Money, Banking and Finance - Essay Example

? Money, Banking & Finance Contents Contents 2 Introduction 3 Interest Rates 3 Yield Curve 4 Risk and Its effects 6 Pure Expectation Hypothesis 7 Liquidity preference theory 8 Preferred Habitat Hypothesis 8 Conclusion 9 References 10 Introduction Rates of interest are considered to be the price that is paid for a period of time for the usage of a sum of money. Thus, for the determination of the value of a bond for a period of time, the rate of interest is a useful metric that would help in determination of the present value and the future value of the bond. Interest rate is generally determined from the market rates which would be captured in the valuation of a long term debt instrument such as a bond. The present prices of the bonds would help in the determination of the market rate of interest, or the price that would be paid for the use of the money for a period of time. There exists a functional relationship between the rate of interest and the time of the bonds. The term structure of interest rates or the yield curve shows the relationship between the rate of interest and the yields of the bonds with the terms to maturities. The curve is a representation of the various opportunities that may exist for the arbitrage as well as the expectation of the markets about the interest rates that may prevail in future. Interest Rates While carrying out the analysis of the yield curve it is essential to know the components of the nominal interest rates. This equation shows that the real rate of interest represented by r is the main component of the rate of interest. On the other hand, sigma is the risk premium that is being added to the rate of interest which is open to fluctuations due to various events. On the other hand, ? is the representative of the rate of inflation while l is the component that would capture the liquidity. The various financial markets would offer bonds and other long term instruments that would be offering a variety of interest or the rates of return (Kettell, 2001, pp. 19-26). The premium is the representation of the consumer behaviour that would depict that the consumers would be unwilling to hold that particular asset class. The following diagram shows the break-up of the various components of the rates of interest. The loans that are provided for the long term cost higher because the premium for liquidity would increase with the increase in the tenure of the bonds. The people would always want to hold liquidity at the present period of time rather than a later period. The opportunity cost of keeping the money in the hand would be less in the present period as compared to the future period. Yield Curve The yield curve is drawn from the yield to maturity of the bonds. The yield to maturity (YTM) is considered to be the approximate value of the rate of interest for a particular term to maturity of a bond. The various points of the terms to maturity and the corresponding yields to maturity are plotted on a plane and the curve that is fitted along these points is known as the yield curve. The following diagram is an example of a yield curve. In the plane the vertical axis measures the yield of the bonds and the horizontal axis measures the term to maturity of the bond. Figure 1: Yield curve The yield curve thus summarises yield of the different bonds that are being traded on a particular date. The yields or the different tenors in such cases may be different. The yield of a bond is the unique rate at which the cash flows that is provided by a bond is discounted. Thus even though the accrual of the cash flows are taking place at the different points in time the rate at which it is taking place is the same (Rossi, 2007, pp. 225-241). This rate is known as the yield to maturity of the bonds. In most cases the interest rates are considered to be fixed for the entire tenor. This would give rise to a flat yield curve as shown in the diagram below. Throughout the tenure of the bond the rate of interest that has been offered in case of this yield curve is 3.5%. Figure 2: Flat Yield Curve The rates of interest vary with the changes in the periods of time. Thus the shapes of the yield curves vary with the differences in the functional relationship that exists between the time and the price of the bonds (Cochrane and Piazzesi, 2005, pp. 138-160). The yield curve may either be an upward sloping, downward sloping, inverted or humped. These shapes are generally explained by the various theories of the yield curves that are prevalent. But prior to the discussions of the different theories it is essential to find the effects of risk on the long term rates of interest. Risk and Its effects The risk premium is the cost that is paid in case of default of repayment of the loans at some level. This is a payment that is paid by the borrowers because a situation might arise where the borrower is not being able to make the repayment either in principal or the interest to the lender (Stoughton, Wu and Zechner, 2011, pp. 947-980). Another reason for the payment of the premium is that the dividends that a share or equity is expected to pay is less than what the investors had expected (Miskin and Eakins, 2000, pp. 75-87). This risk can be specifically claimed as the income risk. On the other hand, the risks which may affect the businesses which are exposed to a lot of economic as well as political activities are known as the business risks. Along with this financial risks also have the adverse effects on the term structure interest rates. This is because there are different avenues that would lend fund to the borrowers (Heinkel and Zechner, 1990, pp. 51-56). In most cases all of these risks that have been stated above can be reduced to some extent with the help of the diversification strategy. The loans and the long term lending process are the ones which are most vulnerable to risks in the long run. The systematic relationship that exists between the bond yield and the term to maturity has been captured by the various theories that are explained below. Pure Expectation Hypothesis According to pure expectation hypothesis the yield curve would be derived out of the forward rates that would be expected by the individuals regarding the price of the bonds. This theory was put forward by Irving Fischer. This is considered to be the most accepted theory of term structure interest rates. The oldest form of the theory assumes that the expected rate of the mean yearly return of the long term instruments would be geometric mean of the short term rate of interest rates that would prevail in the markets. This can be explained with the help of the following example (Madura, 2012, pp. 111-126). The expected rate of the spot market one year hence would be the product of the spot rate six month hence and the six month spot rate. This means that an investor who would be risk neutral would not exercise any particular preference between the 1year spot rate and a combination of the 6 month spot and the rate which would be 6 month forward. Thus the expectation by the investor regarding the future prices would help the investor in the determination of the rates of interests and thereby the yield curves. Liquidity preference theory This theory is a development over the expectations hypothesis which has been discussed in the previous sections of the essay. However, this theory happens to incorporate the risk component into the entire story of interest rates (Hennessy and Zechner, 2011, pp. 3369-3400). The theory holds that people generally prefer the short term instruments compared to the long term instruments. This is mainly because of the fact that the people are apprehensive about the future price of the bonds and they expect that the interest rates may fluctuate in the long term. Thus people would not have the amount of liquidity in their hands in the short term if they invest in the long term bonds. This would imply that at the lower end the rate of interest reflected by the yield curve would be low and at the higher end the rate of interest reflected would be high (Hubbard, 1997, pp. 45-56). Thus the long term rates of interest comprise of the premium for liquidity along with the short term rates of interest that are expected by the individuals. Therefore the liquidity premium component is that part which the investors would like to gain out of their investments if they agree to extend the maturity of their long term debt instruments. Thus the liquidity premium has a tendency to increase with an increase in the term to maturity of the bonds or the debt instruments (Goodhart, 1989, pp. 125-138). Preferred Habitat Hypothesis The preferred Habitat Hypothesis states the expectations that the investors have about the market may not be homogenous for all the periods of time. Thus the investors can be categorised into various segments and they would constitute the investing population over the different segment of the yield curve. This can be explained with the help of an example. The different firms and the other corporate would prefer to invest for the short term periods. This is mainly because they would employ their short term funds in the market which they might need to withdraw from time to time. Therefore their preferred habit or location in the yield curve would be at the end or the bottom of the curve (Orhangazi, 2008, pp. 63-78). On the other hand the pension funds and the insurance companies would prefer to invest for the long term because they might perceive the interest rate to go down in future and thus it would be beneficial for them to invest the money to make a match of their various types of liabilities that are considered for the long term period. Hence the theory posits that the demand and the supply of the funds and capital would match for all the periods, whether long term or short term (Thomas, 2005, pp. 167-184). In case of the shorter periods of maturity, the supply would exceed the demand which would lead to an upward rising yield curve. On the other hand the excess supply over the demand in the longer term would lead to a downward sloping yield curve. Conclusion Thus in case the term structure that would arise from the lending and the borrowing by individuals and firms at different periods of time, the risk would also vary. The various reasons for the risks have been discussed in the essay like the risks of default in repayment or the different types of issues that are associated with the running of the businesses. Each of the theories of the term structure interest rates has a different explanation for the nature of the yield curve. References Hubbard, R.H., 1997. Money, the Financial System and the Economy. Reading: Addison Wesley. Goodhart, C.A.E., 1989. Money, Information and Uncertainty. London: Macmillan. Miskin, F.S. and Eakins, S.G., 2000. Financial Markets and Institutions. Reading: Addison Wesley. Cochrane, J. H., and Piazzesi, M., 2005. “Bond risk premia”. American Economic Review,Vol. 95, pp. 138-160. Kettell, B., 2001. Economics for Financial Markets. Woburn: Butterworth-Heinemann. Orhangazi, O., 2008. Financialization and the US Economy. Massachusetts: Edward Elgar Publishing. Madura, J., 2012. Financial Markets and Institutions. Mason: South Western Cengage Learning. Hennessy, C.A. and Zechner, J., 2011. “A Theory of Debt Market Illiquidity and Leverage Cyclicality”. The Review of Financial Studies, Vol. 24, pp. 3369-3400. Thomas, L. B., 2005. Money, Banking and Financial Markets. Mason: South Western Cengage Learning. Rossi, S., 2007. Money and Payments in Theory and Practice. New York: Routledge. Heinkel, R. and Zechner, J., 1990. “The Role of Debt and Preferred Stock as a Solution to Adverse Investment Incentives.” Journal of Financial and Quantitative Analysis, Vol. 25 (1). Stoughton, N., Wu, Y. and Zechner, J., 2011. “Intermediated Investment Management’’, The Journal of Finance, Vol. 66, pp. 947-980. Read More