🏦Financial Institutions and Markets Unit 5 – Interest Rates and Yield Curve Analysis

Key Concepts

• Interest rates represent the cost of borrowing money and the return on lending money
• Nominal interest rates include inflation, while real interest rates adjust for inflation
• The yield curve graphically represents the relationship between interest rates and maturities
• Term structure of interest rates explains how interest rates vary across different maturities
• Expectations theory, liquidity preference theory, and market segmentation theory attempt to explain the shape of the yield curve
• Interest rate risk arises from fluctuations in interest rates and affects the value of financial instruments
• Duration measures the sensitivity of a bond's price to changes in interest rates
• Convexity captures the non-linear relationship between bond prices and interest rates

Types of Interest Rates

• Nominal interest rates are the stated rates on loans or investments without adjusting for inflation
• Real interest rates account for inflation by subtracting the expected inflation rate from the nominal rate
• Simple interest is calculated based on the original principal amount only
• Compound interest is calculated on both the principal and accumulated interest from previous periods
  • Compounding can occur annually, semi-annually, quarterly, or even daily
• Fixed interest rates remain constant throughout the life of a loan or investment
• Floating or variable interest rates fluctuate based on a reference rate (LIBOR or prime rate)
• Risk-free interest rates are associated with investments considered to have no default risk (U.S. Treasury securities)

Determinants of Interest Rates

• Inflation expectations influence interest rates as lenders demand higher rates to compensate for expected loss of purchasing power
• Economic growth and business cycle affect interest rates through changes in demand for borrowing and investment opportunities
• Monetary policy actions by central banks (Federal Reserve) can impact short-term interest rates
  • Expansionary monetary policy generally lowers interest rates to stimulate borrowing and spending
  • Contractionary monetary policy raises interest rates to control inflation and cool the economy
• Government borrowing and fiscal policy can influence interest rates by affecting the supply and demand for loanable funds
• International capital flows and exchange rates can impact domestic interest rates through the flow of funds across borders
• Credit risk and default risk of borrowers affect the risk premium component of interest rates
• Liquidity of investments also influences interest rates, with less liquid investments typically offering higher yields

Term Structure of Interest Rates

• The term structure of interest rates describes the relationship between interest rates and maturities
• Yield curve is a graphical representation of the term structure, plotting interest rates (y-axis) against maturities (x-axis)
• Normal or upward-sloping yield curve indicates higher interest rates for longer maturities
  • Reflects expectations of rising interest rates and inflation in the future
• Inverted or downward-sloping yield curve occurs when short-term rates are higher than long-term rates
  • May signal expectations of an economic slowdown or recession
• Flat yield curve suggests similar interest rates across different maturities
• Theories attempting to explain the shape of the yield curve include expectations theory, liquidity preference theory, and market segmentation theory
  • Expectations theory suggests that the shape of the yield curve reflects market expectations of future short-term interest rates
  • Liquidity preference theory argues that investors demand a premium for holding longer-term securities due to greater uncertainty
  • Market segmentation theory proposes that supply and demand in specific maturity segments determine interest rates in those segments

Yield Curve Analysis

• Yield curve analysis involves examining the shape, level, and slope of the yield curve to gain insights into economic and financial conditions
• The level of the yield curve indicates the overall interest rate environment (high or low rates)
• The slope of the yield curve reflects the difference between long-term and short-term interest rates
  • Steeper slope suggests a larger spread between long-term and short-term rates
  • Flatter slope indicates a smaller spread between long-term and short-term rates
• Changes in the shape of the yield curve over time can provide signals about shifts in economic expectations and monetary policy
• Yield curve inversions, when short-term rates exceed long-term rates, have historically been associated with economic recessions
• Yield spread analysis compares yields on securities with different credit risks or maturities to assess relative value and market sentiment
• Forward rates can be derived from the yield curve to estimate future short-term interest rates implied by current market prices

Applications in Financial Markets

• Interest rates directly impact the borrowing costs for individuals, businesses, and governments
• Mortgage rates influence housing affordability and the real estate market
  • Fixed-rate mortgages offer stability, while adjustable-rate mortgages (ARMs) are sensitive to interest rate changes
• Corporate bond yields affect the cost of capital for companies and their investment decisions
• Government bond yields serve as benchmarks for pricing other fixed-income securities and influence fiscal policy
• Yield curve shifts can affect the profitability and risk management strategies of financial institutions (banks and insurance companies)
  • Banks typically borrow short-term and lend long-term, benefiting from a steeper yield curve
• Investors use yield curve analysis to make investment decisions, such as asset allocation and portfolio duration management
• Derivatives markets, such as interest rate futures and swaps, allow market participants to hedge interest rate risk or speculate on rate movements

Risk and Interest Rates

• Interest rate risk arises from the potential impact of interest rate changes on the value of financial instruments
• Duration measures the sensitivity of a bond's price to changes in interest rates
  • Higher duration indicates greater price sensitivity to interest rate changes
  • Modified duration adjusts for the compounding frequency of a bond
• Convexity captures the non-linear relationship between bond prices and interest rates
  • Positive convexity means bond prices rise more when rates fall than they fall when rates rise
• Reinvestment risk occurs when interest or principal payments must be reinvested at lower rates than originally anticipated
• Prepayment risk is associated with mortgage-backed securities (MBS) and the uncertainty of cash flows due to early repayments
• Credit risk or default risk is the risk that a borrower will fail to make required interest or principal payments
  • Credit spreads reflect the additional yield demanded by investors to compensate for credit risk
• Liquidity risk relates to the ability to buy or sell a security without significantly affecting its price

Current Trends and Challenges

• Low interest rate environment in many developed economies following the 2008 global financial crisis and the COVID-19 pandemic
  • Central banks have maintained accommodative monetary policies to support economic recovery
• Negative interest rates have emerged in some countries, presenting unique challenges for financial markets and investors
• Flattening or inverted yield curves have raised concerns about economic growth prospects and potential recessions
• Quantitative easing (QE) programs by central banks have involved large-scale asset purchases, impacting interest rates and financial markets
• Technological advancements and the growth of financial technology (fintech) are transforming the lending and investment landscape
• Climate change and the transition to a low-carbon economy are influencing investment decisions and the pricing of climate-related risks
• Demographic shifts, such as aging populations in developed countries, are affecting savings and investment patterns and long-term interest rates
• Globalization and the interconnectedness of financial markets have increased the potential for spillover effects and contagion risks