Advanced Finance Dr. Parviz Aghili 1390-91 2 nd term Interest rate - - PowerPoint PPT Presentation
Sharif University of Technology Graduate School of Management and Economics Advanced Finance Dr. Parviz Aghili 1390-91 2 nd term Interest rate Nominal interest rate: rate at which money invested grows. The nominal interest rate is the
1390-91 2nd term
Sharif University of Technology Graduate School of Management and Economics
Nominal interest rate: rate at which money invested
terms, of interest payable. Real interest rate: measures the purchasing power of interest receipts, so it takes inflation into account.
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The following model describes the relationship between real and nominal interest rate: 𝑗𝑜 = 𝑗𝑠 + 𝐽 + 𝜏 Where: 𝑗𝑜=nominal interest rate 𝑗𝑠=real interest rate 𝐽=inflation rate 𝜏=risk premium *Normally 𝑗𝑠 is between 3-5% (In Iran it’s about 4%).
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The term structure is the relation between the yield and the time to maturity. It’s also known as yield curve. The yield curve may take various shapes such as: ascending, descending, flat and humped.
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The normal shape for yield curve is upward sloping. the longer the maturity, the higher the yield, with diminishing marginal increases.
There are two common explanations for upward sloping yield curves. First: it may be that the market is anticipating a rise in the risk-free rate. If investors hold off investing now, they may receive a better rate in the future. Second: longer maturities entail greater risks for the
longer durations there is more uncertainty.
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An inverted yield curve
yields fall below short- term yields. This happens under unusual circumstances (e.g. a rise in inflation caused by an external factor)
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A humped curve results when medium-term yields are higher than those of the short-term and long-term. This may happen when market anticipates a rise in short-term yields in near future.
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A flat yield curve is
maturities have similar yields. A flat curve sends signals
a normal curve or could later result into an inverted curve.
1) Market expectations hypothesis: This hypothesis suggests that the shape of the yield curve depends on market participants' expectations of future interest rates. Where 𝑗𝑚𝑢 and 𝑗𝑡𝑢 successively represent interest rates for long-term and short-term periods.
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2) Liquidity Preference Theory This Theory asserts that long-term interest rates not only reflect investors’ assumptions about future interest rates but also include a premium for holding long-term bonds. Where rpn is the risk premium associated with an n year bond.
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Theories explaining the yield curve (cont.)
3) Market segmentation theory In this theory, financial instruments of different terms are not substitutable. As a result, the supply and demand for the money market and capital market instruments is determined independently. This theory fails to explain the observed fact that yields tend to move together (i.e., upward and downward shifts in the curve).
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Theories explaining the yield curve (cont.)
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A rise in short-term rates will lead to an inverted yield curve. It can be used as a contractionary monetary policy for dealing with inflation (as in case of U.S.).
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Monetary policy and inflation (cont.)
But increasing short-term and long term rates will lead to an upward shift of the whole curve. This policy -as being used in Iran- will stabilize inflation in the economy.