the impact of inflation & deflation, yield curves, and duration on interest rates and asset...

Money and Capital Markets

7C h a p t e r

Eighth Edition

Financial Institutions and Instruments in a Global Marketplace

Peter S. Rose

McGraw Hill / Irwin Slides by Yee-Tien (Ted) Fu

The Impact of Inflation & Deflation, Yield Curves, and Duration on Interest Rates and Asset Prices

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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Learning Objectives

To learn what inflation is and how it can impact interest rates and asset prices.

To understand the greater concern today over deflation and how deflation may affect the economy and financial system.

To see how yield curves arise and explore the ideas about what determines the shape of the yield curve at any point in time.


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Learning Objectives

To discover how yield curves can be a useful tool for those interested in investing their money and in tracking the health of the economy.

To look at the concept of duration and see how it can assist in the making of investment choices and in protecting against the risk of changing interest rates.


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Inflation and Interest Rates

Inflation refers to the rise in the average level of prices for all goods and services.

7


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In recent years, the U.S. inflation and interest rates appear to be fairly strongly correlated.

1960 1.7 % 1.4 % 3.2 %1970 5.7 5.3 6.51980 13.5 9.2 11.41990 5.4 3.9 7.52000 3.4 2.3 5.92001 2.8 2.2 3.3

YearRate of Inflation (% )CPI GDP Deflator

6-month T-bill Rate(secondary market)


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Nominal and Real Interest Rates In general, lenders will attempt to charge

nominal rates of interest that give them their desired real rates of return on their loanable funds based upon their expectations regarding inflation. nominal rate = published or quoted rate real rate = rate measured in terms of the actual

purchasing power


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The Fisher Effect In a 1896 classic article, economist Irving Fisher

argued thatexpected nominal interest rate

= expected real rate + inflation premium + (expected real rate inflation premium) expected real rate + inflation premium

The inflation premium measures the rate of inflation expected by investors in the marketplace during the life of a particular financial instrument.


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The Harrod-Keynes Effect of Inflation Building upon the Keynesian liquidity

preference theory, Harrod argued that unless inflation affects money demand or supply, the expected nominal interest rate must be the same regardless of inflationary expectations.

So, a rise in inflationary expectations will lower the real rate of interest.


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The simple Fisher effect was the majority view for decades until problems began to surface: Partial anticipation of inflation Inflation-caused wealth effect Inflation-caused income effect Inflation-caused depreciation effect Inflation-caused income tax effect


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The bulk of recent research suggests that nominal rates rise by less than any given increase in the expected inflation rate and decline by less than any given decrease in the expected inflation rate.

However, note that the topic of inflation and interest rates is plagued by numerous measurement problems.


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Impact of Price Deflation There is growing concern that deflation – a fall

in the average level of prices – may soon replace inflation as one of the key problems that nations may face in the future.

Past experiences indicate that price deflation can result in lower output (production) of goods and services, and force real interest rates upward.


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Inflation and Stock Prices Common stock is widely viewed as a hedge

against inflation. However, research evidence seem to support

the view that the impact of inflation on stock prices varies from firm to firm and from industry to industry depending on the actual rate of inflation and the terms of existing nominal contracts.


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Inflation-Adjusted Securities

The U.S. Treasury offers TIPS (Treasury Inflation Protected Securities) and “I bonds” for investors who want some protection against inflation.

Annual nominal interest payment from a TIPS = inflation-adjusted promised nominal value coupon rate

When the public expects higher inflation, inflation-adjusted securities rise in value.


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Source: Economic Trends, Federal Reserve Bank of Cleveland, June & July 2001


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The Maturity of a Loan

One important factor causing interest rates to differ from one another is differences in the maturity (or term) of securities and loans.

The relationship between the rates of return on financial instruments and their maturity is called the term structure of interest rates.

This term structure may be represented visually by drawing a yield curve for all securities having the same credit quality.


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Source: Economic Trends, Federal Reserve Bank of Cleveland, June 2001


Yield curves may be upward sloping, downward sloping, or horizontal (flat).


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The unbiased expectations hypothesis argues that investor expectations regarding future changes in short-term interest rates determine the shape of the curve.

Thus, changes in the relative amounts of long-term and short-term securities will not affect the shape of the yield curve unless investor expectations are also affected.


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The liquidity premium view of the yield curve suggests that there is a bias toward positively-sloped yield curves.

Longer-term securities tend to have more volatile market prices and hence, greater risk of capital loss.

So, investors must be paid an interest rate premium (the liquidity premium) to encourage them to purchase long-term securities.


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The market segmentation argument of the yield curve separates the financial markets into several distinct markets according to the maturity preferences of the investors.

The implication is that governments can alter the shape of the yield curve by shifting the available supplies of securities relative to the demand for those securities in each distinct market.


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The preferred habitat or composite theory of the yield curve argues that investors seek out their preferred habitat – they choose securities that match their risk preferences, tax exposure, liquidity needs, regulatory requirements, and planned holding periods.

An investor will not normally stray from his or her preferred habitat unless the rates of return on some other securities are high enough to overcome his or her preferences.


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Empirical studies on the various yield curve theories have produced mixed results.

As such, the traditional models are giving way today to newer models that are being created in response to recent theoretical developments – in particular, the Black-Scholes option pricing formula and the rational expectations theory.


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The yield curve is a useful tool for … forecasting interest rates – a downward-sloping

yield curve suggests near-term declines in rates identifying portfolio management strategies – a

rising yield curve favors short-term borrowing and long-term lending

detecting overpriced and underpriced securities indicating trade-offs between maturity and yield “riding” the yield curve – active investors may

gain by timely portfolio switching


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Duration: A Different Approach to Maturity

A popular measure of how responsive a debt security’s price is to changes in interest rates is its price elasticity (E).

Greater price elasticity means that an asset goes through a greater price change for a given change in market rates of interest.

0

01

0

01

yyy

PPP

E

% in a security’s price

over time% in a security’s yield

over time


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Longer-term debt securities generally have a larger price elasticity than shorter-term securities.

Debt securities with lower coupon rates also tend to have a larger price elasticity than those with higher coupon rates, since a greater proportion of the lower-coupon security’s total return lies in the final payment at maturity. This is called the coupon effect.


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To enable financial analysts to construct a linear relationship between maturity and security price elasticity, regardless of differing coupon rates, a maturity measure called duration (D) was introduced.


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Duration is thus a weighted average of the time required for the investor to receive the promised payments. The weights are the present values of those payments.

n

tt

t

n

tt

t

yC

tyC

D

1

1

1

1Ct = the expected principal/interest

payment in time period ty = the security’s yield to maturity,

with maturity reached at theend of n periods


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The relationship between an asset’s change in market price and its change in yield or interest rate is called convexity.

Research shows that convexity increases with an asset’s duration.

Moreover, an asset’s change in price is greater at lower market interest rates than it is at higher market interest rates in general.


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Uses of Duration Estimating asset price changes

% in asset price 1001

D

rr

Portfolio immunization against interest rate changes This can be achieved by acquiring a portfolio of

assets whose average duration equals the length of the investor’s desired holding period.


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Limitations of Duration In practice, it is often difficult to find a group

of assets with a certain average duration. As time passes, constant adjustments are also

needed to ensure that the average duration decreases at the same pace.

There is some risk associated with the use of conventional measures of duration due to uncertain future interest rate movements.


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Money and Capital Markets in Cyberspace

Websites that discuss the impact of inflation on interest rates include: http://www.economist.com/ http://www.clev.frb.org/research/index.htm http://www.savingsbonds.gov/sav/sbiinvst.htm

For more on yield curves, visit: http://www.mathematical-finance.com/ http://www.pvlinton.com/securiti.htm http://newrisk.ifci.ch/00011532.htm

http://www.economist.com/

http://www.clev.frb.org/research/index.htm






http://www.savingsbonds.gov/sav/sbiinvst.htm










http://www.mathematical-finance.com/

http://www.pvlinton.com/securiti.htm






http://newrisk.ifci.ch/00011532.htm









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Chapter Review

Inflation and Interest Rates Correlation between Inflation and Interest Rates Nominal and Real Interest Rates The Fisher Effect The Harrod-Keynes Effect of Inflation Alternative Views on Inflation and Interest Rates Impact of Price Deflation Inflation and Stock Prices



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Chapter Review

The Maturity of a Loan The Yield Curve and the Term Structure of Interest

Rates Types of Yield Curves The Unbiased Expectations Hypothesis The Liquidity Premium View of the Yield Curve The Segmented-Markets Argument The Preferred Habitat or Composite Theory Research Evidence on Yield-Curve Theories Uses of the Yield Curve


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Chapter Review

Duration: A Different Approach to Maturity The Price Elasticity of a Debt Security The Impact of Varying Coupon Rates An Alternative Maturity Index for a Security:

Duration The Convexity Factor Uses of Duration Limitations of Duration

the impact of inflation & deflation, yield curves, and duration on interest rates and asset...

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