Module 2: Interest Rates and Market Efficiency PDF

MO DULE 2: INTEREST RATES AND MARKET EFFICIENCY 1.1 TYPES OF INTEREST RATES: N OMI N A L I N T E R E ST R A T E : T HE R A T E C HA R GE D ON A LOA N OR D E POSI T , a. W I T HOUT A D JUST I N G F OR I N F LA T I ON. E F F E C T I VE I N T E R E ST R A T E : T HE R A T...

MO DULE 2: INTEREST RATES AND MARKET EFFICIENCY 1.1 TYPES OF INTEREST RATES: N OMI N A L I N T E R E ST R A T E : T HE R A T E C HA R GE D ON A LOA N OR D E POSI T , a. W I T HOUT A D JUST I N G F OR I N F LA T I ON. E F F E C T I VE I N T E R E ST R A T E : T HE R A T E T HA T R E F LE C T S T HE E F F E C T S b. OF C OMPOUN D I N G I N T E R E ST. R E A L I N T E R E ST R A T E : T HE R A T E A D JUST E D F OR c. I N F LA T I ON , R E F LE C T I N G T HE T R UE PUR C HA SI N G POW E R. A N N UA L PE R C E N T A GE R A T E (A PR ) : T HE R A T E d. C HA RGE D ON A LOA N OR C R E D I T PR OD UC T. 1.2 HO W I NTEREST RATES WORK: a. Borrowing: Interest rates determine the cost of borrowing for individuals and businesses. b. Savings: Interest rates influence the returns on deposits and savings accounts. Investments: Interest rates affect the yields on investments, such as bonds and stocks.  1.4 TYPES OF INTEREST RA TE RISKS: IN TER EST R ATE R EIN V ESTM EN T LIQ UIDITY R ISK: R ISK: R ISK: C ha nge s in int e r e s t r a t e s T he r is k of r e inv e st ing T he r is k of d if f ic u lt y a f f e c t inv e s t ment values pr inc ipal or int er es t at a s elling or t r ad ing an low e r r a t e. inv e s t me nt 1.5 K E Y INT EREST RATE BENCHMARKS : a. Prime Lending Rate: The rate at which banks lend to their best customers. b. Interbank Rate: The rate at which banks lend to each other overnight. c. Treasury Bill Rate: The rate on short-term government securitie s.  2.0 MEASUREMENT AND RISK STRUCTURE OF INTEREST RATES Measurement and risk structure of interest rates are crucial concepts in finance. Here's an overview: 2.1 Measurement of Interest Rates: a. Nominal Interest Rate: The rate charged on a loan or investment, without adjusting for inflation. b. Effective Interest Rate: The rate that reflects the effects of compounding interest. c. Real Interest Rate: The rate adjusted for inflation, reflecting the true purchasing power. d.Annual Percentage Rate (APR): The rate charged on a loan or credit product. 2.2 RISK STRUCTURE OF INTEREST RATES: a.Term Structure: The relationship between interest rates and bond maturities. b.Credit Risk Premium: The additional return required for lending to riskier borrowers. c.Liquidity Premium: The additional return required for less liquid investments. d.Inflation Premium: The additional return required to compensate for expected inflation. 2.3 TYPES OF I NTE REST RATE RISK: a. R einv est ment R isk: T he risk o f reinv est ing pr incipal o r int erest at a l o wer rat e. b. I nt erest R at e R isk: T he risk o f chang es in int erest rat es af f ect ing inv est ment v al u es. c. C redit R isk: T he risk o f bo rro wer def au l t o r credit do wng rade. d. Liqu idit y R isk: The risk of dif f icu l t y sel l ing o r t rading an inv est ment 2.4 MEAS U RI NG INTEREST RATE RISK: a. D u rat io n: A measu r e o f a bo nd' s sensit iv it y t o int er est r at e chang es. b. C o nv ex it y : A measu r e o f a bo nd's cu rv at u r e, af f ect ing it s price sensit iv it y. c. Val u e - at - R isk ( VaR ) : A m easu r e o f po t ent ial l o sses du e t o int er est rat e chang es. d. Sensit ivit y A nal y sis: A nal y zing ho w chang es in int er est r at es af f ect inv est ment v al u es 2.5 MANA G I NG INTEREST RATE RISK: a. Hedg ing : Using der iv at iv es t o mit ig at e int erest r at e r isk. b.D iv ersif icat io n: Spr eading inv est ment s acro ss dif f er ent asset cl asses and mat u r it ies. c. A sset - Liabil it y Manag ement : Mat ching asset s and l iabil it ies t o minimize int erest r at e r isk. d. I nt erest R at e Swaps: E x chang ing f ix ed - r at e pay ment s f or f l oat ing - rat e pay ment s 2.6 KEY INTE RE S T RATE MO DELS: a. Yield Curve Model: A model estimating future interest rates based on current rates. b. Term Structure Model: A model describing the relationship between interest rates and bond maturities. c. Cox-Ingersoll-Ross (CIR) Model: A model describing interest rate dynamics. d. Vasicek Model: A model describing interest rate mean reversion. 3.0 TE RM S TRUCTURE AND C HA NG E S IN INTEREST RATES The term structure of interest rates and changes in interest rates are crucial concepts in finance. Here's an overview: 3.1 Term Structure of Interest Rates: a. Yield Curve: A graphical representation of interest rates across different bond maturities. b. Normal Yield Curve: A curve where long-term rates are higher than short-term rates. c. Inverted Yield Curve: A curve where short-term rates are higher than long-term rates. d. Flat Yield Curve: A curve where rates are similar across maturit ies. 3.2 Factors Influencing Term Structure: Expectations Theory: Interest rates reflect market expectations of future rates. Liquidity Preference Theory: Investors demand higher returns for longer-term investments. Market Segmentation Theory: Different market segments have distinct preferences. Preferred Habitat Theory: Investors have preferred investment horiz ons. 3.3 CHA NG E S IN INTEREST RA TE S : a. Monetary Policy: Central banks adjust interest rates to control inflation and growth. Expectations Theory: Interest rates reflect market expectations of future rates. b. Fiscal Policy: Government spending and taxation influence interest rates. Liquidity Preference Theory: Investors demand higher returns for longer-term c. flation Expectations: Changes in inflation expectations affect interest rates. investments. d. Economic Market Growth: Changes Segmentation in economic Theory: Different growth market influence segments interest have ratpreferences. distinct es. Preferred Habitat Theory: Investors have preferred inve stm 3.4TYPE S OF INTEREST RA TE CHANGES: Parallel Shift: A uniform change in interest rates across all maturities. Non-Parallel Shift: A change in interest rates affecting different maturities differently. Twist: A change in the slope of the yield curve 3.5 IMPA C T O F INTEREST RATE CHANGES: Bond Prices: Changes in interest rates affect bond prices. Stock Prices: Changes in interest rates influence stock prices. Currency Exchange Rates: Changes in interest rates affect exchange rates. Economic Activity: Changes in interest rates influence economic growth. 3.6 KEY MODELS FOR TERM STRUCTURE AND INTEREST RATE CHANGES: a. Cox-Ingersoll-Ross (CIR) Model: A model describing interest rate dynamics. b. Vasicek Model: A model describing interest rate mean reversion. c Ho-Lee Model: A model describing short-rate dynamics. d Heath-Jarrow-Morton (HJM) Model: A model describing forward rate dynamics 4.1 Types of Market Efficiency: Weak-Form Efficiency: Past market data is reflected in current prices. Semi-Strong-Form Efficiency: Publicly available information is reflected in current prices. Strong-Form Efficiency: All information, public and private, is reflected in current prices 4.2 Characteristics of Efficient Markets: a. Random Walk: Prices move randomly, making it impossible to predict future prices. b Unbiased Prices: Prices reflect all available information. c. No Arbitrage Opportunities: No risk-free profit 4.3 Implications of Market Efficiency: No Free Lunch: It's impossible to consistently achieve returns in excess of the market's average. Diversification: Spreading investments to minimize risk. Fundamental Analysis: Analyzing company fundamentals to estimate intrinsic value. Technical Analysis: Analyzing market trends and patterns. 4.4 CRITICISMS a. Behavioral Finance: Markets are influenced by AND psychological biases. b. symmetric Information: Some investors have access CHALLENGES: to better information. c. Market Frictions: Transaction costs, taxes, and other market imperfections. 4.5 EVIDENCE FOR MARKET EFFICIENCY: a. Random Walk Studies: Prices exhibit random walk behavior. b. Event Studies: Stock prices react quickly to new information c. Anomalies: Some studies find deviations from market efficiency 4.6 Key Theories: a. Efficient Market Hypothesis (EMH): Markets reflect all available information. b. Capital Asset Pricing Model (CAPM): Expected returns are proportional to risk. c. Arbitrage Pricing Theory (APT): Expected returns are proportional to macroeconomic factors  THANK YOU Prepared by: Dr. Oreitan Adigun +2348033527798 [email protected]