Financial Institutions, Instruments and Markets 8th edition Instructor's Resource Manual Christopher Viney and Peter Phillips Chapter 13 An introduction to interest rate determination and forecasting Learning objective 1: Describe at a macroeconomic level how the liquidity effect, the income effect and the inflation effect influence the determination of interest rates • In forming a view on the future direction of interest rates, it is necessary to recognise that changes in monetary policy settings are likely to affect the state of the economy, which in turn affects interest rates generally • Within the macroeconomic context, these progressive changes are referred to as the liquidity effect, the income effect and the inflation effect on interest rates • The liquidity effect derives from monetary-policy-induced changes to in interest rates such as an increase in interest rates due to a reduction in liquidity in financial system • As interest rates rise, economic activity will slow and incomes fall This will cause interest rates to begin to ease or fall This is the income effect • The income effect will reduce upward pressures on prices as the economy slows and there is likely to be a reduction in the rate of inflation, thus causing interest rates to fall further (the inflation effect) • Therefore, when trying to forecast the state of an economy and future interest rates, policy makers, economists and financial market participants consider a range of economic indicators, such as the level of employment, productivity and housing approvals • Indicators may be described as leading, coincident and lagging indicators of future economic activity Learning objective 2: Explain the loanable funds approach to interest rate determination, highlighting variables that affect the demand and supply for loanable funds Consider the effects of changes in those variables on interest rate equilibrium • A disciplined approach to forming a view on the future direction of interest rate movements is provided by the loanable funds approach • Typically, the demand for loanable funds within the financial system originates from the business sector and the government sector and is represented by a downward sloping demand curve • The supply of loanable funds derives from the savings of the household sector, changes in the money supply and the hoarding or dishoarding that takes place in response to changes in interest rates This is represented by an upward sloping supply curve • Under the loanable funds approach, the prevailing rate of interest is determined by the intersection of the demand and supply curves; the equilibrium point • Factors that cause the demand or supply curves to change will result in a change in the rate of interest • While the framework is useful in identifying impacts on interest rates, its major shortcoming is that the supply and demand curves are interdependent For example, changes in the level of economic activity or inflationary expectations may impact both the demand side and the supply side of the curves As a result, it is not possible to determine a unique equilibrium interest rate • Another shortcoming of the loanable funds approach is that it addresses interest rate determination as if only one interest rate exists at a particular time This is clearly not the case in reality At any point there are many rates of interest • The differences in rates reflect the different terms to maturity of instruments and the credit risk of a borrower Differences between the interest rates on instruments of similar risk, but with different terms to maturity, are explained by theories of the term structure of interest rates Learning objective 3: Understand interest rate yields and the shape of various yield curves Apply the expectations theory, the segmented markets theory and the liquidity premium theory within the context of the term structure of interest rates • The term structure of interest rates is represented by a yield curve • The yield is the rate of return on debt instruments and a yield curve graphs the relationship between interest rates and the term to maturity of debt instruments in the same risk class • The shape of the yield curve may be normal, inverse or humped • A normal yield curve is an upward-sloping curve where there is an expectation that short-term interest rates in the future will rise A steeper normal curve indicates an expectation that there will be larger interest rate increases in the future • An inverse yield curve is a downward-sloping curve, typically induced through a tightening of monetary policy by a central bank It indicates that current short-term interest rates are high, but that there is an expectation that in the future there will be an easing of monetary policy and shortterm interest rates will begin to fall • The expectations theory argues that, in an efficient market, interest rates on longer-term instruments are determined by two factors: the current short-term interest rate and the shortterm rates that are expected to prevail over the longer term • The segmented markets theory provides a further explanation of the shape of the yield curve It contends that investors not view bonds of different maturities as being close substitutes It is argued that investors will have a preference to accumulate a majority of securities in an investment portfolio that have predominantly short-term, medium-term or long-term maturities The implication is that the shape of the yield curve is explained by the demand and supply conditions that are evident in the various maturity segments of the overall yield curve • However, the arguments of the segmented markets theory ignore the role of market arbitrage and speculation in ensuring that the yield curve over the maturity spectrum remains in equilibrium Also, in a modern financial market, risk managers are able to hedge such risk using synthetic risk management products such as derivatives As a result, the forecasts derived from the segmented markets approach must be treated with caution • An extension to the theory is obtained by the inclusion of a liquidity premium The liquidity premium theory contends that investors need to be compensated for a loss of liquidity and the higher risk levels that may exist in long-term investments; that is, investors will require a borrower to pay a liquidity premium before they are willing to give up their preference for short-term assets Therefore, the liquidity premium will change the slope of a yield curve Learning objective 4: Explain the risk structure of interest rates, discuss the so-called risk-free interest rate and consider the effect of default risk on interest rates • The other element that has to be considered in explaining the range of interest rates that are available at any one moment in time is the default or credit risk of the borrower Higher-risk borrowers must pay a higher rate of return than would be required of lower-risk borrowers • The risk-free rate of interest is defined as the yield on government Treasury bonds All other borrowers will pay a risk premium above the risk-free rate • The risk structure of interest rates incorporates the level of credit risk, over time, attached to a particular debt issue • A corporation with a AA+ credit rating will pay a lower yield than a corporation with a BBB credit rating, but both will pay a margin above the risk-free rate of the government Treasury bond • The yield curve evident within the financial markets for a particular security will change in its shape and slope from time to time, in particular as business and economic conditions change Essay questions The following suggested answers incorporate the main points that should be recognised by a student An instructor should advise students of the depth of analysis and discussion that is required for a particular question For example, an undergraduate student may only be required to briefly introduce points, explain in their own words and provide an example On the other hand, a post-graduate student may be required to provide much greater depth of analysis and discussion Within Australia the Reserve Bank is responsible for the implementation of monetary policy The central banks of other developed economies also have similar responsibilities Briefly identify and discuss a range of issues that the Reserve Bank considers when monitoring its current monetary policy settings (LO 13.1) Current monetary policy is principally directed towards containing inflation within a target range of to per cent over the business cycle In directing its policy decisions to achieve this objective, the central bank will consider: • the underlying rate of inflation over the business cycle • the rate of employment/unemployment/employment growth • the stability of the currency—in particular relative to major trading partners • the welfare of the people • the current economic environment/business cycle • current monetary policy settings • the direction of economic growth • the impact on past monetary policy settings on current and future economic growth • time delays between a change in monetary policy settings and a change in economic growth • economic fundamentals in major trading partner countries • forecast changes in international economic growth • a wide range of economic indicators, such as housing loan approvals (discussed in question 3) The macroeconomic context of interest rate determination attempts to explain the interactions of a change in monetary policy settings with changes in interest rates The macroeconomic context of interest rate determination identifies three distinct effects of a change in monetary policy (a) List the three effects • Liquidity effect • Income effect • Inflation effect (b) If the central bank tightens its monetary policy settings, describe the expected interactions that should occur based on the three effects identified in part (a) • In order to tighten monetary policy the Reserve Bank will implement a strategy of selling securities to the financial market; that is, it sells government paper and therefore receives payment that reduces the amount of funds available within the financial system • This monetary policy action of the central bank will impact upon interest rates, particularly the overnight cash rate (i) Liquidity effect: • The central bank’s action of selling government securities in order to affect the money supply will directly affect the level of liquidity in the financial system • If the central bank sells securities into the financial system, then there will be less cash in the system as investors pay cash to buy the securities thus reducing liquidity in the financial system • By tightening of liquidity, with less cash available for lending, interest rates will rise (ii) Income effect: • The income effect refers to the flow-on effect from the initial liquidity impact on interest rates • In the example, the central bank has tightened liquidity and increased interest rates Increased interest rates will typically reduce the levels of spending in the economy • Reduced levels of spending will result in lower incomes in all sectors of the economy: the household sector, the business sector and the government sector • This occurs as employment growth slows, demand for goods and services eases and taxation revenues to government decline • As the rate of growth in economic activity slows, the demand for loans also slows • The slowing in the demand for funds eventually will result in an easing in interest rates (iii) Inflation effect: • In so far as the economy was previously experiencing inflationary pressures due to high levels of demand, now the slowing of the pace of economic activity will cause the rate of inflation to ease • This easing allows rates of interest to ease as well • The nominal rate of interest is said to comprise two components, being the real rate of return plus compensation for the expected rate of inflation • If the rate of inflation is expected to fall, then it is expected that the nominal or market interest rates should fall Market participants, including financial institutions, funds managers and corporations, must understand monetary policy setting impacts on economic activity and the business cycle A central bank will typically implement monetary policy settings in order to achieve certain economic outcomes over a business cycle In order to forecast future economic conditions and business activity, business managers therefore need to understand the business cycle (LO 13.1) (a) Briefly describe the principal monetary policy objective of the Reserve Bank of Australia • The principal objective of current monetary policy is to implement monetary policy initiatives that contain inflation within a target range of to per cent over the business cycle (b) Draw a diagram and explain the structure of a business cycle over time • The business cycle is a measure of changes in the level of economic activity in an economy over time • It tends to move in changing cycles of peaks and troughs • Business cycle peak—the highest level of economic activity during a cycle • Business cycle trough—the lowest level of economic activity during a cycle Economic activity Peak Business cycle Trough Time (c) Discuss and give examples of different economic indicators that may give an insight into the future stages of a business cycle • Economic indicators are constructed from a set of historic data that provide some insight into possible future economic growth • Leading indicators—economic variables that change before there is a change in the business cycle • Coincident indicators—economic variables that change at the same time as the business cycle changes • Lagging indicators—economic variables that change after there is a change in the business cycle There is a wide range of economic indicators Governments, central banks, corporations and analysts will select a number of indicators that best inform them, including: • the rate of inflation over the business cycle • the rate of growth in gross domestic product • the balance of payments • credit growth and associated debt levels • the exchange rate relative to major trading partner currencies • the rate of unemployment, job vacancies and ratio of full-time and part-time employment • the balance of payments, imports and exports growth • finance for housing, residential and non-residential building approvals • economic activity and capacity utilisation • wages growth and overtime worked • retail sales • share price movements At a recent financial markets seminar, a participant asked the guest speaker to explain the loanable funds approach when forecasting interest rates (LO 13.2) (a) Describe the basic concept of the loanable funds approach to interest rate determination • The loanable funds approach contends that the current rate of interest is determined by the supply of and the demand for loanable funds • Future interest rates are therefore affected by changes in the demand and supply of loanable funds • Loanable funds are the flows of funds into the market for securities (b) Extend your answer in (a) above and draw diagrams showing the demand curve, the supply curve and the equilibrium interest rate With each diagram, identify and explain each of the components that comprise the supply and the demand curves, plus discuss how the equilibrium interest rate is derived Demand for loanable funds: There are two principal components: • Business demand for funds—to finance its liquidity and capital investment requirements The lower the rate of interest, all else being constant, the greater will be the volume of funds demanded This is represented by the downward-sloping curve (labelled B) Any factors that cause an increase (decrease) by business in its demand for funds would be represented by a shift to the right (left) in the B curve The curve shown represents the net business demand for funds • Government sector demand for funds—the total public sector borrowing requirement This includes the Commonwealth, States and local governments and their instrumentalities It is normally proposed that the public sector borrowing interest rate is independent of the market rate of interest, and this is represented by the vertical curve labelled G With a smaller (larger) borrowing requirement, the G curve would be located further to the left (right) in the diagram The two demand curves are combined to give the total demand for loanable funds (labelled G + B) Interest rates Interest rates Interest rates B G G+B Q Loanable funds Q Loanable funds Q Loanable funds Supply of loanable funds: There are three principal components: • Savings of the household sector—the curve (S) is drawn with an upward slope on the basis of the presumption that as interest rates increase people will save a larger proportion of their incomes The curve is steep because empirical evidence suggests increases in interest rates cause only small increases in the quantity saved • Changes in the money supply (∆M)—since the money supply is assumed to be independent of the rate of interest, changes in the money supply are represented diagrammatically as a vertical line When ∆M is added to the savings curve it simply changes the location of the curve (S + ∆M) It does not change the slope of the curve If, for example, the Reserve Bank increased the money supply, the S + ∆M curve would move to the right of the S curve • Dishoarding (D)—as interest rates increase, there is an incentive to acquire more securities in order to obtain the increased yields that are available In attempting to buy more securities money is given up (or dishoarded) Dishoarding is added to the S + ∆M curve to give the total supply of loanable funds curve 10 • The positive or upward-sloping curve is labelled as the ‘normal’ yield curve • The normal yield curve is typically the shape most frequently observed over the years • The combination of the expectations theory and the liquidity premium explains the observed dominance of the normal curve • At times, even though the pure expectations outcome is an inverse curve, when the liquidity premium is added to the curve it results in a positive or normal curve • At other times, the slope of an inverse yield curve will become flatter as a result of the effect of the liquidity premium; that is, the inverse curve will move upward (c) Does the existence of an inverse yield curve indicate a violation of the liquidity premium contention? • No, an inverse yield curve is still possible • In this instance, the downward slope of the inverse yield curve will be reduced by the liquidity premium effect That is, the yield curve will become flatter, but still retain an inverse slope Yield % observed yield curve liquidity premium expectations yield curve Time 12 The daily financial press regularly report data released on current economic variables and provide expert analysis on the forecast impact of changes in these variables on the future direction of interest rates Market participants, including policy makers, regulators and corporate managers also actively monitor changes in economic variables and interest rates Within this context, why is it important for market participants to understand the term structure of interest rates? Provide examples in your response (LO 13.3) • The term structure of interest rates represents the relationship of yield to the term to maturity 21 on a particular security such as Treasury bonds • Yield is expressed at a given point in time where there is constant risk, the same security, but a varying period to maturity • Yield curves may be categorised as normal, inverse and flat The shape and slope of each of these types of curves provides information to the market • Under the pure expectations theory, a normal yield curve implies that future short-term interest rates are expected to be higher than current short-term rates On the opposite side, an inverse yield curve implies that future short-term interest rates are expected to be lower than current short-term rates • If the term structure of interest rates within the market are correct and in equilibrium, then the shape and slope of the yield curve provides some very important indicators to market participants: • Borrowers—assists borrowers to make informed decisions on the future direction of their borrowing costs The borrower may be able to restructure or reschedule their existing funding arrangements to take advantage of expected movements in interest rates New borrowing issues may be brought forward, or alternatively delayed, depending on the forecast future movement in interest rates Decisions may also be made on the maturity structure of existing and new funding arrangements • Investors—will consider the term structure of interest rates in forecasting the future direction of interest rates This will influence their investment acquisition and disposal strategies; for example, an investor with a portfolio of bonds may determine to sell the bonds if an interest rate rise is forecast so as to avoid the price risk that prevails if yields increased • Financial institutions—are particularly concerned with current and future interest rates The price of most financial institution products is based on an interest rate Therefore any movement in rates will have a direct impact on the institutions’ net interest margins Institutions will implement strategies to restructure their existing asset portfolios, together with their liability commitments (gap management) Institutions will set the pricing of their borrowing and lending products based on their interpretation of the future movement in interest rates • Government and Reserve Bank—government will analyse the term structure of interest rates, having regard to its economic, social and political objectives These will be supported by the 22 determination and implementation of monetary policy by the Reserve Bank in order to achieve its objectives of full employment, stability of the currency and maintenance of the welfare of the people of Australia To this end, monetary policy is currently directed towards achieving an underlying inflation rate of to per cent over a business cycle The level of anticipated inflation will affect the slope or steepness of the yield curve If inflation is expected to remain relatively low, then the slope of the yield curve should remain relatively flat 13 A group of university students are asked to investigate interest rates on debt securities issued in the financial markets They soon discover that many interest rates exist The students are then asked to explain: (a) • the term 'risk-free rate of interest' The risk-free rate of interest is a return (yield) earned with certainty of payment; that is, there is no risk of default by the issuer • Within the Australian markets, the Treasury bond, issued by the Commonwealth government, is adopted as a proxy for the risk-free rate of return • The Treasury bond is accepted as being risk-free in that it is presumed that the government is able to meet its monetary commitments (b) why the existence of the risk-free rate of interest is important when examining the level of interest rates generally in the financial markets (LO 13.4) • The importance of the risk-free rate of return is that it is the basis upon which other financial assets are priced • Securities that have a higher degree of risk attached to them are priced at a margin above the risk-free rate • Therefore, the Treasury bond becomes the benchmark upon which interest rates on other securities with similar maturities are established • The risk-free rate of interest is applied in a number of important pricing models, including the options pricing model developed by Black & Scholes, and the Capital Asset Pricing Model 23 • The following graph demonstrates the role of the Treasury bond as the risk-free rate Debentures are priced above the Treasury bond rate, but unsecured notes are further priced above the debenture rate This reflects the relative risk of each of the securities Yield % Unsecured notes Risk premium Debentures Risk premium Treasury bonds Time (years) 14 The lending manager at a commercial bank is asked to explain to a corporate borrower what the bank’s policy is in relation to risk premiums on corporate loans (LO 13.4) (a) Discuss the concept of a risk premium and the effect that a risk premium will have on the yield curve for a corporate borrower • Risk premiums will be applied to corporate borrowers relative to the risk-free rate, being the Treasury bond yield for the similar term to maturity • Underlying the risk premium charged against a particular corporate borrower will be a range of operational and financial variables, however, the basic measure will be the level of perceived credit or default risk • That is, what is the probability that a borrower will be able to meet its future on-going cash flow commitments when they are due; in particular, repay its debt commitments and remain a financially viable corporation • The level of the risk premium will impact the cost of funds and the level of profitability of a corporation • A standard measure of risk used in the international corporate debt market is a credit rating given by a recognised credit rating agency such as Standard and Poor’s • The higher the credit rating, the lower is the risk premium and the cost of borrowing • Usually for domestic lending, a commercial bank will conduct its own assessment of the 24 level of credit risk associated with a local corporate borrower (b) Is it inevitable that the risk premium for a corporate borrower will be constant throughout the maturity spectrum? Explain your response • While conceptually it is possible for a risk premium attached to a particular corporate borrower to be constant over the maturity spectrum, it is more likely that the risk premium may vary • One set of conditions under which a widening risk premium gap may occur is if the corporate borrower has been a highly successful corporation, but its future is somewhat uncertain • For example, this could occur if the corporation's main products are towards the end of the product life cycle, and the company has not devoted sufficient resources to the research and development of a new product or production technique that will maintain its competitive advantage • The increasing gap could also open up if the company has recently been involved in a takeover or merger, the likely commercial success of which has not been clearly established by lenders • In both cases, there is a low risk of default on the near-to-maturity instruments, but greater uncertainty about the company's performance further into the future • It is also possible that the yield curve for a higher-risk borrower may show a narrowing of the risk premium gap as the term to maturity increases • Such an outcome could result from a concern that, in the current business environment, the company may have difficulty in redeeming the soon-to-mature instruments, but market participants believe that if the company survives the near-term, then its prospects are relatively good • Another example may be a company that is involved in a reasonably speculative exploration activity, or the development of a new technology, or an attempt to convert a laboratory discovery into a commercial product Near-term risk is high, but if successful the longer-term risk premium will fall Extended learning question 15 This question requires calculations relating to the yield curve and the expectations theory (LO 13.5) 25 (a) If an investor possesses the following information, and expectations on Treasury bond yields are: i = 4.25% p.a E1i1 = 5.20% p.a calculate the yield on a two-year bond (0i2) that would result in the investor being indifferent between placing funds in a one-year bond now, to be followed by a one-year bond in a year’s time, or placing the funds in a two-year bond now (1) Calculation using arithmetic average: i = (0i1 + E1i1 ) = 4.25 + 5.20 = (2) 4.725 % Calculation using geometric average: i = [( + 0i1 ) ( + E1i1 )] 0.5 – = [( 1.0425 ) ( 1.0520 )] 0.5 – = [ 1.09671 ] 0.5 – = 4.723923 % (b) You are given the following data: i = 4.00% p.a E1i1 = 5.00% p.a E2i1 = 5.75% p.a E3i1 = 6.20% p.a On the basis of the expectations theory of the yield curve, complete the following: (1) Calculate the 0i2, 0i3 and 0i4 rates formula: 0in = [(1 + 0i1) (1 + E1i1) (1 + E2i1) (1 + En - 1i1)]1/n – (i) i = [(1 + 0.04) (1 + 0.05)]1/2 – = 4.498804% 26 (ii) i = [(1 + 0.04) (1 + 0.05) (1 + 0.0575]1/3 – = 4.914216% (iii) i = [(1 + 0.04) (1 + 0.05) (1 + 0.0575) (1 + 0.0620]1/4 – = 5.234195% (2) Explain what is meant by implicit forward rates of interest On the basis of the expectations theory, a yield curve provides information regarding market participant’s future on-balance expectations concerning a large range of future interest rates That is, implicit in the yield curve there are indicators, or information, on a series of expectations about future interest rates (3) List the full range of one-year implicit rates of interest that could be calculated on the basis of the yield curve data that provide the current rates on bonds with one, two and three years to maturity 27 Yield % Years i i Actual rates i i 1 i Implicit rates i Implicit interest rates that could be calculated on the basis of the above yield curve are 1i1 , 1i2 and 2i1 (4) Given the following yield curve data, calculate the 2i2, 1i2 and 3i1 implicit rates: i = 4.30% p.a i = 5.15% p.a i = 5.80% p.a i = 6.25% p.a 28 Yield % i Years 4.30% i 5.15% i Actual rates 5.80% i 6.25% i 1 i i Implicit rates i i i formula: where: n = the number of periods until the future rate starts k = the number of periods over which the future rate applies (i) calculate 2i2 where: n = 2; k = = [(1 + 0.0625)4]0.5 –1 [(1 + 0.0515)2] = 7.361507% 29 (ii) calculate 1i2 where: n = 1; k = = [(1 + 0.0580)3]0.5 –1 [(1 + 0.0430)1] = 6.558070% (iii) calculate 3i1 where: n = 3; k = = [(1 + 0.0625)4]1/1 –1 [ (1 + 0.0580)3] = 5.135093% FINANCIAL NEWS CASE STUDY Chapter 13 considered the macroeconomic context, the loanable funds approach and the main theories that explain the determination of interest rates Also, as discussed in both Chapters 12 and 13, the central bank has an important impact on interest rates through the implementation of monetary policy The following article recognises that current economic conditions and monetary policy settings should significantly change in the near future and this will have an impact on the level of interest rates Next year could be even tougher for fixed-income investors, with long-dated bond prices likely to be driven down by foreign central bank policies During 2013, the performance of all asset classes and the weakness in the Australian dollar was heavily influenced by the actions of the US Federal Reserve, with its $US85 billion ($93 billion) in monthly bond purchases underpinning financial markets and helping restore confidence in United States-denominated assets 30 While fixed-income managers are divided on whether the Fed will start reducing its bond purchases as early as next week, most agree yields will track higher in the months ahead, sending bond prices down 'Given the uncertainty of tapering, I think it is going to be a tough year for investors in 2014, much harder than 2013,' Kapstream Capital managing director Kumar Palghat said He added the better returns of around per cent will be in corporate bonds, infrastructure bonds and asset-backed securities 'The removal of tapering could imply that the cost of borrowing for the US government goes up,' he said 'Yields on five- and 10-year bonds in the US will rise in 2014 because the largest buyer (the Federal Reserve) will no longer be buying bonds.' Yields, which move inversely to price, on comparable Australian bonds are also expected to follow US Treasuries higher – even if the Reserve Bank of Australia decides to keep the local cash rate on hold at 2.5 per cent Typically, shorter-dated bonds reflect future interest rate expectations 'In Australia, it is notable that the bond market is already repricing to an improved economic outlook and we expect to see this continue,' he said 31 UBS strategist Mike Schumacher said politics, economic growth and inflation, which typically influence bond market returns, would still take a back seat in the year ahead because of the sheer scale of Fed stimulus and interest rates decisions to come 'Bond yields are likely to trend higher next year in all major markets, with Australia being no exception,' said Steven Mansell, Citi head of G10 rates strategy for Asia Pacific SOURCE: Bianca Hartge-Hazelman, Tough time for bonds in 2014, Smart Investor, 12 December 2013 DISCUSSION POINTS • The article contends that long-dated bond prices are likely to be driven down by foreign central bank policies during 2014 Discuss the relationship between bond prices and the monetary policy initiatives of central banks As mentioned in the article and in the text book, there is an inverse relationship between the price of existing (fixed interest) bonds and changes in market interest rates The monetary policy initiatives of a central bank will change the level of interest rates If a central bank decides to tighten monetary policy, then interest rates across the maturity spectrum will progressively rise; on the other hand, if monetary policy is loosened, then interest rates are expected to fall At the time of this article, a very loose monetary policy in the USA has seen interest rates at very low levels, but it is expected that as the USA economy improves monetary policy will tighten thus pushing up interest rates This will mean that the prices of existing bonds in the USA will fall However, the article also contends that yields on bonds in Australia and other major markets may well rise in response to the rise in forecast interest rates in the USA; that is, yields will increase (without any monetary policy action by an overseas country’s central bank) in order to encourage fixed interest investors to continue to buy those bonds rather than moving a large part of their bond portfolios into the US bond market • The article refers specifically to the stimulus package initiatives of the Federal Reserve in the United States Why and how did the Federal Reserve implement the stimulus 32 package? In 2009, at the height of the global financial crisis, the US Federal Reserve implemented an economic stimulus package, often referred to as quantitative easing Quantitative easing (QE) has moved through three phases during which the Fed bought over US$4 trillion worth of securities from the market QE3 saw the Fed buying US$85 each month from the market Essentially, the Fed was pumping US$85 billion into the economy each month As at July 2014 this had tapered to US$35 billion per month as the Fed winds back its stimulus package At the time of this article, it appears that the Fed plans to end its economic stimulus plan by the end of October 2014 The QE stimulus package was designed to put money into the financial system in order to encourage bank lending to the corporate sector, which in turn would stimulate economic growth and lower the very high unemployment rate • Tapering of the Federal Reserve stimulus package is forecast to begin in 2014 What does this mean and how will the ongoing tapering of the above stimulus package impact interest rates in the debt markets? Tapering refers to the gradual reduction of the QE3 economic stimulus being conducted by the Federal Reserve Bank in the USA As mentioned above, as at July 2014, the Fed had reduced its monthly US$85 billion stimulus package down the US$35 billion each month Unless economic conditions deteriorate in the US the Fed proposes to finish QE3 by the end of October 2014 As noted in the article, the slowdown in QE3 has begun to push yields up on longer-term fixed interest securities As QE3 winds down fully, it is to be expected that yields will rise further The rise in interest rates should flow through to interest rates throughout the maturity spectrum True/False questions 33 T Initially, an easing of monetary policy will result in a fall in interest rates, but as economic activity increases, the income and inflation effects are likely to result in an increase in interest rates F Economic indicators such as the level of employment provide market participants with clear and certain indication as to the future direction of economic activity and growth F A coincident economic indicator is one that might be used to indicate the future direction in which the economy is headed T In the loanable funds approach to interest rates, the demand for funds originates from the business sector and the government sector T The supply of loanable funds is derived from the savings of the household sector, changes in the money supply and dishoarding F An increase in the money supply would permanently shift the supply curve of loanable funds to the right T Dishoarding is generally more evident when interest rates in the market have increased F The government sector demand curve in the loanable funds approach is downward sloping, with the slope changing in response to the size of government expenditures T With the loanable funds approach to interest rate determination, the demand and supply curves are not independent of each other; therefore it is not possible to accurately determine a unique equilibrium interest rate 10 F Applying the non-Fisher outcome to the loanable funds approach, an increase in inflationary expectations will result in an increase in interest rates equal to the increase in inflationary expectations 11 F The long-term yield curve is a single curve at a point in time that shows the various interest rates for different terms to maturity on all fixed-interest securities issued by governments and corporations 12 T When the central bank implements tight monetary policy, an inverse yield curve should occur as short-term interest rates will be higher than longer-term interest rates 13 F The various theories of interest rate determination are independent of each other and market participants usually adopt one theory when analysing interest rates 14 T Under the expectations theory of the yield curve, longer-term interest rates are a 34 function of the current short-term interest rate and forecast future short-term interest rates that will exist over the longer term 15 F Using the expectations approach, a bank is offering a one-year term deposit interest rate of 4.75 per cent per annum, and a two-year rate of 5.25 per cent per annum Therefore an investor should expect that in 12 months’ time the new one-year interest rate will have increased to 5.25 per cent per annum 16 T Under the segmented markets approach to explaining the yield curve, an increase in the supply of short-term instruments and an equal reduction in the supply of long-term instruments would cause the short end of the yield curve to rise and the long end to fall 17 T The liquidity premium theory suggests that investors will demand a higher rate of interest to induce them to buy long-term instruments so that they will be compensated for increased risk and loss of liquidity 18 F The existence of an inverse yield curve indicates that investors are not demanding a liquidity premium in periods of tight monetary policy 19 T The risk structure of interest rates includes a margin for default or credit risk for each corporate debt issuer A corporation with a AA– credit rating will pay a lower risk premium than a corporation with a BBB+ credit rating 20 F The risk-free rate of interest is the yield paid on longer-term securities issued by corporate borrowers that have an investment-grade credit rating 35