Interest Rate Theories PDF

THEORIES OF INTEREST RATES Revisiting Interest Rates Interest rates affect borrowing costs and investment decisions. Rates are determined by multiple factors, including central banks. Understanding theories helps predict market behavior. Importance for investors, policymakers, and financial...

THEORIES OF INTEREST RATES Revisiting Interest Rates Interest rates affect borrowing costs and investment decisions. Rates are determined by multiple factors, including central banks. Understanding theories helps predict market behavior. Importance for investors, policymakers, and financial analysts. 3: Overview of Interest Rate Theories  Three major theories to explain interest rate movements: 1. Expectations Theory 2. Market Segmentation Theory 3. Liquidity Premium Theory  Each theory provides different insights into how rates are set. 4: Expectations Theory – Introduction  Long-term rates reflect future short-term rates.  Investors expect future rates to influence today’s long-term rates.  If short-term rates are expected to rise, long-term rates rise too.  Applies to decisions on bonds of different maturities. 5: Expectations Theory – Bond Investment  Comparing a two-year bond vs. two consecutive one-year bonds.  Investors choose based on anticipated short-term rate changes.  If rates are expected to rise, longer-term bonds demand higher returns.  Returns are balanced between short-term and long-term bonds. 6: Expectations Theory – Key Assumptions  Assumes investors are indifferent between short-term and long-term bonds.  Focus is only on returns, ignoring risk and liquidity differences.  Assumes perfect foresight of future interest rate changes.  Limits: Does not account for investor behaviour in the real world. 7: Yield Curve Dynamics  Yield curve: a graph showing the relationship between bond yields and maturities.  Reflects investor expectations about future interest rates.  Shapes of yield curves provide insight into economic conditions.  Three common shapes: upward-sloping, flat, and inverted. 8: Upward-Sloping Yield Curve  Typical shape of a yield curve.  Longer-term bonds offer higher yields than short-term bonds.  Indicates expected economic growth and rising interest rates.  Investors demand more return for holding long-term investments 9: Flat Yield Curve  Indicates uncertainty about future interest rate movements.  Short-term and long-term bonds offer similar yields.  Signals a transition period in the economy.  Often occurs when growth slows or the economy is in flux. 10: Inverted Yield Curve  An unusual situation where short-term yields are higher than long- term yields.  Signals investor concerns about an economic downturn.  Historically, an indicator of upcoming recessions.  Reflects expectations of falling short-term rates in the future. 11: Yield Curve and Investor Behaviour  Upward-sloping curve encourages long-term investments.  Flat curve creates uncertainty about investment strategies.  Inverted curve drives investors to seek safety in long-term bonds.  Investors adjust portfolios based on yield curve movements. 12: Yield Curve and Policymakers  Central banks use the yield curve to gauge economic health.  Inverted curve puts pressure on central banks to adjust policies.  Yield curve helps predict inflation and future rate adjustments.  Example: The Federal Reserve monitoring curve before rate hikes. 13: Real-World Example: 2008 Financial Crisis  Yield curve inverted before the 2008 financial crisis.  Investors anticipated an economic downturn despite a strong housing market.  The Federal Reserve lowered short-term rates in response.  Investors benefitted from long-term bond holdings as yields fell. 14: Recent Yield Curve Trends Post-Pandemic  Yield curve steepened after the COVID-19 pandemic.  Economic recovery led to rising long-term rates.  Central banks like the Federal Reserve & RBI signalled rate increases. 15: Market Segmentation Theory – Introduction  Bonds are not interchangeable across maturities.  Different investors have different preferences for bond maturities.  Investors choose bonds based on their specific needs (e.g., liquidity, safety).  Rates are determined by supply and demand within each segment. 16: Market Segmentation – Investor Preferences  Institutional investors (pension funds) prefer long-term bonds.  Banks prefer short-term bonds to maintain liquidity.  Segmented markets create independent yield dynamics.  Maturity preference drives supply and demand for each segment. 17: Market Segmentation – Supply and Demand  High demand for short-term bonds reduces their yields.  Lower demand for long-term bonds increases their yields.  Yield curve reflects independent pricing in each segment.  Unlinked to future short-term rate expectations. 18: Market Segmentation – Impact on Yield Curves  Yield curves can be steeper or flatter based on investor preferences.  Long-term rates may rise due to low demand, independent of short- term rates.  Investor behavior influences bond market movements.  Example: Insurance companies investing in long-term bonds. 19: Liquidity Premium Theory – Introduction  Builds on Expectations Theory but adds a premium for long-term bonds.  Investors require compensation for holding riskier, less liquid bonds.  Long-term rates exceed short-term averages due to this premium.  Explains upward slope of the yield curve. 20: Liquidity Premium Theory – Risk Factors  Long-term bonds carry more interest rate risk (value falls if rates rise).  Less liquidity: harder to sell long-term bonds quickly.  Higher yield compensates for these additional risks.  Short-term bonds are more flexible and less risky. 21: Liquidity Premium Theory – Yield Curve  Curve slopes upwards even if short-term rates are expected to remain stable.  Premium explains higher yields for long-term bonds.  Reflects investor preference for short-term liquidity and safety.  Bonds with longer maturities are less attractive without a premium. 22: Liquidity Premium Theory – Example  Post-2008 financial crisis: long-term yields stayed high despite low short-term rates.  Investors demanded a premium for long-term bonds due to economic uncertainty.  Liquidity premium plays a key role in explaining this behavior. 23: Comparing Theories – Expectations vs. Market Segmentation  Expectations Theory: Rates linked across maturities based on expectations.  Market Segmentation: Bonds of different maturities operate independently.  Expectations Theory assumes investor indifference to maturities.  Market Segmentation highlights strong investor preferences for specific maturities. 24: Comparing Theories – Liquidity Premium vs. Expectations  Liquidity Premium builds on Expectations but adds risk compensation.  Explains the persistent upward slope of the yield curve.  Accounts for real-world investor risk aversion and liquidity needs.  Expectations Theory does not consider investor risk preferences. 25: Central Banks and Interest Rate Theories  Central banks use these theories to guide monetary policy.  Yield curve analysis helps anticipate market expectations.  Policymakers adjust rates to influence long-term economic growth.  Interest rate theories assist in managing inflation and recessions. 26: Real-World Application – Post-2008 Bond Markets  Post-2008: Central banks kept short-term rates low to stimulate growth.  Long-term rates did not drop as expected, due to liquidity premiums.  Investors demanded higher yields for holding long-term bonds.  Bond markets reflected real-world risk and liquidity concerns. 27: Real-World Application – Post-COVID-19 Bond Markets  Steep yield curve post-pandemic reflected recovery expectations.  Investors anticipated inflation, leading to higher long-term yields.  By 2022, curve flattened/inverted due to inflation and rate hike fears.  Example of how theories help interpret bond market behavior. 28: Key Takeaways – Expectations Theory  Long-term rates are an average of expected short-term rates.  Investor expectations shape bond market behavior.  Key for understanding yield curves and future rate movements. 29: Key Takeaways – Market Segmentation & Liquidity Premium  Market Segmentation: Investor preferences create segmented markets.  Liquidity Premium: Investors require compensation for holding riskier bonds.  Both theories account for real-world complexities beyond Expectations Theory. 30: Conclusion  Interest rate theories provide critical insights into bond markets.  Each theory helps explain different aspects of investor behavior.  Understanding these theories is essential for investors and policymakers.  Use these concepts to anticipate and navigate