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Log inglossary & summary
glossary & summary
Admin on Tue Dec 16, 2008 1:27 am
chapter 5
This important chapter focuses on the leading ideas today of what determines the level of and changes in market interest rates and asset prices. Its specific target is the pure or risk-free rate of interest (such as the interest rate attached to a government bond). Each theory of interest attempts to account for changes we see every day in this pure or risk-free market interest rate.
• The chapter explores the critical roles played by interest rates in the functioning of the money and capital markets and the economy. These fundamental interest rate roles include: (a) generating an adequate volume of savings in order to fund investment and growth in the economy; (b) directing the flow of credit in the economy toward those investment projects carrying the highest expected returns; (c) bringing the supply of money (cash balances) into alignment with the demand for money; and (d) serving as a tool of government economic policy so that the nation can better achieve its broad economic goals of full employment and avoidance of inflation.
• The classical theory of interest rates emphasizes the roles of savings and investment demand in determining market rates. The supply of savings is assumed to be positively related to the market interest rate, while the demand for investment is negatively related to the level of interest rates. The equilibrium interest rate in this interest rate model is established at the point where the supply of savings and investment demand are in balance with each other.
• The liquidity preference theory of interest looks at the demand and supply for money (cash balances), fixing the equilibrium interest rate in the money market at the point where the quantity of money in supply matches the demand for money. Demand for money consists of demands for cash balances for transactions purposes, precautionary savings, and speculation about the future course of interest rates and asset prices. The supply of money is heavily influenced by actions of the government, principally the central bank.
• The popular loanable funds theory of interest brings together elements of both the classical and liquidity preference theories, focusing upon the demand for credit (loanable funds) and the supply of credit (loanable funds). The aggregate demand for loanable funds includes credit demands from all sectors of the economy—businesses, consumers, and governments. The aggregate supply of loanable funds includes domestic and foreign savings, the creation of money by the banking system, and the hoarding or dishoarding of cash balances by the public. The equilibrium loanable funds interest rate tends to settle at the point where total demand for credit matches total credit supply.
• The rational expectations theory of interest focuses on the expected supply of credit relative to the expected demand for credit. This view of interest rates and asset prices assumes the money and capital markets are highly efficient in the use of information in determining the public’s expectations regarding future changes in interest rates and asset prices. Interest rates and asset prices incorporate all relevant information quickly and change only when relevant new information appears. Forecasting market interest rates is presumed to be virtually impossible on a consistent basis because forecasters must know what new information is likely to arrive before that information appears and must assess how that new information will influence interest rates and asset prices when it does arrive.
• Collectively, the different views discussed in this chapter help guide us toward those fundamental forces that shape the level of and changes in market rates of interest, as well as the prices of assets. These include such critical forces as domestic and foreign savings, the demand for investment, the money supply, the demand for cash balances, and government economic policy (including the workings of central banks around the world). This chapter sets the stage for future chapters in Part Two of this text, where we attempt to discover what factors cause one interest rate to differ from another (including inflation, the term or length of a loan, credit or default risk, and several other important causal elements).
Glossary
(See related pages)
rate of interest The price of acquiring credit, usually expressed as a ratio of the cost of securing credit to the total amount of credit obtained.
classical theory of interest rates An explanation of the level of and changes in interest rates that relies on the interaction of the supply of savings and the demand for investment capital.
income effect The relationship between interest rate levels and the volume of saving in the economy that argues that the advent of higher interest rates may induce savers to save less because each dollar saved now earns a higher rate of return.
liquidity preference theory of interest rates An explanation of the level of and change in interest rates that focuses on the interaction of the supply of and demand for money.
loanable funds theory of interest rates The credit view of what determines the level of and changes in interest rates that focuses on the interaction of the demand for and the supply of loanable funds (credit).
price of credit The rate of interest that must be paid to secure the use of borrowed funds.
rational expectations theory of interest rates An explanation of the level of and changes in interest rates based on changes in investor expectations regarding future asset prices and returns.
risk-free rate of interest The rate of return on a riskless asset, often called the pure rate of interest or the opportunity cost of money.
substitution effect Positive relationship between rate of interest and volume of savings in the economy.
wealth effect (of saving and interest rates) Contends that the net wealth position of savers (the balance in their portfolios between debt and financial assets) determines how their desired levels of saving will change as interest rates change.
chapter 6
Chapter Summary
(See related pages)
Interest rates and asset prices are among the most important ingredients needed to help make sound financial decisions. Over the years, a number of methods have been developed to aid in the measurement and calculation of interest rates and asset prices within the financial system.
• Dealers in the wholesale money markets quote one another bid and ask bank discount rates on money market assets they are trading. These bank discount rates differ from actual rates of return, or investment rates, that investments yield to investors.
• Debt securities, such as government or corporate bonds, provide the investor with a fixed stream of returns. However, the market price of debt securities will vary inversely with market interest rates. The higher the rate of return the market demands for a fixed stream of income, the less it will pay, and the lower will be the asset’s price.
• The yield to maturity is the expected rate of return of an asset if it is held until maturity. It effectively determines the asset’s market value. If an investor chooses to sell an asset before maturity, the rate of return the investor receives, or the asset’s holding-period yield, could be above, equal to, or below the asset’s yield to maturity on date of sale, depending upon whether market interest rates have fallen, remained unchanged, or risen since the investor purchased the asset.
• Corporate stocks represent ownership in a firm and claims to a share of the firm’s earnings. The price of the stock is given by the present value of its expected future stream of dividend payments. The rate at which these future dividends are discounted back to the present incorporates the risk the investor takes that the firm will not meet the dividend payments expected by the market. The greater this risk, the higher is the rate of discount on future expected dividends, and the lower tends to be the stock price.
• Often we observe stock prices falling during periods of rising interest rates. However, unlike bonds and other fixed-income securities, stock prices are sensitive to other factors besides interest rates (such as the condition of the economy, business profits, and dividend payouts to stockholders), so that the relationship between stock prices and interest rates is less predictable than in the case of debt securities.
• Lending institutions often calculate the loan rates they quote borrowers according to different interest rate measures. Examples include the simple interest rate (where interest owed is adjusted for repayments of the principal of a loan) and the add-on interest rate (where interest owed is added to the principal of a loan and divided by the number of payments called for in a loan agreement). Other loan-rate measures include the discount loan method (where interest is deducted at the beginning of a loan) and the APR (or annual percentage rate), which adjusts interest owed for repayments of loan principal. The APR is subject to regulation so that lenders must calculate it the same way and borrowers can more meaningfully compare one loan agreement against another in order to find the best deal.
• Interest rates or yields on deposits today are increasingly quoted as the annual percentage yield or APY. Regulations require that depositors receive APY information when taking out a new deposit or renewing an existing deposit in order to make an informed financial decision.
• Most depository institutions today pay compound interest on their deposits— that is, interest is earned on accumulated interest as well as on the principal invested in a deposit. Increasingly deposits accrue compound interest on a daily or other, more frequent basis than in the past.
• One of the more complicated interest rate and loan payment methods is the procedure used to figure loan rates and payment amounts on home mortgage loans. Under most home mortgage contracts, payments made early in the life of such a loan go largely to pay interest; only after several years are substantial portions of home mortgage payments directed to help repay loan principal.
Glossary
(See related pages)
add-on rate A method for calculating the interest charge on a loan when the interest bill is added to the principal amount of the loan. That sum is divided by the number of installment payments required to determine the amount of each payment needed to eventually pay off the loan.
annual percentage rate (APR) The actuarially determined rate on a consumer loan that Truth in Lending law requires lenders to communicate to borrowers.
annual percentage yield (APY) The annualized rate of return on a savings account that U.S. depository institutions must report to their customers.
bank discount rate (DR) Rate of return measure used in the money market which is based on the par value of a financial instrument and assumes a 360-day year.
basis point A measure of rate of return equal to one onehundredth of a percentage point.
compound interest The payment of additional interest earnings on previously earned interest income.
coupon rate The promised interest rate on a bond or note consisting of the ratio of the annual interest income promised by the security issuer to the security’s face (par) value.
discount loan method A method for calculating the interest rate on a loan that deducts the interest cost up front from the face amount of the loan with the borrower receiving only the net amount remaining for his or her use.
holding-period yield (HPY) The rate of return received or expected from a financial asset or other investment over the period the asset or investment was held, including the price for which the asset or investment was sold to another investor.
home mortgage interest rate The percentage cost of borrowed funds used to purchase a house or other residential dwelling.
interest rate The price of credit, or ratio of the fees charged to secure credit from a lender to the amount borrowed, usually expressed on an annual percentage basis.
investment rate Sometimes referred to as the coupon equivalent or bond-equivalent rate of return on a debt instrument that reflects its par value, purchase price, and days to maturity.
perpetuity rate Rate of return on a financial instrument that is perpetual (never matures).
present value Funds received today are worth more than an equal nominal amount of funds promised in the future.
simple interest method A method of figuring the interest on a loan that charges interest only for the period of time the borrower actually has use of the borrowed funds.
yield to maturity The interest rate on a debt security that equates the purchase price of the security to the present value of all its expected annual net cash inflows (income) from now until its maturity date.
This important chapter focuses on the leading ideas today of what determines the level of and changes in market interest rates and asset prices. Its specific target is the pure or risk-free rate of interest (such as the interest rate attached to a government bond). Each theory of interest attempts to account for changes we see every day in this pure or risk-free market interest rate.
• The chapter explores the critical roles played by interest rates in the functioning of the money and capital markets and the economy. These fundamental interest rate roles include: (a) generating an adequate volume of savings in order to fund investment and growth in the economy; (b) directing the flow of credit in the economy toward those investment projects carrying the highest expected returns; (c) bringing the supply of money (cash balances) into alignment with the demand for money; and (d) serving as a tool of government economic policy so that the nation can better achieve its broad economic goals of full employment and avoidance of inflation.
• The classical theory of interest rates emphasizes the roles of savings and investment demand in determining market rates. The supply of savings is assumed to be positively related to the market interest rate, while the demand for investment is negatively related to the level of interest rates. The equilibrium interest rate in this interest rate model is established at the point where the supply of savings and investment demand are in balance with each other.
• The liquidity preference theory of interest looks at the demand and supply for money (cash balances), fixing the equilibrium interest rate in the money market at the point where the quantity of money in supply matches the demand for money. Demand for money consists of demands for cash balances for transactions purposes, precautionary savings, and speculation about the future course of interest rates and asset prices. The supply of money is heavily influenced by actions of the government, principally the central bank.
• The popular loanable funds theory of interest brings together elements of both the classical and liquidity preference theories, focusing upon the demand for credit (loanable funds) and the supply of credit (loanable funds). The aggregate demand for loanable funds includes credit demands from all sectors of the economy—businesses, consumers, and governments. The aggregate supply of loanable funds includes domestic and foreign savings, the creation of money by the banking system, and the hoarding or dishoarding of cash balances by the public. The equilibrium loanable funds interest rate tends to settle at the point where total demand for credit matches total credit supply.
• The rational expectations theory of interest focuses on the expected supply of credit relative to the expected demand for credit. This view of interest rates and asset prices assumes the money and capital markets are highly efficient in the use of information in determining the public’s expectations regarding future changes in interest rates and asset prices. Interest rates and asset prices incorporate all relevant information quickly and change only when relevant new information appears. Forecasting market interest rates is presumed to be virtually impossible on a consistent basis because forecasters must know what new information is likely to arrive before that information appears and must assess how that new information will influence interest rates and asset prices when it does arrive.
• Collectively, the different views discussed in this chapter help guide us toward those fundamental forces that shape the level of and changes in market rates of interest, as well as the prices of assets. These include such critical forces as domestic and foreign savings, the demand for investment, the money supply, the demand for cash balances, and government economic policy (including the workings of central banks around the world). This chapter sets the stage for future chapters in Part Two of this text, where we attempt to discover what factors cause one interest rate to differ from another (including inflation, the term or length of a loan, credit or default risk, and several other important causal elements).
Glossary
(See related pages)
rate of interest The price of acquiring credit, usually expressed as a ratio of the cost of securing credit to the total amount of credit obtained.
classical theory of interest rates An explanation of the level of and changes in interest rates that relies on the interaction of the supply of savings and the demand for investment capital.
income effect The relationship between interest rate levels and the volume of saving in the economy that argues that the advent of higher interest rates may induce savers to save less because each dollar saved now earns a higher rate of return.
liquidity preference theory of interest rates An explanation of the level of and change in interest rates that focuses on the interaction of the supply of and demand for money.
loanable funds theory of interest rates The credit view of what determines the level of and changes in interest rates that focuses on the interaction of the demand for and the supply of loanable funds (credit).
price of credit The rate of interest that must be paid to secure the use of borrowed funds.
rational expectations theory of interest rates An explanation of the level of and changes in interest rates based on changes in investor expectations regarding future asset prices and returns.
risk-free rate of interest The rate of return on a riskless asset, often called the pure rate of interest or the opportunity cost of money.
substitution effect Positive relationship between rate of interest and volume of savings in the economy.
wealth effect (of saving and interest rates) Contends that the net wealth position of savers (the balance in their portfolios between debt and financial assets) determines how their desired levels of saving will change as interest rates change.
chapter 6
Chapter Summary
(See related pages)
Interest rates and asset prices are among the most important ingredients needed to help make sound financial decisions. Over the years, a number of methods have been developed to aid in the measurement and calculation of interest rates and asset prices within the financial system.
• Dealers in the wholesale money markets quote one another bid and ask bank discount rates on money market assets they are trading. These bank discount rates differ from actual rates of return, or investment rates, that investments yield to investors.
• Debt securities, such as government or corporate bonds, provide the investor with a fixed stream of returns. However, the market price of debt securities will vary inversely with market interest rates. The higher the rate of return the market demands for a fixed stream of income, the less it will pay, and the lower will be the asset’s price.
• The yield to maturity is the expected rate of return of an asset if it is held until maturity. It effectively determines the asset’s market value. If an investor chooses to sell an asset before maturity, the rate of return the investor receives, or the asset’s holding-period yield, could be above, equal to, or below the asset’s yield to maturity on date of sale, depending upon whether market interest rates have fallen, remained unchanged, or risen since the investor purchased the asset.
• Corporate stocks represent ownership in a firm and claims to a share of the firm’s earnings. The price of the stock is given by the present value of its expected future stream of dividend payments. The rate at which these future dividends are discounted back to the present incorporates the risk the investor takes that the firm will not meet the dividend payments expected by the market. The greater this risk, the higher is the rate of discount on future expected dividends, and the lower tends to be the stock price.
• Often we observe stock prices falling during periods of rising interest rates. However, unlike bonds and other fixed-income securities, stock prices are sensitive to other factors besides interest rates (such as the condition of the economy, business profits, and dividend payouts to stockholders), so that the relationship between stock prices and interest rates is less predictable than in the case of debt securities.
• Lending institutions often calculate the loan rates they quote borrowers according to different interest rate measures. Examples include the simple interest rate (where interest owed is adjusted for repayments of the principal of a loan) and the add-on interest rate (where interest owed is added to the principal of a loan and divided by the number of payments called for in a loan agreement). Other loan-rate measures include the discount loan method (where interest is deducted at the beginning of a loan) and the APR (or annual percentage rate), which adjusts interest owed for repayments of loan principal. The APR is subject to regulation so that lenders must calculate it the same way and borrowers can more meaningfully compare one loan agreement against another in order to find the best deal.
• Interest rates or yields on deposits today are increasingly quoted as the annual percentage yield or APY. Regulations require that depositors receive APY information when taking out a new deposit or renewing an existing deposit in order to make an informed financial decision.
• Most depository institutions today pay compound interest on their deposits— that is, interest is earned on accumulated interest as well as on the principal invested in a deposit. Increasingly deposits accrue compound interest on a daily or other, more frequent basis than in the past.
• One of the more complicated interest rate and loan payment methods is the procedure used to figure loan rates and payment amounts on home mortgage loans. Under most home mortgage contracts, payments made early in the life of such a loan go largely to pay interest; only after several years are substantial portions of home mortgage payments directed to help repay loan principal.
Glossary
(See related pages)
add-on rate A method for calculating the interest charge on a loan when the interest bill is added to the principal amount of the loan. That sum is divided by the number of installment payments required to determine the amount of each payment needed to eventually pay off the loan.
annual percentage rate (APR) The actuarially determined rate on a consumer loan that Truth in Lending law requires lenders to communicate to borrowers.
annual percentage yield (APY) The annualized rate of return on a savings account that U.S. depository institutions must report to their customers.
bank discount rate (DR) Rate of return measure used in the money market which is based on the par value of a financial instrument and assumes a 360-day year.
basis point A measure of rate of return equal to one onehundredth of a percentage point.
compound interest The payment of additional interest earnings on previously earned interest income.
coupon rate The promised interest rate on a bond or note consisting of the ratio of the annual interest income promised by the security issuer to the security’s face (par) value.
discount loan method A method for calculating the interest rate on a loan that deducts the interest cost up front from the face amount of the loan with the borrower receiving only the net amount remaining for his or her use.
holding-period yield (HPY) The rate of return received or expected from a financial asset or other investment over the period the asset or investment was held, including the price for which the asset or investment was sold to another investor.
home mortgage interest rate The percentage cost of borrowed funds used to purchase a house or other residential dwelling.
interest rate The price of credit, or ratio of the fees charged to secure credit from a lender to the amount borrowed, usually expressed on an annual percentage basis.
investment rate Sometimes referred to as the coupon equivalent or bond-equivalent rate of return on a debt instrument that reflects its par value, purchase price, and days to maturity.
perpetuity rate Rate of return on a financial instrument that is perpetual (never matures).
present value Funds received today are worth more than an equal nominal amount of funds promised in the future.
simple interest method A method of figuring the interest on a loan that charges interest only for the period of time the borrower actually has use of the borrowed funds.
yield to maturity The interest rate on a debt security that equates the purchase price of the security to the present value of all its expected annual net cash inflows (income) from now until its maturity date.
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