Tài chính doanh nghiệp - The impact of inflation & deflation, yield curves, and duration on interest rates and asset prices

Money and Capital Markets7C h a p t e rEighth EditionFinancial Institutions and Instruments in a Global MarketplacePeter S. RoseMcGraw Hill / IrwinSlides by Yee-Tien (Ted) FuThe Impact of Inflation & Deflation, Yield Curves, and Duration on Interest Rates and Asset Prices Learning Objectives To learn what inflation is and how it can impact interest rates and asset prices.To understand the greater concern today over deflation and how deflation 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 at any point in time. 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 assist in the making of investment choices and in protecting against the risk of changing interest rates.Inflation and Interest RatesInflation refers to the rise in the average level of prices for all goods and services.7Inflation and Interest RatesIn recent years, the U.S. inflation and interest rates appear to be fairly strongly correlated.1960 1.7 % 1.4 % 3.2 %1970 5.7 5.3 6.51980 13.5 9.2 11.41990 5.4 3.9 7.52000 3.4 2.3 5.92001 2.8 2.2 3.3YearRate of Inflation (% D)CPI GDP Deflator6-month T-bill Rate(secondary market)Inflation and Interest RatesNominal and Real Interest RatesIn 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 ratereal rate = rate measured in terms of the actual purchasing powerInflation and Interest RatesThe Fisher EffectIn 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 premiumThe inflation premium measures the rate of inflation expected by investors in the marketplace during the life of a particular financial instrument.Inflation and Interest RatesThe Harrod-Keynes Effect of InflationBuilding 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 RatesThe simple Fisher effect was the majority view for decades until problems began to surface:Partial anticipation of inflationInflation-caused wealth effectInflation-caused income effectInflation-caused depreciation effectInflation-caused income tax effectInflation and Interest RatesThe bulk of recent research suggests that nominal rates rise by less than any given increase in the expected inflation rate and decline by less than any given decrease in the expected inflation rate.However, note that the topic of inflation and interest rates is plagued by numerous measurement problems.Inflation and Interest RatesImpact of Price DeflationThere is growing concern that deflation – a fall in the average level of prices – may soon replace inflation as one of the key problems that nations may face in the future.Past experiences indicate that price deflation can result in lower output (production) of goods and services, and force real interest rates upward.Inflation and Interest RatesInflation and Stock PricesCommon stock is widely viewed as a hedge against inflation.However, research evidence seem to support the view that the impact of inflation on stock prices varies from firm to firm and from industry to industry depending on the actual rate of inflation and the terms of existing nominal contracts.Inflation-Adjusted SecuritiesThe 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 rateWhen the public expects higher inflation, inflation-adjusted securities rise in value.Inflation-Adjusted SecuritiesSource: Economic Trends, Federal Reserve Bank of Cleveland, June & July 2001The Maturity of a LoanOne 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 securities having the same credit quality.Source: Economic Trends, Federal Reserve Bank of Cleveland, June 2001The Maturity of a LoanYield curves may be upward sloping, downward sloping, or horizontal (flat).The Maturity of a LoanThe 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 amounts of long-term and short-term securities will not affect the shape of the yield curve unless investor expectations are also affected.The Maturity of a LoanThe 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 LoanThe 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 Maturity of a LoanThe 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 Maturity of a LoanEmpirical studies on the various yield curve theories have produced mixed results.As such, the traditional models are giving way today to newer models that are being created in response to recent theoretical developments – in particular, the Black-Scholes option pricing formula and the rational expectations theory.The Maturity of a LoanThe yield curve is a useful tool for forecasting interest rates – a downward-sloping yield curve suggests near-term declines in ratesidentifying portfolio management strategies – a rising yield curve favors short-term borrowing and long-term lendingdetecting overpriced and underpriced securitiesindicating trade-offs between maturity and yield“riding” the yield curve – active investors may gain by timely portfolio switchingDuration: A Different Approach to MaturityA popular measure of how responsive a debt security’s price is to changes in interest rates is its price elasticity (E).Greater price elasticity means that an asset goes through a greater price change for a given change in market rates of interest.% D in a security’s priceover time% D in a security’s yieldover timeDuration: A Different Approach to MaturityLonger-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 MaturityTo 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 MaturityDuration 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.Ct = the expected principal/interest payment in time period ty = the security’s yield to maturity, with maturity reached at the end of n periodsDuration: A Different Approach to MaturityThe relationship between an asset’s change in market price and its change in yield or interest rate is called convexity.Research shows that convexity increases with an 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 MaturityUses of DurationEstimating asset price changes % D in asset price 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.Duration: A Different Approach to MaturityLimitations of DurationIn 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.Money and Capital Markets in CyberspaceWebsites that discuss the impact of inflation on interest rates include: more on yield curves, visit: ReviewInflation and Interest RatesCorrelation between Inflation and Interest RatesNominal and Real Interest RatesThe Fisher EffectThe Harrod-Keynes Effect of InflationAlternative Views on Inflation and Interest RatesImpact of Price DeflationInflation and Stock PricesInflation-Adjusted SecuritiesChapter ReviewThe Maturity of a LoanThe Yield Curve and the Term Structure of Interest RatesTypes of Yield CurvesThe Unbiased Expectations HypothesisThe Liquidity Premium View of the Yield CurveThe Segmented-Markets ArgumentThe Preferred Habitat or Composite TheoryResearch Evidence on Yield-Curve TheoriesUses of the Yield CurveChapter ReviewDuration: A Different Approach to MaturityThe Price Elasticity of a Debt SecurityThe Impact of Varying Coupon RatesAn Alternative Maturity Index for a Security: DurationThe Convexity FactorUses of DurationLimitations of Duration