Upsurge in International Trade - Essay Example

Introduction The past decades have seen an upsurge in international trade, financing and investments, and related cash and credit transactions at anextremely rapid pace. This is further prompted with the advent of globalisation, whereby firms have that capacity to invest in another continent. To accommodate the need for foreign-currency denominated transactions, international monetary systems have continued to evolve and in the process have provided opportunities for meeting these growing demands. Increasingly, international trade is affected by monetary policies such as changes in interest rates. Change of short term interest rates by the central bank has an effect on domestic real economic conditions through its influence on the long-term interest rate and consequently on those of other countries should there be involved in trade. Investors are now more prone to foreign exchange and interest rate risks due to all these changes in the global market place. Definition The term structure of interest rates represents the pattern for interest rates appropriate for discounting cash flows of various maturities. This is done through the use of a yield curve by plotting the interest rates against their terms so as to display the relationship between spot rates of zero-coupon securities and their term to maturity. The resulting curve allows an interest rate pattern to be determined, which can then be used to discount cash flows appropriately. Unfortunately, most bonds carry coupons, so the term structure must be determined using the prices of these securities. In the case of a zero-coupon bond, the yield to maturity is sometimes called the spot rate, as this rate is said to be the rate that prevails today for a period corresponding to the maturity of the zero. The shape of the yield curve above is said to be a “normal yield curve” as it is thought to reflect the higher “inflation risk premium” that investors demand for longer term bonds especially as longer term interest rates are usually higher than shorter term interest rates. A “parallel shift” in the yield curve may occur provided the interest rates change by the same amount for bonds for all terms and when this occurs, the shape of the yield curve stays same although interest rates may appear to be higher or lower across the curve. But when interest rates for bonds of some terms change different than for other bonds, the yield curve may change and such a change is called the “twist”. But since term structures are continuously changing, the changes may result to the yield curve having its usual normal shape, or may even result to the curve to become flat or inverted.1 These changes in the yield curve shape can be said to come largely as a result of the monetary policies or due to some small or negligible difference between short and long term interest rates that have occurred later in the economic cycle when interest rates increase due to higher inflation expectations and tighter monetary policy. When this happens, the shape of the yield curve changes and is known as “shallow” or “flat” yield curve. It is worthwhile mentioning here that higher short term rates always are reflected by less money available in the economy due to tightened monetary policy and higher expected inflation levels to occur later in the economic cycle. But at the same time, the gradient of the yield curve may become “steep” due to a large difference between long and short term interest rates. When this happens, it is said that the yield curve reflects a “loose” monetary policy meaning that credit and money is readily available in the economy. This situation usually develops early in the economic cycle if a country’s monetary authorities are trying to stimulate the economy if the country was faced with a recession or slowdown in economic growth. It should be noted here that, the low short term interest rates reflect the easy availability of money in the economy, and low or declining inflation whereas higher longer term interest rates reflects investors’ fears of future inflation, recognizing that future monetary policy and economic conditions could be much different. Simon & Zvi (1998, pp 1-9)2 In any economy, when there is a tightened monetary policy, it results in short term interest rates being higher than longer term rates. This occurs mostly when there is a shortage of money in the economy and in effect, credit drives up the cost of short term capital. But when there is a loose monetary policy, longer term rates stay lower, as investors see an eventual declining inflation. This increase then pushes up the demand for long term bonds which are locked in the higher long term rates. The term structure of interest rate uses different theories to better explain the shape of the yield curve. 1. The Expectations Hypothesis: In its simplest form, the Expectation Hypothesis states that the forward rate equals the market consensus expectations of the future short term interest rate. Bodie et al (2005, pp 461). In other words, f2 = E(r2) and the liquidity premiums are zero. Therefore, since short term bonds can be combined for the same time period as a longer term bond, the total interest earned should be equivalent, given the efficiency of the market and the chance for arbitrage (speculators using opportunities to make money). Mathematically, for the Expectations Hypothesis to be correct, (1 + y2)2 = (1 + r1)(1 + E(r2)). This means that the yield to maturity can be solely determined by the current and expected future one-period interest rates. If this results to an upward sloping yield curve, it should be clear evidence that investors are anticipating an increase in interest rates. 2. Liquidity Preference Theory: Recall that, long and short term investors are unwilling to hold long term bonds unless the forward rate exceeds the expected short term interest rate {f2 > E(r2)} at the same time, long term investors will be unwilling to hold short term bonds unless {E(r2) > f2}. This therefore means that both groups of investors require a premium to induce them to hold bonds with different maturities different from their investment horizons. The liquidity preference theory believes that the market is mostly dominated by short term investors since the forward rate exceeds the expected short term rates. That excess of f2 over E(r2) is the liquidity premium that pushes the short term investors to dominate the market since it is positive. 3. The market segmentation theory: Proponents of this theory believe that both the expectation hypothesis and liquidity preference theories view bonds of different maturities as potential substitutes for each other. But in contrast, the market segmentation theory holds that the long and short term bonds are traded in essentially distinct and segmented markets, each of which finds its own equilibrium independently. They believe that, long term bond rates and short term rates are set independently of each other due to the activities of the various borrowers and lenders. The segmentation theory explains the shape of the yield curve by investors’ term preferences. Some investors need to deploy their funds for specific periods of time, hence a preference for long or short term bonds which is reflected in the shape of the yield curve. An inverted curve can then be seen to reflect a definite investor preference for longer term bonds.3 Conclusion: Following Irving Fisher’s Theory of interest rates, economists have become more interested on what the theory may have on the economy especially as higher interest rates on particular securities have a great consequence on the amount of funds that will be available on the capital market. This has drawn great importance on what will happen on the yield curve following the risk aversion of the various investors, how changes in short term interest rates on short term securities will affect long term interest rates especially as we know that long term rates play a critical role in a number of important economic decisions, such as firms’ decisions about investment, and households’ decisions about purchases of homes and other durable goods. (Steven Russell). Therefore, the role of interest rates cannot be undermined in any economy, for it helps the authorities shape their economy and puts checks and balances. References Steven Russell, “Understanding the term structure of interest rates: Expectations Theory” retrieved online at http://research.stlouisfed.org/publications/review/92/07/Structure_Jul_Aug1992.pdf on 10-12-2008 at 10:50am Simon Benninga & Zvi Weiner (1998); “The Term Structure of interest rates”, Mathematica in Education and Research, Vol. 7 (2) pp 1 - 9 Zvi Bodie, Alex Kane & Alan Marcus (2005); Investments. McGraw Hill, 5th Edition, pp 452 – 481 Websites consulted http://www.finpipe.com/, retrieved on 09-12-2008 at 17:50 pm http://www.investopedia.com/terms/t/termstructure.asp, retrieved on 09-12-2008 at 06:49 am Read More