The Target Funds Rate - Essay Example

Question one: From the CEP news it is evident that the consumer price index which also signify the rate of inflation has remained flat, this means that inflation has not risen in the last few months, therefore there is a high possibility that the Federal Reserve meeting will most probably tend to reduce borrowing rates which is a 50bps cut or 0.5% cut. Scenarios: The Fed does nothing to the target funds rate, but the economy weakens further amid anchored inflation expectations The market expects the interest rates to be reduced, this means that investors and other financial institutions expect to gain from the discount rate cut and therefore inflation is expected to rise as more funds are available in the market. If the Fed does not change the fund rates then the increase in inflation will lead to a decline in the level of GDP. The Fed lowers the target funds rate and the economy continues on its (expected, pre-rate cut) path. When the Fed lowers rates then we expect an increase in borrowing, when rates are reduced there is an expectation that inflation will rise, therefore inflation will increase when the rates are reduced. The Fed lowers the target rate, and as a result, the economy grows. When the Fed lowers rates then we expect an increase in borrowing, an increase in borrowing means that there will be an increase in spending which will lead to an increase in output. An increase in output means that the economy will grow. The Fed lowers the target rate, and as a result, inflation expectations rise. When the Fed lowers interest rates this may result into an increase in money supply, n increase in money supply in the economy means that there will be a rise in expected inflation rate and therefore inflation rates are expected to increase. Question 2: Given that 1 year rate = 1.64% 2 year rate = 1.53% 5 year rate = 2.56% and 10 year rate = 3.65% One-year rate markets expect for next year We determine the expected one year rate in the second year as follows: We determine the expected rate using the following formula: P = 1 / (1 + (Ri)) t = 1 / (R1) (R2) (R3) (Rn) Where R1, R2 and R3 are the rates for year 1, 2 and 3 Ri is the expected rate by investors, for the one year rate in the second year we determine the rate as follows: 1/ (1.0164) (1.0153) = 1 / (1 + (Ri)) 2 = 1/ (1.031951) = 1 / (1 + (Ri)) 2 (1 + (Ri)) 2 = 1.031951 (1 + (Ri)) = 1.01585 Ri = 1.585% Therefore the one year rate in the second year is expected to be 1.585% 5-year 5-year forward rate We assume that the expected rate in the 3rd and 4th year is 2.56 and so we determine our value as follows: 1/ (1.0164) (1.0153) (1.0256) (1.0256) (1.0256) = 1 / (1 + (Ri)) 5 1/1.113250962 = 1 / (1 + (Ri)) 5 (1 + (Ri)) = 1.021688761 Ri = 2.16% Therefore the expected forward rate for 5 year is 2.16% How about the 3 year rate in two years 1/ (1.0153) (1.0256) = 1 / (1 + (Ri)) 2 (1 + (Ri)) = 1.020437 Ri = 2.04% Therefore we expect the third year rate in year two will be 2.04 Complications: Calculation of future spot rate is complicated in that we assume that the 3rd year rate is equal to the five year rate, in the last calculation we consider two years which is the second and third year rate and also assume that the third year rate is equal to 2.04, the values provided are an estimate of what is expected by investors and this is because of uncertainties in future. Question 8: The yield curve: The yield curve is a curve that depicts the yield or the cost of borrowing over time, the yield curve is an upward sloping curve and this means that if an investor invests his funds for a duration of t years then the yield will be a function of time, this means that the more the investor invests in terms of years then the higher is the yield. Prevailing interest rates which is the cost of borrowing will determine the position of the yield curve, in our case the chart shows that the yield curve has shifted downwards compared to the 2007 curve, the October 2008 yield curve has also shifted downwards compared to the September 2008 yield curve. The chart below shows weekly federal rates from 2007 to date: From the chart it is evident that federal rates have declined over the last few weeks and because interest rates are the costs of borrowing the yield curve is also likely to shift downwards, therefore the reason why the yield curves have shifted downward over time is due to the declining federal rates. Question 9: We have two remarks one by Jim Cramer and the other by Warren Buffett, Jim Cramer states that an investor should spend more time checking the current state of the companies they have invested with and should not just buy stocks and forget about them, this way an investor will be in a position to analyze and predict future outcomes of the company's stocks. Warren remarks by saying that an investor should invest where others are afraid to invest and be afraid to invest in places where everyone is investing. His remarks show that investors today are afraid to invest and therefore this is the right time to invest. The two individuals have one thing in common, this is that they are urging investors to invest and giving them the best way in which they can get optimal returns, Cramer however states that the best way to invest is to spend more time analyzing the company's business while Warren states that investors should be encouraged to invest where others do not want to invest and also states that this is the right time to invest when everyone is afraid. Reference: Bank of Canada website (2008) historical federal rates, retrieved on 29th October, available at http://www.bank-banque-canada.ca/cgi-bin/famecgi_fdps Bruce Tuckman (2000) Fixed Income Securities, McGraw Hill publishers, New York Read More