Question

What is the, r, RR, IP, DRP, MRP and LP means in the determinants of market interest rates?

What are the marketable obligations? , types of bill and bonds available

What is the dealer system, nonmarketable government securities, term structure, yield curve, expectation theory?

What are the types of inflation listed in this chapter?

What are Investment graded bonds?

Answer 1

What is the, r, RR, IP, DRP, MRP and LP means in the determinants of market interest rates?

r = the quoted, or nominal, rate of interest on a given security.

r* = the real risk-free rate of interest and it is the rate that would exist on a riskless security in a world where no inflation was expected.

IP = inflation premium. IP is equal to the average expected rate of inflation over the life of the security.

DRP = default risk premium. This premium reflects the possibility that the issuer will not pay the promised interest or principal at the stated time.

DRP is zero for Treasury securities, but it rises as the riskiness of the issuer increases.

LP = liquidity (or marketability) premium. This is a premium charged by lenders to reflect the fact that some securities cannot be converted to cash on short notice and at a “reasonable” price.

MRP = maturity risk premium. Longer-term bonds, even Treasury bonds, are exposed to a significant risk of price declines due to increases in interest rates; and a maturity risk premium is charged by lenders to reflect the interest rate risk.

MRP is paid to cover interest rate risk.

Interest rate risk: The risk of capital losses to which investors are exposed because of changing interest rates.

While long term bonds are exposed to interest rate risk, short term bonds are exposed to reinvestment rate risk.

Reinvestment rate risk: The risk that a decline in interest rates will lead to lower income when bonds mature and funds are reinvested

Determinants of Interest Rates

The interest rate quoted on any debt security is composed of a real risk-free rate, r*, plus several premiums that reflect inflation, the security’s risk, its liquidity (or marketability), and the years to its maturity. This relationship can be expressed as follows:

r = r* + IP + DRP + LP + MRP

r = required return (or nominal interest rate)

r* = real risk-free rate of interest

IP = inflation premium

DRP = default risk premium

LP = liquidity premium

MRP = maturity risk premium

CF> r*+IP → nominal risk free rate

What are the marketable obligations? , types of bill and bonds available

Marketable securities are direct obligations of the U.S. government that can be bought and sold in the secondary market. There are five types of marketable securities: Bills, notes, TIPS, Floating Rate Notes and bonds

Treasury bills are money market instruments issued by the Government of India as a promissory note with guaranteed repayment at a later date. Funds collected through such tools are typically used to meet short term requirements of the government, hence, to reduce the overall fiscal deficit of a country.

They are primarily short-term borrowing tools, having a maximum tenure of 364 days, available at zero coupons (interest) rate. They are issued at a discount to the published nominal value of government security (G-sec).

Government treasury bills can be procured by individuals at a discount to the face value of the security and are redeemed at their nominal value, thereby allowing investors to pocket the difference. For example, a 91-day treasury bill with a face value of Rs. 120 can be bought at a discounted price of Rs. 118.40. Upon maturity, individuals are eligible to receive the entire nominal value of Rs. 120, which allows them to realise a profit of Rs. 1.60. Now, take a look at other important treasury bill details.

What is the dealer system, nonmarketable government securities, term structure, yield curve, expectation theory?

Most non-marketable securities are government-issued debt instruments. Common examples of nonmarketable securities include U.S. savings bonds, rural electrification certificates, private shares, state and local government securities, and federal government series bonds

What are the types of inflation listed in this chapter?

Stagflation and Hyperinflation: Two Extremes

Although as consumers we may hate rising prices, many economists believe a moderate degree of inflation is healthy for a nation’s economy. Typically, central banks aim to maintain inflation around 2% to 3%.1 Increases in inflation significantly beyond this range can lead to fears of possible hyperinflation, a devastating scenario in which inflation rises rapidly out of control.

There have been several notable instances of hyperinflation throughout history. The most famous example is Germany during the early 1920s when inflation reached 30,000% per month. Zimbabwe offers an even more extreme example. According to research by Steve H. Hanke and Alex K. F. Kwok, monthly price increases in Zimbabwe reached an estimated 79,600,000,000% in November 2008.

Stagflation (a time of economic stagnation combined with inflation) can also wreak havoc. This type of inflation is a witch’s brew of economic adversity, combining poor economic growth, high unemployment, and severe inflation all in one. Although recorded instances of stagflation are rare, the phenomenon occurred as recently as the 1970s, when it gripped the United States and the United Kingdom—much to the dismay of both nations’ central banks.

Stagflation poses a particularly daunting challenge to central banks because it increases the risks associated with fiscal and monetary policy responses. Whereas central banks can usually raise interest rates to combat high inflation, doing so in a period of stagflation could risk further increasing unemployment. Conversely, central banks are limited in their ability to decrease interest rates in times of stagflation because doing so could cause inflation to rise even further. As such, stagflation acts as a kind of check-mate against central banks, leaving them with no moves left to make. Stagflation is arguably the most difficult type of inflation to manage.

Negative Inflation

Also known as deflation, negative inflation occurs when prices drop for various reasons. Having a smaller money supply increases the value of money, which in turn decreases prices. A reduction in demand either because there is too large of a supply or a reduction in consumer spending can also cause negative inflation. Deflation may seem like a good thing because it reduces the prices of goods and services, thus making them more affordable, but it can negatively affect the economy in the long run. When businesses make less money on their products, they are forced to cut costs, which often means laying off or terminating employees, thereby increasing unemployment.

What Causes Inflation?

We can define inflation with relative ease, but the question of what causes inflation is significantly more complex. Although numerous theories exist, arguably the two most influential schools of thought on inflation are those of Keynesian and monetarist economics.

Keynesian Economics

The Keynesian school of thought derived its name and intellectual foundation from British economist John Maynard Keynes (1883–1946).5 Although its modern interpretation continues to evolve, Keynesian economics is broadly characterized by its emphasis on aggregate demand as the prime mover of economic development. As such, adherents of this tradition advocate government intervention through fiscal and monetary policy as a means of achieving desired economic outcomes, such as increasing employment or dampening the volatility of the business cycle. The Keynesian school believes inflation results from economic pressures such as rising costs of production or increases in aggregate demand. Specifically, they distinguish between two broad types of inflation: cost-push inflation and demand-pull inflation.

Cost-push inflation results from general increases in the costs of the factors of production. These factors—which include capital, land, labor, and entrepreneurship—are the necessary inputs required to produce goods and services. When the cost of these factors rise, producers wishing to retain their profit margins must increase the price of their goods and services. When these production costs rise on an economy-wide level, it can lead to increased consumer prices throughout the whole economy, as producers pass on their increased costs to consumers. Consumer prices, in effect, are thus pushed up by production costs.

Demand-pull inflation results from an excess of aggregate demand relative to aggregate supply. For example, consider a popular product where demand for the product outstrips supply. The price of the product would increase. The theory in demand-pull inflation is if aggregate demand exceeds aggregate supply, prices will increase economy-wide.

What are Investment graded bonds?

A bond that is investment grade has a rating of Baa or higher from Moody's Investors Service, a rating of BBB or higher from Standard & Poor's or both. Many institutional investors have policies that require them to limit their bond investments to investment-grade issues.