Interest rate analysis,

yield curve and Monetary

Policy
 Interest rate is a price that a borrower pays
in order to be able to consume resources now
rather than at a point in time in future.
Correspondingly it is therefore the price that
a lender receives to forgo current
consumption in order to take advantage of
consumption of resources at some point in
the future.
Inflation risk
The possibility that the value of assets or
income will decrease as inflation shrinks the
purchasing power of a currency. Inflation
causes money to decrease in value at some rate
and does so whether the money is invested or
not.
Real and Nominal Interest Rates
A nominal interest rate is what is normally
observed and quoted and represents the
actual money paid by the borrower to the
lender expressed as a percentage of sum
borrower over a stated period of time.
A real rate of interest on the other hand is
a nominal rate that is adjusted to take
account of the impact of inflation on the real
value.
For example
If the price level is not constant but rises by
say 3% over that year then while the nominal
interest rate is 4% the real interest rate is
only 1%.
This is because the investor can only
purchase additional goods and services
equivalent to 1% of the loan when the loan
matures due to increase in price.
The real interest rate will always be less than
the nominal interest rate when inflation
occurs (when purchasing power of money is
falling).
Interest Rate Risk
Whenever there is a change in market
interest rates bond values do change but
inversely. The change in bond values as a
result of change in market interest rate (or
required rate of return of the investors) is
known as interest rate risk.
Reason for emergence of interest rate risk in bond
investment is obvious. Coupon payment and the
redemption value payment are pre-specified. The
payment schedule and absolute value of payment are
both defined in the bond indenture.
Every bond investor expects minimum annual %
return on his investment. This minimum required rate
of return is an opportunity cost and is related to
market interest rates. Therefore when there is a
change in market interest rates, it is reflected in
change in required return of investors and hence in
bond values because other variables (coupon and
redemption value )are constant.
Change in bond prices as a result of change
in market interest rate is also known as
interest rate sensitivity.
Malkiel properties of bond values
Required rate of return (market interest rate)
and the bond values are inversely related. As
the required rate increases, the bond prices
fall and vice versa. The reason for this
directly stems from the effect of the time
value of money.
Prices of long-term bonds are more sensitive
to interest rate changes than the price of
short-term bonds (this is due to more-distant
cash flows).
Contd.
Prices of high coupon rate bonds are less
sensitive to changes in interest rates than
prices of low coupon bonds. Thus, bond price
volatility is inversely related to coupon rate.
Yield curve
Defined as the curve depicting relation between the yield
and the terms to maturity.
Normal yield curve represents an ascending
term structure. In this case the interest rate
increase with lengthening of maturities. It
shows that interest rates in future will rise.
Normal yield curve is formed when the yield
on short term bonds are low and rise
consistently as the maturity lengthens.
The upward slope of the normal yield curve is
due to liquidity preference and risk.
Liquidity preference
Lending involves loss of immediate
purchasing power.
Lending for longer periods of time require
higher level of compensation.
This compensation should be reflected in
interest rate.
Risk
Default risk of either principle or interest.
Real capital loss due to inflation.
Other Types of Yield Curve
Inverse Yield Curve
Flat Yield Curve
Inverse yield curve has a declining tendency
which is signalling a decrease in interest
rates. An inverse yield curve is formed when
yield on short term bonds are high and on
long term maturities it is declining.
Flat yield curve depicts that investor are
indifferent between varying maturity of
bonds.
Classical Theory
The theory is associated with the names of
Ricardo, Hume, Fisher and others.
According to it rate of interest is a real
phenomenon in the sense it is determined by
the real factors.
It is the supply of savings and the demand for
investment that determine the rate of
interest.
Aggregate saving is difference between the
total national income and total consumption
expenditure.
There is a time preference in favor of present
rather than future consumption.
Because of this time preference it is
necessary that the current consumption
should be postponed there is a sacrifice
involved in such a postponement.
The various economic units can be induced to
undergo such sacrifice and save if they are
offered a reward for such an action.
This reward is known as rate of interest.
Keynesian theory / Liquidity Preference
theory
According to keynes interest rate is a purely
monetary phenomenon.
This means that the rate of interest is
determined by the monetary factors.
It depends on the actions of monetary
authorities the central bank and government.
The rate of interest is the reward offered to
people to induce them to hold securities
instead of cash.
Cash is perfectly liquid and safe in the sense
that there is no danger of physical
deterioration.
On the other hand securities can vary in
value therefore there is a risk when securities
are held.
Interest rate is a price for giving up liquidity
of holding money in favor of holding
securities.
The demand to hold money is liquidity
preference.
Reasons behind liquidity preference
Transactions motive
(business firms and individuals hold ready cash to be
able to effect day to day transactions)
Precautionary motive
(economic units hold some cash for purpose of
providing for a rainy day or contingencies.)
Speculation motive
(The speculative motive refers to the desire to hold
one’s assets in liquid form to take advantages of
market movements regarding the uncertainty and
expectation of future changes in the rate of interest.)
According to Keynes, “rate of interest is
determined by the interaction between the
supply and demand for money”. Thus,
according to liquidity preference theory,
people’s desire for liquidity can be reduced
by offering them high rate of interest.
According to Liquidity Preference Theory, the
rates of long-term bonds will remain higher
than short term ones.
Expectations Theory
The theory is based on basic rationale for the
shape of the yield curve. It asserts that the
long-term rate is an average of the expected
future short-term interest rates over the time
horizon.
Expectations of a rise in interest rates
If there are generalized expectations of a rise in
interest rates.
Borrowers will seek to borrow long term in order
to lock in at the current low rates.
Increased demand for long term loans
Reduced demand for short term loans
Lenders/ investors will be unwilling to lend long-
term if rates are expected to rise.
Instead lend only short term.
Conversely, if short term rates are expected to fall
over time longer maturity bonds will offered.
Expectations theory testifies that if investors
expect interest rates to increase, they would
tend to lend for shorter periods and would
avoid long-term commitment. However, the
borrowers will attempt to borrow for a longer
period and lock in lower interest rates. If
short term rates are expected to fall over
time longer maturity bonds will be offered at
higher yields.
The combination of a reduced demand from
borrowers and an increased supply from
lenders of short-term loans means that short
term rates will fall while increased demand
from borrowers and reduced supply from
lenders of long-term loans means that long-
term rates will increase.
Segmented Market
Theory
 The Segmented Market Theory assumes that the bond market
is divided into various segments and each segment offers a
variety of advantages. The segments are vulnerable to the ups
and downs of the market and the yield depends on demands
vs supply.
 Most investors want to match their assets with liabilities and
hence choose different options according to their needs.
Investors usually require certainty of returns. The theory
suggests that the borrowers do not shift from one maturity to
another readily. So, the returns are based purely on demand
and supply.
 Note − The Segmented Market theory suggests that investors
strongly prefer assets that match the liabilities and borrowers
prefer to issue liabilities that match with the assets.
Example : a commercial bank that has
liabilities of relatively shorter maturities will
prefer to invest in shorter term debt
maturities while institutional investors may
have strong preferences for longer maturities
to match their liabilities.
This theory asserts that long-term and short-
term bonds are not substitute to each other
and these are traded essentially in distinct
and segmented markets.
The long-term equilibrium rates and short
term equilibrium rates are determined
separately by long-term and short term
participant respectively.
There are different classes of investors in
the bond market.
Yield Spread
Difference in yields of different types of
bonds is known as Yield spread.
Different types of bonds provide different
levels of yield. Yield spread depends upon
the relationship between bond yields and
issue feature of bonds. There are a number of
factors for the emergence of yield spread as
follows:
1. Difference in marketability- some bonds
are less liquid and less marketable than
others. Lesser marketability is compensated
by higher YTM and vice versa.
2. Difference in call features – callable
bonds have higher YTM in order to induce
investors to invest.
3. Difference in credit rating or risk of
default – bonds issued by blue chip
companies have lower YTM than those issued
by other companies. In order to be
compensated for degree of risk undertaken
the YTMs differ. In India bonds with AAA
ratings will offer lesser YTM than offered by
BBB rating bonds or C rating bonds.
Monetary Policy and Interest Rates
Monetary Policy
It is a macroeconomic policy tool used by the
Central Bank to influence the money
supply in the economy to achieve certain
macroeconomic goals. It involves the use of
monetary instruments by the central bank to
regulate the availability of credit in the
market to achieve the ultimate objective of
economic policy.
Objectives of Monetary Policy

Some of its major objectives are as follows:

• Accelerating the growth of the economy.
• Maintaining price stability.
• Generating employment.
• Stabilizing the exchange rate.
Fiscal Policy Vs Monetary Policy
Fiscal Policy Monetary Policy

Definition It is a macro- It is a macroeconomic

economic policy used policy used by the
by the government to Central Bank to
adjust its spending influence money
levels and tax rates supply and interest
to monitor a nation’s rates.
economy
Institutional Controlled by the Controlled by the
Control Government Central Bank
Prime Objective To influence the To influence the
economic condition money supply and
interest rates.
Major Tools Public Expenditure, Bank Rate, Cash
Taxation, etc Reserve Ratio,
Statutory Liquidity
Types of Monetary Policy

Broadly, there are two types of monetary

policy – Expansionary Monetary Policy, and
Contractionary Monetary Policy.
Expansionary Monetary Policy

• It is also called Accommodative Monetary Policy.

• Its primary purpose is to increase the money supply in the
economy through measures such as:
• Decreasing interest rates – It makes it less expensive for
consumers to borrow money, thus increasing the money supply in the
market.
• Lowering reserve requirements for banks – It leaves commercial
banks with more money to lend to the public, thus infusing more
money into the economy.
• Purchasing government securities by central banks – The RBI
buys government securities by paying cash. This means that money
available in the market increases.
• It is aimed at fueling economic growth by stimulating business
activities and consumer spending and also helps to lower
unemployment rates.
• However, it may have an adverse effect of occasional hyperinflation.
Contractionary Monetary Policy

• It is used to decrease the amount of money

supply in the economy through measures such as:
• Raising interest rates – It makes it more expensive
for consumers to borrow money, thus reducing the
money supply in the market.
• Increasing the reserve requirements for banks –
It leaves commercial banks with less money to lend
to the public, thus reducing the money supply in the
economy.
• Selling government bonds – The buyers of
government securities pay cash to the RBI. This
means that money available in the market decreases.
• It is aimed at reducing inflation.
Tools of Monetary Policy

• Bank Rate is the rate at which the RBI is

ready to buy or rediscount Bills of
Exchange or other Commercial
Papers from the Scheduled Commercial
Banks (SCBs).
• If the RBI fixes a high Bank Rate, banks
would not want to rediscount bills from the
RBI as their profits will be low. This will have
the effect of reducing the money supply in the
market.
• Thus, an increase in the Bank Rate results
in a tightening of money supply and vice
Cash Reserve Ratio (CRR) -4.5%
• Cash Reserve Ratio (CRR) is the minimum percentage that
a Scheduled Commercial Bank is obligated to deposit
with the RBI in the form of cash.
• If CRR is increased: If the RBI increases the CRR, the
commercial banks have to deposit more money with the
RBI and are left with less money to lend to customers.
Thus, the effect is reduced money supply in the economy.
• If CRR is decreased: If the RBI decreases the CRR, the
commercial banks have to deposit less money with the RBI
and are left with more money to lend to customers. Thus,
the effect is increased money supply in the economy.
Statutory Liquidity Ratio (SLR) -18%
• Statutory Liquidity Ratio (SLR) is the
percentage of that a Scheduled Commercial
Bank (SCB) has to keep with itself, in the
form of:
• Cash, or
• Gold, or
• SLR Securities (such as government bonds,
treasury bills, and any other instrument
notified by the RBI), or
• Any combination of the above three.
• If SLR is increased: If the RBI increases the
SLR, the commercial banks are left with less
money to lend to customers. Thus, the effect
is reduced money supply in the economy.
• If SLR is decreased: If the RBI decreases
the SLR, the commercial banks are left with
more money to lend to customers. Thus, the
effect is increased money supply in the
economy.
Repo Rate (Re-purchase Option Rate) -
6.5%
Repo Rate is the rate of interest at which
the RBI provides short-term loans to
SCBs against approved securities.
Market Stabilization Scheme (MSS)

• Market Stabilization Scheme (MSS) refers to

intervention by the RBI to withdraw excess liquidity
by selling government securities in the economy.
• Under it, the RBI sells government bonds on a general
basis depending upon the volume of excess liquidity in
the system. Here bonds go to financial institutions and
money goes back to the RBI.
• This withdrawal of excess liquidity is
called sterilization.
• The securities issued under the MSS are, basically,
government bonds and are called Market Stabilization
Bonds (MSBs).
Inflation Targeting

• It is a central banking policy that revolves

around adjusting monetary policy to achieve
a specified annual rate of inflation.
• The principle of inflation targeting is based
on the belief that long-term economic growth
is best achieved by maintaining price stability,
and price stability is achieved by controlling
inflation.
• Broadly, there are two types of Inflation
Targeting:
Strict Inflation Targeting

Under Strict Inflation Targeting, the central

bank is only concerned about keeping
inflation as close to a given inflation target as
possible, and nothing else.
Flexible Inflation Targeting

Under Flexible Inflation Targeting, apart

from keeping inflation within the target
range, the central bank is also concerned
about other things, such as the stability of
interest rates, exchange rates, output, and
employment.
Significance of Monetary Policy
• It plays an important role in maintaining price
stability and ensuring economic growth.
• By maintaining price stability, it helps manage
inflation.
• It shapes variables like Consumption, Savings,
Investment, and capital formation.
• An increase in the money supply helps to stimulate
the business sector, which also helps to create
more jobs.
• By controlling the money supply in the market, it
helps balance Currency Exchange Rates.