deviation
Fly-by-Night Airlines is a riskier stock because its
standard deviation of returns of 5% is higher than the zero
standard deviation of returns for Feet-on-the-Ground Bus
Company, which has a 100% certain return
A risk-averse person prefers stock in the Feet-on-the-
Ground to Fly-by-Night stock, even though the stocks
have the same expected return, 10%.
A person who prefers risk is a risk preferrer or risk lover

We assume people are risk-averse, especially in their


financial decisions
Liquidity
Liquidity - The ability to convert an asset into cash
quickly without a loss in value

The more liquid an asset is relative to alternative


assets, holding everything else unchanged, the
more desirable it is, and the greater will be the
quantity demanded
Summary of the Determinants of Asset Demand
SUPPLY & DEMAND CURVE
The Demand Curve
Lets consider a one-year discount bond with a
face value of $1,000. The return on this bond is
entirely determined by its price
If the bond is selling for $900, the return is
11.11%
The return is the bonds yield to maturity
Derivation of Demand Curve
Point A: if the bond was selling for $950

At this return, demand is 100 bonds, Bd


Derivation of Demand Curve
Point B: if the bond was selling for $900

At this return, demand is 200 bonds, Bd


Derivation of Demand Curve
To continue

Point C: P = $850 i = 17.6% Bd = 300


Point D: P = $800 i = 25.0% Bd = 400
Point E: P = $750 i = 33.0% Bd = 500

Demand Curve is Bd, which we can plot


Supply and Demand for Bonds
Derivation of Supply Curve
Point F: P = $750 i = 33.0% Bs = 100
Point G: P = $800 i = 25.0% Bs = 200
Point C: P = $850 i = 17.6% Bs = 300
Point H: P = $900 i = 11.1% Bs = 400
Point I: P = $950 i = 5.3% Bs = 500

Shows the simple point, the higher the interest rate the
less bonds will be supplied
People do not like to pay higher interest rates
Instead, they will forgo the project the bond would fund
Supply and Demand for Bonds
Market Equilibrium
The equilibrium follows what we know from supply-demand
analysis:
Equilibrium where Bd = Bs
at P* = 850, i* = 17.6%
When P = $950, i = 5.3%, Bs > Bd
Excess supply
P to P*, i to i* to adjust to equilibrium
When P = $750, i = 33.0, Bd > Bs
Excess demand:
P to P*, i to i* to adjust to equilibrium
Market Conditions
Market equilibrium occurs when the amount that people
are willing to buy equals the amount that people are willing
to sell at a given price

Excess supply occurs when the amount that people are


willing to sell is greater than the amount people are willing
to buy at a given price

Excess demand occurs when the amount that people are


willing to buy is greater than the amount that people are
willing to sell at a given price
CHANGES IN INTEREST RATES
Changes in Demand
2 Types of Changes:
1. Movements along the curve
We have seen that this occurs when prices change

Price

A If we are at point A and the price of the


Bond decreases, we move down the
curve to B

Quantity
Changes in Demand
2 Types of Changes:
1. Movements along the curve
We have seen that this occurs when prices change

Price

D If we are at point C and the price of the


Bond increases, we move up the curve
to D

Quantity
How Factors Shift the Demand Curve
How does wealth/savings affect the demand curve?
If economy and wealth

If we are at point C on curve Bd1


Price and the economy and wealth
increase while prices remain
constant,
the Bd curve will shift out and right
C D
Point C will move to Point D (the
same price, but higher demand)
Bd2
Bd1
Quantity
How Factors Shift the Demand Curve
How does wealth/savings affect the demand curve?
If economy and wealth

If we are at point C on curve Bd1


Price and the economy and wealth
decrease while prices remain,
the Bd curve will shift in and left

Point C will move to Point D (the


D C same price, but lower demand)

Bd1
Bd2
Quantity
Changes in Demand
2. Shifts the curve

If price remains constant, Demand goes up

As Expected interest rates , less people will


want bonds at the current interest rates, because
they can get a higher return on the higher
expected interest rates bonds
Changes in Demand
If price remains constant, Demand goes up
If you think inflation will increase, you will be less
likely to buy bonds today, because inflation will
quickly devalue the bonds

If price remains constant, Demand goes down


If I can buy a different asset and receive the same
return with less risk, I will buy less of the bonds

If price remains constant, Demand goes down


Just like we prefer less risky assets, we prefer more
liquid assets. So, if bonds are more liquid, we will buy
As Demand Increases, Curve Shifts
Summary of Shifts in the Demand
Wealth: in a business cycle expansion with
growing wealth, the demand for bonds rises,
conversely, in a recession, when income and
wealth are falling, the demand for bonds falls

Expected returns: higher expected interest


rates in the future decrease the demand for long-
term bonds, conversely, lower expected interest
rates in the future increase the demand for long-
term bonds
Summary of Shifts in the Demand
Risk: an increase in the riskiness of bonds
causes the demand for bonds to fall, conversely,
an increase in the riskiness of alternative assets
(like stocks) causes the demand for bonds
to rise

Liquidity: increased liquidity of the bond market


results in an increased demand for bonds,
conversely, increased liquidity of alternative asset
markets (like the stock market) lowers the
demand for bonds
Factors That Shift Supply Curve
As Supply Increases, the Curve Shifts
Summary of Shifts in the Supply of Bonds
Expected Profitability of Investment Opportunities: in
a business cycle expansion, the supply of bonds
increases, conversely, in a recession, when there are far
fewer expected profitable investment opportunities, the
supply of bonds falls

Expected Inflation: an increase in expected inflation


causes the supply of bonds to increase

Government Activities: higher government deficits


increase the supply of bonds, conversely, government
surpluses decrease the supply of bonds
Case: Business Cycle Expansion
Another good thing to examine is an expansionary
business cycle. The amount of goods and services for the
country is increasing, so national income is increasing

What is the expected effect on interest rates?


Business Cycle Expansion
1. Wealth , Bd ,
Bd shifts out to
right
2. Investment ,
Bs , Bs shifts
right
3. If Bs shifts
more than Bd
then P , i
Business Cycles and Interest Rates