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## Chapter 7

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**Chapter 7**Inflation & Deflation, Yield Curves, and Duration: Impact on Interest Rates and Asset Prices**To learn what inflation is and how it can impact interest**rates and the prices of financial assets. To understand the greater concern today over deflation and how it 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. 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 be used to assist in making investment choices and in protecting against the risk of changes in interest rates. Learning Objectives **Why are the interest rates on U.S. Treasury bills, Treasury**bonds, municipal bonds, corporate bonds, personal loans, etc. so different from one another? Understanding the factors that cause interest rates to differ is an indispensable aid to the investor and saver in choosing financial assets for a portfolio. Introduction**Inflation refers to the rise in the average level of prices**for all goods and services. 7 Inflation and Interest Rates**In recent years, the U.S. inflation and interest rates**appear to be fairly strongly correlated. Source: U.S. Department of Commerce and Board of Governors of the Federal Reserve System Inflation and Interest Rates**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 Inflation and Interest Rates**The Fisher Effect**In a 1896 classic article, economist Irving Fisher argued that expected 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. Inflation and Interest Rates**Alternative Views**While the Fisher effect is among the most popular explanations of the linkages between inflation and interest rates, several alternative views have emerged over the years. Inflation and Interest Rates**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. Inflation and Interest Rates**Anticipated versus Unanticipated Inflation**One of the most obvious weaknesses of the Fisher effect was its failure to distinguish between anticipated (or expected) and unanticipated (or unexpected) inflation. In particular, there is no way to be certain about what the equilibrium nominal interest rate will be if all or a portion of the increase in inflation is unanticipated. Inflation and Interest Rates**Inflation and Interest Rates**The Impact of Fully Anticipated Inflation on Interest Rates**The Inflation Risk Premium**Inflation risk premium represents compensation paid to a lender for that component of inflation that is not expected. Recent research suggested that the inflation-interest rate equation may look more like: nominal interest rate = real interest rate + expected inflation rate + inflation risk premium Inflation and Interest Rates**The Inflation-Caused Income Tax Effect**Lenders and investors not exempt from income taxes make lending and investing decisions on the basis of their expected real rate of return after taxes. This effect may actually widen movements in nominal interest rates, resulting in nominal rates changing by more than any given change in expected inflation. Inflation and Interest Rates**Conclusions**The inflation-nominal interest rate relationship appears to be positive: higher rates of inflation mostly lead to higher nominal interest rates. However, nominal interest rates tend to change by less than the expected change in the inflation rate. Note that this topic is plagued by numerous measurement problems. Inflation and Interest Rates**The Nature and Impact of Price Deflation**There is growing concern that deflation – a fall in the average level of prices – may eventually replace inflation as a significant economic problem for the future. Past experiences indicate that price deflation may result in lower output (production) of goods and services, and force real interest rates upward. Inflation and Interest Rates**Common stock is widely viewed as a hedge against inflation.**However, the facts are often contradictory. There are several conflicting arguments on the inflation-stock price relationship. One line of argument suggested that the impact will vary from firm to firm and from industry to industry depending on the actual inflation rate and the terms of existing nominal contracts. Inflation and Stock Prices**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. Inflation-Adjusted Securities**Note that the TIPS investor’s real rate of return has not**changed: Inflation-Adjusted Securities**Inflation-Adjusted Securities**Source: Economic Trends, Federal Reserve Bank of Cleveland, Aug & Dec 2003**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 financial assets having the same credit quality. The Maturity of a Loan**Yield curves may be upward sloping, downward sloping, or**horizontal (flat). The Maturity of a Loan Source: Economic Trends, Federal Reserve Bank of Cleveland, June 2001**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 quantities of long-term versus short-term financial assets will not affect the shape of the yield curve unless investor expectations are also affected. The Maturity of a Loan**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. The Maturity of a Loan**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. The Segmented-Markets and Preferred Habitat Arguments**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. The Segmented-Markets and Preferred Habitat Arguments**Empirical studies on the various yield curve theories have**produced mixed results. As such, recent research as delved more deeply into the issue of what kinds of events cause the yield curve’s overall shape to change. Statistically, yield curves may change along any of at least three different dimensions: level, slope, or curvature. Research Evidence on Yield Curves**Research Evidence on Yield Curves**The Level, Slope, and Curvature of Yield Curves**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 over- and under-priced financial assets indicating trade-offs between maturity and yield “riding” the yield curve – active investors may gain by timely portfolio switching Uses of the Yield Curve**A popular measure of how responsive a debt security’s**price is to changes in interest rates is its price elasticity (E). % D in a security’s price over time % D in a security’s yield over time Duration: A Different Approach to Maturity • Greater price elasticity means that an asset goes through a greater price change for a given change in market rates of interest.**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. Duration: A Different Approach to Maturity**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. Duration: A Different Approach to Maturity**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. Duration: A Different Approach to Maturity Ct = the expected principal/interest payment in time period t y = the security’s yield to maturity, with maturity reached at the end of n periods**The relationship between a financial asset’s change in**market price and its change in yield or interest rate is called convexity. Research shows that convexity increases with a financial 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. Duration: A Different Approach to Maturity**Uses of Duration**Estimating asset price changes % D in asset price Duration: A Different Approach to Maturity • 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.**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. Duration: A Different Approach to Maturity**Central Bank Websites at www.bis.gov/cbanks.htm**European Central Bank at www.ecb.int Federal Reserve System at www.federalreserve.gov Global Financial Data at www.globalfindata.com Interest Rate Calculator at www.interestratecalculator.com Markets on the Net**The Economist at www.economist.com**The Bond Market Association at www.investinginbonds.com The Financial Pipeline at www.finpipe.com U.S. Savings Bonds Online at www.savingsbond.com Markets on the Net**Introduction**Inflation and Interest Rates Correlation between Inflation and Interest Rates Nominal and Real Interest Rates The Fisher Effect The Harrod-Keynes Effect of Inflation Anticipated versus Unanticipated Inflation The Inflation Risk Premium The Inflation-Caused Income Tax Effect The Nature and Impact of Price Deflation Chapter Review**Inflation and Stock Prices**The Development of Inflation-Adjusted Securities 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 Chapter Review**The Segmented-Markets and Preferred Habitat Arguments**The Possible Impact of Segmented Markets on the Yield Curve The Preferred Habitat or Composite Theory of the Yield Curve Research Evidence on Yield Curves Uses of the Yield Curve Chapter Review**Duration: A Different Approach to Maturity**The Price Elasticity of a Bond or other Debt Security The Impact of Varying Coupon Rates An Alternative Maturity Index for a Financial Asset: Duration The Convexity Factor Uses of Duration Limitations of Duration Chapter Review