6 September

FNCE 4070Financial Markets and Institutions

Duration

How interest rates affect duration

• For a single cashflow interest rates do not affect duration

• For multiple cashflows on different dates– as interest rates rise duration decreases– as interest rates fall duration increases

Risk and Duration

Inflation

• Inflation occurs when the prices of goods and services increase over time. – Inflation cannot be measured by an increase in the cost of one

product or service, or even several products or services. Rather, inflation is a general increase in the overall price level of the goods and services in the economy (Fed Reserve comment)

• The inflation rate is the percentage change in a price index.• General consensus is that an inflation rate of around 2% is

reasonable…– Many countries have adopted an explicit inflation target of

around 2%

Related Terms

• Deflation– A sustained decrease in the aggregate price level,

which corresponds to a negative inflation rate• Hyperinflation

– An extremely fast increase in the aggregate price level, which corresponds to an extremely high inflation rate

• Disinflation– A decline in the inflation rate, such as from 10% to 5%.

Note, inflation rates remain positive just reduces.

Deflation

• When deflation occurs the value of money increases. – Debt contracts are written in fixed amounts means that

real liabilities are increasing.– Faced with increasing real debt costs a company that is

short of cash will cut its spending, workforce etc. – Less spending and high unemployment exacerbate the

situation• Occurred in Great Depression, briefly in US during

2008-9 and periodically in Japan since the late 1990’s

Episodes of Hyperinflation

• It is considered that the basic cause for hyperinflation is too much money in circulation.

• Germany– In 1923-24 at the peak prices doubled every 3.7 days

• Yugoslavia– In January 1994 the monthly inflation rate peaked at 313

million percent• Zimbabwe

– In November 2008 the monthly inflation rate peaked at 79.6 billion percent

Episode of Disinflation around the world

Year 1979 1980 1983 1984 1985

Country

Germany 4.0 5.4 3.3 2.4 2.1

United States 11.3 13.5 3.2 4.3 3.5

United Kingdom 13.4 18.0 4.6 5.0 6.1

Consumer Price Index (CPI)

• It measures the relative cost of a basket of goods where the basket is changed infrequently

• Problems with CPI– Three main biases

• Substitution bias - As the price of one good or service rises it may be substituted with another. This will cause an upwards bias in the inflation rate

• Quality bias - As the quality of the same product improves over time it may satisfy peoples needs and wants better. This will cause an upwards bias in the inflation rate

• New Product Bias - New products are frequently introduced and these are not adequately reflected in the basket. This will cause an upwards bias in the inflation rate.

• CPI-U (urban) is used to adjust the notional for TIPS

Personal Consumption Expenditures (PCE)

• This covers all personal consumption in the US– Done via business surveys. – This is the main index that the Fed uses for

targeting inflation.

Explaining Inflation

• Supply-Demand– The supply of money goes up.– The supply of goods goes down.– Demand for money goes down.– Demand for goods goes up.

Explaining Inflation

• Cost-Push– Rising costs compel businesses to raise prices

• Wages• Raw materials

• Demand-Pull– Increasing demand raises prices which then feeds back

into workers demands for higher wages to compensate for the rising cost of living

• Increase in the money supply• Increases in government purchases• Increases in prices in the rest of the world

Inflation Expectations

• Once inflation becomes embedded in an economy, businesses, workers, consumers etc all begin to expect it and build those expectations into their actions.

• This creates an inflation momentum of its own– Workers may demand larger wage increases to pay for

expected increases in the cost of living which in turn cause goods to become more expensive.

• Can try to identify expectation through the prices of TIPs– But it is viewed that Insurance Companies have used TIPS to

match long-term liabilities and thus have depressed yields and thus TIPs might underestimate inflation rates.

Distinction Between Real and Nominal Interest Rates

• Real interest rate1. Interest rate that is adjusted for expected

changes in the price level

ir = i – pe

2. Real interest rate more accurately reflects true cost of borrowing

3. When the real rate is low, there are greater incentives to borrow and less to lend

Distinction Between Real and Nominal Interest Rates

• Real interest rate

ir = i – pe

We usually refer to this rate as the ex ante real rate of interest because it is adjusted for the expected level of inflation. After the fact, we can calculate the ex post real rate based on the observed level of inflation.

U.S. Real and Nominal Interest Rates