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Systematic risk

Systematic risk arises an account of the economy-wide uncertainties and the tendency of individual securities to move together with changes in the market. Also known as market risk.This is the risk can not be reduced through diversification.

Investor are exposed to market risk. Even when they hold well-diversified portfolio of securities systematic risk of the security.It can not be diversified because like other securities it also moves with the market.

As mention in paragraph systematic risk is not diversifiable. Investor do not pay any premium for diversifying total risk via reduction in non-systematic risk.They can do on their own, cheaply and quickly.

Add in the last of part example of systematic risk.

->The government changes the interest rate policy. The corporate tax rate increased.

->The government result to massive deficit financing.

->The RBI promulgates a restrictive credit policy.

->The government relaxes the foreign exchange contracts and announces full convertibility of the Indian rupee.

->The government withdrawal tax on dividends payment by companies.

->The government eliminates reduces the capital gain tax rate.

All securities have some systematic risk, whether bonds or stocks.I have systematic risk directly compasses interest rate risk, market risk,and inflation risk. In this discussion, however the emphasis will be on the systematic risk of common stock.

In this case, systematic risk is that part of the variability correlated with the variability of the stock market as a whole.

Measuring systematic risk.

A measure needed of this unavoidable systematic or nondiversifiable based on modern portfolio theory. The beta has emerged as such a measure. Beta’s usefulness as a measure of risk is briefly discussed here.

Beta is a relative measure of risk of an individual stock in relation to the overall market, as measure by the volatility of its returns by statistically relating the return for a security to the returns.

By statistically relating the returns for the stock market as whole (using a regression equation) it is possible to determine how the security’s returns move in relation to the market’s returns move  more( less) then the markets returns.

If the security’s returns move more(less) than the market’s returns. As  the latter changes, the security is said to be more (less) volatile than the market for example. A security whose returns rise or fall an average 15% when the market return rise or falls 10% is said to be volatile security.

Beta is the slope of the regression line relating a securities returns to those of the market. If the slope of this relationship for a particular security is a 45- degree angle. This means that for every 1% change in the market return, on average this security’s returns change 1%  if the line is higher, beta is higher,managing that the volatility( market risk) is greater

For Example, security A’s beta of 1.5 indicate that, on average security returns are 1.5 as volatile as market returns Both up and down. If the line is less steep than the 45 degree line beta is less than 1.0. This indicate that, on average, a stock’s returns have less volatility than the market as a whole. For example security c’s beta of 0.6 indicate that stock returns move up or down generally only 60% as much as the market as a whole.

The aggregate market has beta of 1.0. More volatile (risky) stock have betas small than 1.0 as a relative measure of risk, beta is very convenient if an investor is considering a particular stock and is informed that is beta 1.0,this investor can recognize immediately that the stock is very risky.

In relation to the average beta for all stock is 1.0 many brokerage houses and investment advisory services report betas as part of the total information given for individual stocks.

Estimating systematic risk

Betas are estimated from historical data, regressing for the individual security against the for some market index. As result, the usefulness of betas will depend on, among other factors, the volatility of the regression equation. Regardless of how good the fit it, however beta is an estimate subject to errors.

It is important to note that most calculated betas are ex post betas. What is actually needed in investment decision is an ex ante beta measuring expected volatility.

The common practice of many investor is simply to calculate the beta for a security and assume it will remain constant in the future . A risky assumption in the case of individual securities similar to standard deviations portfolio betas often are quite stable across time whereas individual security betas often are notoriously unstable.

However, this is not an unfavorable outcome for investors because the basic premise of portfolio theory is the necessity of holding a portfolio of securities rather than only on or a few securities.

Substantive evidence has been presented that betas tend to move toward 1.0 overtime. Betas substantially larger( smaller) than 1.0 should tend to be followed by betas that are lower, and closer to 1.0 .

Thus, forecasted betas should be closer to 1.0 thus, forecasted betas should be closer 1.0 than the estimates based solely on historical data would suggest. Several models have been advocated for adjusting betas for this tendency to ” regress toward the mean. As a result it is not unused to find ” adjusted ” betas rather than historical betas.

 

 

 

 

Covariance

Covariance of returns on two assets measures their co-movenenent.

The risk of a portfolio could be measured in terms of its variance or standard deviation.

Three steps are involved in the calculation of covariance.

1)Determine the expected return on assets.

2)Determine the deviation of possible returns from the expected return for cash asset.

3)Determine the sum of the product of each deviation of returns of two assets and respective probability.

Formula of calculating covariance of x and y

Cov_{xy} =\sum_{i=1}^{n}[R_{x}-\varepsilon (R_{x})][R_{y}-\varepsilon(R_{y})]\timesP_{i}

Cov_{xy}=the return on securities x and y

Y,R_{x} and R_{y}= returns on securities X and Y

E(R_{x}) and E(R_{y})=expected return of x and y

P_{i} = probability of occurrence of the state of economy

Following possibilities between the return of securities x and y

->Positive covariance- x’s and y’s return could be above their average returns at the same time. Alternative x’s and y’s return below their average returns at the same time, In either situation this implies positive relation between two returns. It would be positive.

->Negative covariance-X’s return could be above its average return while y’s return could be below its average return and vice versa. This denotes a negative relationship between returns of x and y. It would be negative.

->Zero covariance-Returns on x and y could show no pattern that is, there is no relationship. In this situation, it would be zero. In reality, covariance may be non-zero due to randomness and negative and positive terms may not cancel out each other.

 

 

 

Correlation

The degree of association or strength of relationship between two variable is represented by a number called a correlation coefficient. The person product moment correlation coefficient is a measure of the linear relationship between two variable X and Y, and is denoted by r_{xy} or simply r, The population correlation coefficient is denoted by the Greek letter r(rho).

The value of a correlation coefficient can range from -1 to 1. A value of +1 denotes a perfect positive relationship. All the data points fall on straight line such that high scores on one variable are paired with high scores on the other, and low scores are paired with low scores.

A coefficient of -1 denotes a perfect negative or inverse relationship. For this case all the data points on a straight line such that high scores on one variable are paired with high scores on the other, and low scores are paired with low scores.

A coefficient of -1 denotes a perfect negative or inverse relationship. For this case, the data points also fall on a straight line,but high scores on one variable are paired with low scores on the other and vice versa resulting in a line that slopes down instead of up, If these is no linear association between the variables, r is equal to 0. In this case the data points tend to fall in a circle.

Intermediate degree of association are represented by coefficient less then 0 (-1<r<0)  or by coefficient greater then 0 (0<r<1).

Beta

A measure is needed of this unavoidable systematic or non diversification risk. Based on modern portfolio theory, the beta has emerged as such as measure Beta’s usefulness as a measure of risk is briefly discussed here.

Beta is a relative measure of risk -the risk of an in individual stock in relation to the overall market. As measured by the volatility of its return. By statistically relating the returns for a security to the returns for the stock market as a whole. It is possible to determine how the security’s return move in relation to the market’s return move more(less) volatile than market.

For example a security whose returns rise or fall on average 15% when the market return rise or falls 10% is said to be volatile security.

Beta is the slope of the regression line relating a security’s returns to those of the market. If the slope of this relationship for a particular security is a 45 degree angle for security B beta is 100.

This means that for every 1% change in the market’s return,on average this security’s returns change 1%. If the line is higher. Beta is higher meaning that the volatility (market risk) is greater.

For example security A’s beta of 15 indicate that, on average security return are 1.5 times as volatile as market return both up and down.

If line is less steep than the 45 degree line. Beta is less than 1.0 this indicate that, on average a stock’s return have less volatility than the market as a whole.

For example, security’s beta of 0.6 indicates that stock returns move up or down generally only 60% as much as the market as whole.

In summary, the aggregate market has a beta of 1.0. More volatile(risky) stock have larger bets and lets volatile(risky) stocks have bets smaller than 1.0. As a relative measure of risk, beta is very convenient.

If an investor is considering a particular stock and is if informed that its beta is 1.9. This investor is considering a particular stock and is informed that its beta is 1.9.

This investor can recognize 7immediately that the stock is very risky. In relation to the average stock because the average beta for stock is 1.0.

Many brokerage house and investment advisory services report beta as part of the total information given for individual stock

Beta (estimating systematic risk)

Betas are estimated from historical data, regressing for the individual security against for the some market index. As a result, the usefulness of beta will depend among other factors the validity of the regression equation. Regression of how good the fit is, Beta is an estimate subject to errors.

It is important note that most calculated betas are ex post betas what is actually needed in investment decision is a beta measuring expected volatility.

The common practice of many investor is simply to calculate the beta for a security and assume it, will remain constant in the future, a risky assumption in the case of individual securities similar to standard deviations.

Portfolio betas after are quite stable across time whereas individual security betas often are notoriously unstable. However this is not an unfavorable  outcome for investor because the basic premise of portfolio theory is the necessity of holding a portfolio of securities rather than only one or a few securities.

One method of estimating beta is to employ the historical regression estimate but subjectively modify it for expected as known change. Infact, it is logical to begin the estimation of beta using the best estimate of the historical beta.

Substantive evidence has been presented that betas tend to move toward too over time. Betas substantially larger (smaller) then too should tend to be followed by betas that are lower(higher) and closer to 1.0 than the estimate based solely a historical data would suggest.

Several models have been advocated for advertising beta for this tendency to “regrets forward the mean”as result ,it is not unusual to find “adjusted” betas rather than historical betas.

Investor who obtain beta information from such sources are actually  using estimated betas.

 

 

 

 

 

 

USA bank risk and return

The ability of commercial bank in the united states to engage in securities activities. It either directly or indirectly through affiliates of parent holding companies. It has been restricted through much of U.S. history but the boundaries of the restrictions have varied both through time and according to regulatory jurisdiction.

Restriction were imposed by some reasons.

->Fears of potential conflict of interest.

->Fear that commercial banks would have excessive economic power.

->Assume adverse effect on bank safety.

->A desire to protect non bank dealers.

Commercial bank or commercial bank holding companies or their risk and return moderate increase in private securities activities have not increased either the riskiness or the failure rate of commercial bank in the past, nor do, they promise to do so in the future.

The area of discussion.

The Nature of bank risks

Financial risk may be defined as the probability(uncertainty) of realizing a (outcome) an investment. It is lower than the investor expected at the time the investment was made. As losses net of gains must be charged against an institution’s capital (net worth). Sufficiently large losses can drive it into economic insolvency.Thus excessively risk activities relative to an institution’s capital to assets ratio can have an adverse impact on its safety and soundness.

The riskiness of a bank’s  activities depends both on the riskiness of all of the individual activities conducted in its asset, liability and off-balance sheet.

Portfolio and on the interaction or covariance of the returns on these activities through time.That is the riskiness of the over all bank can not be determine by simply summing the risk of its individual activities.

Bank would never want to eliminate all risks

They could do so only at the expense of lower return rather, well managed bank seek to control their risk exposure through risk management.

Risk management involves selecting individual activities with know risk and return portfolio. Combining them through diversification so as to obtain the highest overall net income gains.

Possible while exposing the bank to an aggregate risk exposure  that is consistent with the banks capital position.

The risk that banks generally assume are follows.

1)Credit risk

2)Interest risk

3)Liquidity risk

4)Foreign risk

5)Operation risk

6)Regulatory risk

7)Legal risk

8)Black box risk

Evaluation of the riskiness of securities activities

In theory,securities activities can increase,decrease,or not change the risk exposure of commercial banks. Bank holding companies.The potential impact be measured in two basic ways.

Change in volatility and return

A number of studies seek to measures the impact risk if banks were permitted to engage. In addition securities activities.Either through hypothetical acquisitions of existing investment firms or through expansion of the same activities as under taken by existing securities dealer.

Basically, these studies  the change in measures of volatility and return. It would occur if banks generally would hypothetically acquire different percentage of investment banking activities.

Most of the studies estimate the total risk by calculating the covariance of returns.Banking and other activities that might be combined with banking.Some studies also estimate the additional revenue earned by summing the revenue from the activities.

Several of the papers that use market return on the share of commercial  banks and securities companies do not include measures of capital available to absorb losses.They provide useful information only if the correlation of return implies smaller risk.Other studies relate risk to capital by calculating “Z” score,which measures the probability that a reduction in return might exceed a firm’s capital.

All the studies suffer from an additional serious shortcoming.They fail account for the fact that both commercial banks and investment bank hold, underwriter and trade U.S. government and municipal general obligation bond.

Change in the failure puts of banks engaging in securities

Thought history,few if any U.S. commercial bank  have failed because their involvement in securities activities before or after glass-stegall.J.F.I.O connor.Connor is the comptroller of the currency from 1933 to 1938 cut to  give the reason for the failure of call 2955 national banks that failed from 1865 through 1936, including the depression years 1929 to 1933.

Securities were not a sufficiently frequent reason to be classified separately the among the seven categories of the reason listed for the reason listed for these failure.

->It was strongly asserted at the time that banks involvement in securities understanding and trading was an important case of the great number of banks failures, experienced during the great depression.

->Securities purchased by smaller banks from banks that dealt in securities was a cause of the smaller banks’failures.

->Major cause of bank failures of commercial bank in easy 1930 had been the extensive investment of bank assets in long-term securities.

Three risk need to be considered

>Underwriting risk-Securities underwriting is riskless when the issue is underwritten on a “best offers”basis.In these situation, the underwriter contracts to market the issue and is not liable if the amount obtained is less than the amount expected.

When underwriters purchase and then sell the issue they may incurr risk.

->Dealing risk-Securities hold for trade could pose additional risk to the extent that the market values of the securities might decline.These potential costs are offset by gains in these values.

Both stock  and bond price are volatile and dealers at times have experienced large losses an net.

Banks already can assume as much interest risk as they wish through dealing and investing in government securities and colaterlized mortgage obligation.

->Brokerage risk– Securities brokerage activity at banks is likely to increase were commercial banks permitted to underwrite and sell securities without limit however, this activity involves to price risk.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Supply

The quantity supplied of a good is the amount that produces plan to sell in a given period of time.The quantity supplied is not the amount a firm would like to sell but the amount it definitely plans to sell. However the quantity supplied is not necessarily the same as the quantity a firm sales plan will be frustrated like quantity demanded,the quantity supplied is expressed as an amount per unit of time.

A change in supply now consider another change this time on the side of products. Begin as before by imagining a situation in with farmers are equally satisfied by producing sprouts and carrots and in which consumer are willing to buy at prevailing market prices, the quantities of these how commodities that are being produced.

A change in supply means that the willing of producers to sell a particular product has changed as a result of something other than a change in the price of the commodity.

Imagine that, at existing prices some change occurs so that farmers become more willing to produce sprouts them in the past and less willing to produce carrots production and lower that of carrot production an additional unit of the good increase as the quantity produced increases to include them to incur a higher cost and increases production firm must be compensated with a higher price.

   

Supply schedule and supply curve

A supply schedule lists the quantities supplied at each different firms plan to sell are held constant let’s construct a supply schedule to do so, we examine how the quantity supplied of a good varies,holding constant the prices of other goods, the price of factor of production used to produce it expected future prices and the state of technology.

A supply schedule can be illustrated by drawing a supply curve graphs the relationship between the quantity supplied and the price of good, holding everything else constant.

  A change in supply

 

The term supply refers to entire relationship between the quantity supplied of a good and its price.

1)Price of factors of production-The prices of the factors of production used to produce of a good influence it supply.

2)Price of related goods-The supply of good can be influenced by the prices of related goods, for example, if an automobile assembly line can produce either sports cars or sedans, the quantity of sports car produced will depend on the price of sedans.These two goods are substitutes in production.

An increase in the price of substitutes in production complements in production arise when two thing are of necessity, produced together for example extracting chemical from coal produce coke, coal tar, nylon. An increase in the price of any one of these by production of coal increase the supply of the other by products.

3) Expected future price– If the price of a good is expected to rise, it makes sense to sell less of the good today and more in the future, when it price is higher similarly, if its price is expected to fall, it pays to expand 10 day’s supply of the good.

4) The number of supplier– other things remaining the same, larger the number of firms supplying the good, the  larger is the supply of good

5) Technology-New technology to enable the producer to use fewer factor of production will lower the cost of production and increase the supply.

 

 

 

Demand

The quantity demanded of a goods or services is the amount that consumers plan to buy in a given period of time at a particular price.Demands are different from wants.

Wants are the unlimited desires or wishes that people have for goods and services.Security guarantees that many perhaps most of our wants will never be satisfied.Demand reflects a decision about which wants to satisfy.If you demand something then you have made a plan to buy it.

The quantity demanded is not necessarily the same amount as the quantity actually bought sometimes the quantity demanded is greater than the amount of goods available.So the quantity bought is less than the amount of goods available so the quantity bought is less than the quantity demanded.

The quantity demanded is measured as a an amount per unit of time.For example suppose a person consumes one cup of coffee a day.The quantity of coffee demanded by that person can be expressed as 1 cups per day or 7 cups per week or 365 cups per year without a time dimension, we can not tell whether a particular quantity demanded is large or small.    

  The law of Demand

 

Other things remaining the same,the higher the price of goods the lower is the quantity demanded.

Why does a higher price reduce the quantity demanded?The key to the answer lies in other things remaining the same.Because other things are being held constant, when the price of a good rises.It rises relative to the prices of all other goods. Although each good is unique. It has substitutes other goods that serve almost as well as the price of a good climbs higher, relative to the prices of its substitutes, people buy less that good and more of its substitutes. 

Demand schedule and demand curve

A demand schedule lists the quantities demanded at each different price, when all other influences an consumers planned purchase such as the prices of related goods of incomes expected future prices, population,and preference remain the same.              

               The point on the demanded curve labeled a through represent the row of the demand schedul.                     

                Willingness to pay

Another way of looking at the demand curve is as a willingness to pay curve.It tells us the higher price.that will be paid for the last unit available.If a large quantity is available, that price is low.If a small quantity is available that price is high

    A change in demand

The term demand refers to the entire relationship between the quantity demanded by both the demand schedule and the demand curve.

1)Price of related goods-The quantity of tapes that consumer plan to buy does not depend only on the price of types.It also depends in part on the prices of related goods fall in to two categories substitute and complement.

            A complement is a good used in conjunction with another good.Some example of complements are hamburger and French fries pastry snack and drink spaghetti and meat sauce running shoes and jogging paints.

2)Income -Another influence on demand is consumer income other things remaining the same when income increases decreases they buy less of most goods.It does consume with lower incomes demand less of most of goods rich people consume more food,clothing housing art,vacations and entertainment them do poor people.

        Although an increase in income leads to an increase in the demand for most goods.It does not lead to an increase in the demand as income increase are called normal goods.

               Goods that decrease in demand when income increase are called inferior goods.Eg of inferior goods are rice and potatoes.These two goods are a major part of the diet of people with very low income.Its income increase,the demand for these goods decline as major expensive meat and dairy products are substituted for them.

3)Expected future price-If the price of good is expected to rise,it make sense to buy more of the good today and less in the future when its price is higher.Similarly if its price is expected to fall.It pays to cut back on today’s purchase and buy more later when the price is expected to be lower.Thus the higher the expected future price of a good, the larger is today’s demand for the good.

4)Population-Demand also depends on the size of the population,the size of two population,the greater is the demand for all goods and services and the smaller the population, the smaller is the demand for all goods and services.

5)Preference-Finally demand depends on preference.Peeference are an individual attitudes towards goods and services for example a rock music fanatic has much greater than does a tone deaf workaholic 

         Preference are not observed. But preferences change.Slowly and so have little influence a change in demand.

Inflation

Inflation is an upward movement the average level of prices.Its opposite deflation,a downward movement in the average prices.The boundary between inflation and deflation is price stability.Prices is moving neither up or nor down.The average level of prices is called the price level.It is measured by a price index.

A price index measures the average level of prices in one period called the base period.

The Inflation rate and the price level.

The inflation rate is the percentage change in the price level.The formula for the annual inflation rate is

Inflation rate=\frac{current year's price level-last year price level}{last year's price level}

A common way of measuring the price level is to use the consumer price Index(CPI)

Inflation and the value of money

When inflation is present money is losing value.The value of money is the amount of goods and services that can be bought with a given amount of money falls you can not buy as many groceries with $50 this year.As last year.The rate at which the value of money falls is equal to the inflation rate.When the inflation rate is high,as it money loses it value at a rapid pace,when inflation is low the value of money falls slowly.

Inflation is a phenomenon that  all countries experience,but inflation rates vary from one country to another when inflation rate differ over a prolonged period of time,the result is a change in the foreign exchange value of money.A foreign exchange rate is the rate which one country is money or currency exchange another country’s money.

Is inflation a problem?

 

Is it a problem  if money loses its value and does so at a rate that varies from one year to describe the problem,we need to distinguish between anticipated and unanticipated inflation.

When prices are rising people are aware of the fact and have some idea about the rate at which prices are rising.The rate at which people believe that the price level is rising is called the expected inflation rate,But expectations may be right or wrong. If they turn out to the expected rate equals the expected inflation rate and inflation is anticipated.

Anticipated inflation is an inflation rate that has been correctly forecasted .To be extent,that the Inflation rate is misforecasted.It is said to be unanticipated.That is,unanticipated inflation is the part of the inflation rate that has caught people by surprise.

The problem of unanticipated inflation

With unanticipated inflation gains and losses occur because of unanticipated changes in the value of money.Money is used as measuring rod of the value of the transaction that we understake.Borrowers and lenders,workers and their employers.All make contracts in terms of money.If the value of money varies unexpectedly overtime then the amounts really paid and received differ from those that people intended to pay and receive when they signed the contracts.Measuring value with a measuring rod whose units vary is a bit like trying to measure a piece of cloth depends on how tightly the ruler is stretched.

The problem of anticipated inflation

Anticipated inflation is a problem when the inflation rate is high.At high inflation rates people know that money is losing value quickly.So they try to avoid holding on to money for too long.The inflation rate the rate at which money is losing value is part of the opportunity cost of holding money they recieved from the sale of their goods and services they pay it out in wages as quickly as possible.

High and variable Inflation

Even if inflation is reasonably well anticipated, and even if its rate is not as high as during a period of hyperinflation.It can still impose very high costs. A High and variable inflation rate causes resources to be diverted from productive activities to forecasting  inflation.

It becomes more profitable to forecast the inflation rate correctly than to invent a new product.

 

 

 

 

Government securities in India

The government securities market in the pre-reforms period was characterized by administered (and often artificially low) rates of interest the participants were captive investors due to high SLR requirements there was an absence of a liquid and transparent secondary market for G-sec resulting in the lack of a smooth and robust yield curve for pricing of the instruments.

The volume of debt expanded considerably,particularly short-term debt, due to automatic accommodation to the central government  by the reserve bank of the India, through the mechanism of ad hoc Treasury Bills with a captive investor base and interest below the market rate,the secondary market for government bonds remained dormant.Non market related yields on government securities affected the yield structure of financial assets in the system and led to higher lending rate.

The yield structure of the government securities.

A loan Carries a yield as a compensation for the loss of liquidity which ready money can provide.In an integrated market under equilibrium situation therefore,the yield on a loan should be a direct function of its liquidity and an index series of relative liquidity of different maturities should be nothing but the ratios of the reciprocal of such yield.

The market price of a loan need not be at par nor should the coupon rate have any definite relationship with its remaining terms to maturity the coupon was decided up on at the time.

         

The concept of yield curve

 

In the market,there is nothing like the rate of interest, nor for that matter, is there anything like the long- term or the short term rate of interest.Each rate of interest is at least two-dimensional.It is related on the one hand to the type of asset or loan for which it is being quoted and on the other to its term to maturity.Thus at any point of time the whole system of interest rate in the market can be represented in the form of a set of vector of interest rates in such a way that each vector pertains to one particular asset and consist of rates quoted for that asset for different maturities.

One such vector of interest rate is called a term structure of interest rates-it is a set of interest rates that pertain, at any point of time t, to a given type of assets such that the rate differentials within this set are solely due to the differences in the  term to maturity.In the case of public debt,we have a term structure of yield rates-where yield refers to the yield to redemption inclusive of capital gain/loss.The theory of term structure of interest rates in such a term structure as also the rate differentials contained theirn.It does not explain,however,the rate differentials between different types of  assets of a given maturity.

       

 Shape of the Yield Curves

 

While the interest rate measure the price the borrower is agreed to pay for a loan, the yield or rate of return on the loan, from the lender’s point of view, may be quite different since it depends on the total rate of return on the transaction yield takes into account number of factors example change in market value of the security, default rate, deferring of payment etc.

The relationship between the rates of return or yield on financial instruments and their maturity is labeled the term structure of interest rates.The term structure of rates may be represented visually by drawing a yield curve for all securities of equivalent grade or quality.The yield curve consider only the relationship between the maturity or term of a loan and its yield at one moment in time, with all other factor held constant.

Yield Curves change their shape over time in response to change in the public’s interest- rate expectation,  fluctuations in the demand for liquidity in the economy, and other factors.

       Sensitivity of the Yield Curve

This bring us to the question of the sensitivity of the yield curve to debt management operation and policies,the yield curve could be expected to be sensitive to such exogenous changes if

a)the market was a completely segmented one, or if

b)there were maturity habits in the market.

In the absence of a complete integration of the market, the authorities should be able to “twist the yield structure and thereby effect the relative liquidity of different maturities.The extent of such “twisting” ability of the authorities is a function of many factors including the constitution of the market,the expectation that the debt management policies generate in the market,the scale of operations and the sensitivity of the liquidity premiums to the level of the yield curve and so on.

     

 Uses of the yield     curve

1)Forecasting interest rates-First, if the expectation hypothesis is correct the yield curve gives the investor a clue concerning the future course of interest rates.If the curve has an upward slope,the investor may be well advised to look  for opportunities to move away from bonds and other long term securities.A downward sloping yield curve, suggest the likelihood of near term decline in interest rates and a rally in bond prices.

2)Uses for financial intermediaries-The slope of the yield curve  is critical for financial intermediaries,especially commercial banks,saving and loan associations,and saving banks.A rising yield curve is generally favorable for the these institution because they borrow most of their funds by selling short-term deposits and lend a major portion of those funds long term.

The more steeply the yield curve slopes upward, the wider the spread between borrowing and lending rates and the greater the potential profit for a financial intermediary.

3)Indicating tradeoffs between maturity and yield-Still another use of the yield curve is to indicate trade-off between maturity and yield confronting the investor.

With an upward-sloping yield curve an investor may be able to increase a bond portfolio’s expected Annual yield by extending the portfolio’s average maturity.The investor must weigh the gain in yield from extending the maturity of his or her portfolio against added price,liquidity,and marketability risk.

4)Riding the yield curve-Finally ,some active security investor, especially dealers in government securities.have learned ti “ride” the yield curve for profit. If the curve is positively sloped,with slope steep enough to offset transaction costs from buying and selling securities,the investor may gain by timely .

 

 

Inflation and interest rate(Fisher effect)

Inflation is defined as a rise in the  average level of prices for all goods and services.Some prices of individual goods and services are always rising,while others are declining.

However, inflation occurs when the average level of all prices in the economy rises.Interest rates represent the “price” of credit.

The Nominal and Real Interest Rate

To examine the relationship between inflation and interest rates, several key terms must be defined.First, we must distinguish between nominal and real interest rates.The nominal rate is the published or quoted interest rate on security or laon.In contrast, the real rate of interest is the return to the lender or investor measured in terms of its actual purchasing power.In period of inflation,of course,the real rate will be lower than the nominal rate.Another important concept is the inflation premium, which measures the rate inflation expected  by investor in the marketplace during, the life of financial instrument.

These three concepts are all related to each other.Obviously,a lender of funds is most interested in the real rate of return on a loan.that is purchasing power of any interest earned.In general,lenders will attempt to charge nominal rates of interest which give them desired real rates of return on their loanable funds.And nominal interest rates will change as frequently as lenders alter their expectations regarding inflation.

 The Fisher Effect

In a classic article written just before the turn of the century,economist living fisher argued that the nominal interest rate was related to the rate by the following equation:

Nominal interest rate=(Real rate)+(Inflation premium)+(Real rate×Inflation premium)

The cross-product term in this equation is normally ignored because it is usually quite small.

Fisher argues that the real rate of return tends to be stable over time because it depends on such long-run factors as the productivity of capital and the volume of saving in the economy.Therefore, a change in the inflation premium is likely to influence only the nominal interest rate.The nominal rate will rise as the expected rate of inflation increases, and decline with a drop in expected inflation.For example,the real rate is 3 percent and the drop rate of inflation is 10 percent.Example,suppose the real rate is 3 percent and the expected rate of inflation is 10 percent.Then the nominal rate will be calculated as follows

Nominal interest rate= 3%+10%=13

According to Fisher’s hypothesis, if the expected rate of inflation now rises to 12 percent,the real rate will remain unchanged at 3 percent, but the nominal rate will rise to 15 percent.

If this view is correct, it suggests a method of judging the direction of future interest rate changes.To the extent that rise in the actual rate of inflation causes investor to expect greater inflation, in the future, higher nominal may causes investors to revise downward their expectation of future inflation, leading to lower nominal interest rates.

Another view on Fisher effect

The Fisher effect conflicts with another view of the inflation-interest rate phenomenon,developed originally by the British economist Sir Roy Harrod.It is based upon the liquidity preference theory of interest, Harrod argues that the real rate will be affected by inflation,but the nominal rate is determined by the demand for and supply of money.Therefore ,unless inflation affects either the demand for and supply of money,the nominal rate must remain unchanged regardless of what happens to inflationary expectations.

In liquidity preference theory,the real rate measures the real rate of interest.In liquidity preference theory,the real measures the inflation adjusted return on bonds. However,conventional bonds,like money,are not a hedge against inflation,because their rate of return is fixed by contract.

However,conventional bonds,like money,are not a hedge against inflation,because their rate of return is fixed by contract.Therefore,a rise in the expected rate of inflation lowers investors’ real return from holding bonds..While the nominal rate of return on bonds remains unchanged,the real rate is squeezed by expectations of rising prices.

While theories of interest rate determination typically assume there is a single interest rate in the economy,in point of fact there are thousand of different interest rates confronting investors at any one time.The investors must focus upon several factors the maturity or term of a loan,the risk of borrower default,and inflationary expectations.