financial market report
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Topic-2FlowofFundsandInterestRates-2.pptx
FINANCIAL MARKETS
Topic 2
The Flow of Funds and Determination of Interest Rates
Overview
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Sectors in the financial system
The flow of funds between sectors
The nature of interest rates
Determination of the level of interest rates
Determination of the structure of interest rates
Interest rate calculations
Sectorial Players in the Financial System
Households
Financial Corporations
Corporations
Government
Domestic Economy
Rest of the World
Rest of the world
Sectorial Players in the Financial System
Households
Traditionally a net lender of funds
Over 80% of funds raised by this sector are by means of loans from financial intermediaries.
Non-financial corporations
Traditionally a net deficit sector. Funds must be raised for asset acquisition.
In Australia, approximately 60% of funds are raised by equity and 40% debt.
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Sectorial Players in the Financial System
Financial corporations
Traditionally a net borrower of funds, but this varies from year to year.
Claims on
Non-financial corporations
General government
Liabilities to
Households
Rest of the world
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Sectorial Players in the Financial System
Government
Depends on overall government budgetary policy, traditionally a net deficit sector in western economies.
Most funds raised by issuing long term debt securities (bonds). Also issue short term debt securities (treasury notes/bills).
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Sectorial Players in the Financial System
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Rest of the world
Traditionally a net lender of funds, though some countries are net borrowers.
Claims on non-financial corporations, financial corporations, general government
Liabilities to households
Sectorial Players in the Financial System
Domestic Economy
Rest of the World
| Net Lenders | Net Borrowers |
| Households | Government |
| Rest of the World | Financial Corporations |
| Non-financial Corporations |
Australia Inter-sectoral Financial Flows
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Source:http://www.abs.gov.au/AUSSTATS/[email protected]/Previousproducts/5232.0Main%20Features4Mar%202017?opendocument&tabname=Summary&prodno=5232.0&issue=Mar%202017&num=&view=
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Nature of Interest rates
What is ‘interest rates’?
Interest rates can represent:
the cost of borrowing funds
the rate of return from lending
the opportunity cost of holding money
the time value of money
$10,000 now or
$10,000 in 3 years ?
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Time Value of Money
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Interest rate calculations
Simple interest
Compound interest
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Simple interest
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Where I = interest amount
i = annual interest
t = term of the investment in years
Simple interest
Example: Term Deposit
$100
For 5 years
At 5% interest rate
What are the interest?
What is the future value?
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Simple interest
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Putting everything in one formula:
Compound Interest
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$100 invested for 5 yrs at 5% nominal interests compounded annually, meaning that the interest are reinvested.
| Year | Sum at beginning ($) | Interest earned ($) | Sum at end ($) |
| 1 | 100 | 5.0 | 105 |
| 2 | 105 | 5.25 | 110.25 |
| 3 | 110.25 | 5.51 | 115.76 |
| 4 | 115.76 | 5.79 | 121.54 |
| 5 | 121.54 | 6.08 | 127.63 |
Compound interest formula (compounded annually)
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Compound interest formula (> one compounding period)
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Step 1. Adjust interest rate to the compounding frequency
Step 2. Adjust interest power to the compounding frequency as well
Example
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a) What is the accumulated value of a $10,000 deposit made for four years with a yield of 9% per annum, compounded annually
b) What is the future value of the deposit described in (a) if interest is compounded quarterly
a)
b)
Other aspects of interest rates…
Effective interest rates:
compound interest rates are normally quoted as nominal interest rates (i.e. % per annum, without taking into account the compound effect and how many times it is compounded during the year)
Discount rates:
used to determine the price of
Discount securities
Fixed Interest Securities
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1.Effective/comparative/comparison interest rate
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Annual rate taking into account the compounding effect.
ie: effective interest rate
Effective/comparative/comparison interest rate
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Example:
10% Nominal rate
Compounded semi-annually
What is the effective rate?
2. Price of a discount security
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For some money market financial assets the future value is given and you have to calculate the discount price (Present Value).
At maturity the investor will receive the future value (also called face value).
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Price of a discount security
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For such securities the rate of interest i is generally represented by y yield not i.
The yield is the total rate of return on an investment; it comprises of investment income and capital gain (or loss).
2(a) Price of short term discount security
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Example: Bank Bill
FV = 70,000$
Term to Maturity = 30 days
y= 7.5% yield (p.a.)
Simple interest
What is the discount value/price/present value/ amount invested?
Price of short term discount security
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A corporation is selling a 30-day bank accepted bill with a total face value of $800,000. A bank is quoting the following rate 4.20. If the company accepts the quote the proceeds of the transaction will be:
$707,233.86
$767,754.31
$797,247.86
$833,677.32
None of the above.
If selected write the correct
answer on the answer sheet
2(b) Price of long-term discount security
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Also sold at a “discount” With compounding periods = interest are calculated periodically.
Price of long-term discount security
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Example:
Zero Coupon Bond
Future value= $1,000
Term to maturity= 3 years
9.25% market yield (p.a.)
Compounded annually
What is the discount value/price/present value/ amount invested?
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The level of interest rates
The overall position of interest rates, as a whole, within the aggregate economy or financial system
Central banks have a strong influence over it; use changes to the level of interest rates to affect consumer spending and borrowing
Note: In finance, when we refer to the interest rate, we normally refer to the nominal rate Nominal rate = Real rate + Inflation rate
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Determination of the level of interest rates
Loanable funds theory
The level interest rate can partially be explained by the loanable fund theory. The price of loanable funds (ie. the interest rate) will be the equilibrium price established by the interaction of the supply of and demand for loanable funds
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Determination of the level of interest rates Loanable funds theory
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Surplus economic units
Deficit
economic units
Determination of the level of interest rates
Main factors contributing to changes in level of interest rates:
Inflationary expectations
Central bank actions
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Determination of the level of interest rates
Inflationary expectations
Demanders of loanable funds will increase their demand for funds to maintain their pre-inflation investment plans
Suppliers of loanable funds will demand a higher rate of interest to maintain the real (after inflation) rate of return
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Determination of the level of interest rates
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Inflationary expectations
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Determination of the level of interest rates
Central Bank Action
Central banks intervene in the money market to influence the money supply, by buying and selling government securities
The increase or decrease in the money supply (respectively) will result in a change in the equilibrium interest rate
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Determination of the level of interest rates
RBA sells gov’t bonds:
Decrease in supply:
Q1 to Q2
Rates go up: R1 to R2
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Central Bank Action
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The structure of interest rate
The relationship, or variation, between different interest rates in different markets at one point in time, or in a particular market over different points in time
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The structure of interest rates
Term structure of interest rates
Shows how interest rates vary with term to maturity for otherwise identical investments
= Rates function of time
Risk structure of interest rates
Shows how interest rates vary with risk (credit risks, default risks, liquidity risks) for otherwise identical investments
Rates are a function of risk
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The structure of interest rates
Term structure of interest rate
The yield curves
A graphical representation of the term structure of interest rates
Can be constructed for different investments, or for the same investment over different time periods
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Term structure of interest rate Different shapes of the Yield Curve
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Normal
Flat
Humped
Downward
Term structure of interest rates We use government security yield curve=Government bonds
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Determinants of the shape of the yield curve
Market (pure) expectations theory
Expectations plus liquidity premium
Market segmentation approach
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1. Market (pure) expectations theory
Assumptions:
Investors are primarily concerned with maximising returns
They see all investments, regardless of maturity, as perfectly substitutable
Financial markets operate efficiently
See e.g.: ASX Target Rate Tracker
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Market (pure) expectations theory
The term structure of interest rates is determined by:
Current short-term rates
Expected future short-term rates
Predicts that long-term rates will be the average of the expected future short-term rates over the period
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Pure expectations theory: Long term interest rates represent current short term rates and futures future expected short term rates.
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Market (pure) expectations theory
An example:
3% current rate for 1 years bonds (vintage 2016).
4% is expected rate for 1 years bonds in 12 months (vintage 2017).
5% is expected rate for 1 years bonds in 24 months (vintage 2018).
According to the theory, today’s rate should be:
One year bonds 3%
Two years bond 3.5% = (3+4)/2
Three years bond 4% = (3+4+5)/3
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REMOVE THE WORD “VINTAGE”
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2. Expectations plus liquidity premium
Assumption:
Investors are indifferent between short and long-term investments, BUT require a liquidity premium to compensate them for the higher risk associated with long-term investments
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One of the criticisms of liquidity premium theory is that investors are indifferent to holding long-term bonds or short-term bonds. It says that long-term are more sensitive to large fluctuation in prices and therefore more risk. A 50 basis points change in the interest rates will cause a higher change in price of a long-term bond than a short term bond.
Investors prefer holding short term securities because of the lower interest rate risk and higher liquidity. They are also less exposed to risk of default. However borrowers want to borrow for long-term. Hence lenders require a compensation i.e. a premium, for investing for a long period.
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Expectations plus liquidity premium
In order to encourage investors to invest long-term, borrowers must offer higher returns for long-term investments - a liquidity premium
Predicts that the yield curve will show an “upward bias” compared to the yields predicted by pure expectations
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Can also represented by adding L to the formula of pure expectations theory.
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Expectations plus liquidity premium
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3. Segmented market approach
Assumptions:
Investors see investments with different maturities as imperfect substitutes
They are primarily concerned with matching the maturity of assets and liabilities in order to minimise risk
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Segmented market approach
Markets for financial assets with different terms to maturity are seen as separate markets from each other
Predicts that yield for different maturities will be a function of supply of and demand for investments with that maturity
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Segmented market approach
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S
S
S
D
D
D
1 year bond
3 year bond
2 year bond
Summary
Sectors of the financial system
The flow of funds between sectors
The nature of interest rates
Time value of money
Interest rate calculations
Simple and compound interest and effective rates
Pricing securities
The level of interest rates (D&S, inflation, OMO)
Structure of interest rates (various theories)
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Interest
I
Value
Present
PV
Value
Future
FV
Where
=
=
=
+
=
I
PV
FV
t
i
PV
I
´
´
=
(
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(
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it
PV
t
i
PV
PV
I
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FV
+
=
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1
125
25
100
25
5
05
.
0
100
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(
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127.63
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the
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number
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number
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PV = FV 1+ yt( )
= 70,000
1+ 0.075( ) 30 365 ⎛
⎝ ⎜
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= 69,571.14
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=
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