Determinants of interest rate structure
Answers
Explanation:
What might one conclude from the observation that longer-term bonds usually offer higher yields to maturity? One possibility is that longer-term bonds are riskier and that the higher yields are evidence of a risk premium that compensates for interest rate risk. Another possibility is that at these times investors expect interest rates to rise and that the higher average age yields on long-term bonds reflect the anticipation of high interest rates in the latter year of the bond’s life. We start our analysis of these possibilities with the easiest case: a world with no uncertainty where investors already know the path of future interest rates.
Types of interest rates:
Bond Pricing The interest rate for a given time of interval is known as SHORT INTEREST RATE for that period. Suppose that all participants in the bond market are convinced that the short rates .Market participants cannot look up such sequence of short rates in The Wall Street Journal. All they observe there are price and yields of bonds of various maturities. Nevertheless, we can think of the Short Rate Sequence of the above mentioned table as the series of the interest rates that investors keep in back of their minds when they evaluate the price of different bonds. Given this pattern of rates, what price might we observe on various maturity bonds.
A bond paying Rs.1,000 in one year will sell today for Rs.1,000/1.08 = Rs.925.93. similarly a two year maturity bond will sell today at price
P = Rs.1,000 = Rs.841.75
(1.08)(1.10)
From the bond price we can calculate the yield to maturity on each bond. Recall that the yield in the single interest rate that equates the present value of the bond’s payments to the bond’s price. Although interest rates may vary over time, the yield to maturity is calculated as one “average” rate that is applied to discount all of the bond’s payments.
The yield to maturity on Zero-coupon bonds is sometimes called the spot-rate that prevails today for a period for a period corresponding to the maturity of the zero. Repo Rates
Whenever the banks have any shortage of funds they can borrow it from RBI. Repo rate is the rate at which our banks borrow rupees from RBI. A reduction in the repo rate will help banks to get money at a cheaper rate. When the repo rate increases borrowing from RBI becomes more expensive.
A repo or repurchase Agreement is an instrument of money market. Usually reserve bank (federal bank in U.S) and commercial banks involve in repo transactions but not restricted to these two. Individuals, banks, financial institutes can also participate in repurchase agreement.
Repo is a collateralized lending i.e. the banks which borrow money from Reserve Bank to meet short term needs have to sell securities, usually bonds to Reserve Bank with an agreement to repurchase the same at a predetermined rate and date. In this way for the lender of the cash (usually Reserve Bank) the securities sold by the borrower are the collateral against default risk and for the borrower of cash (usually commercial banks) cash received from the lender is the collateral.
Reserve bank charges some interest rate on the cash borrowed by banks. This rate is usually less than the interest rate on bonds as the borrowing is collateral. This interest rate is called ‘repo rate’. The lender of securities is said to be doing repo whereas the lender of cash is said to be doing ‘reverse repo’.
In a reverse repo Reserve Bank borrows money from banks by lending securities. The interest paid by Reserve Bank in this case is called reverse repo rate.
Borrower of funds is called as seller of repo and lender of funds is called as buyer of repo. When the term of the loan is for one day it is known as an overnight repo and if it is for more than one day it is called a term repo.
The forward clean price of bonds is set at a level which is different from the spot clean price by adjusting the difference between repo rate and coupon earned on the security.
Bank Rate
The rate at which central banks lend funds to national banks. A central bank adjusts the supply of currency within national borders by adjusting the bank rate. When the central bank reduces the bank rate, it increases the attractiveness for commercial banks to borrow, thus increasing the money supply. When the central bank increases the bank rate, it decreases the attractiveness for commercial banks to borrow, consequently decreasing the money supply.
A bank rate is the interest rate that is charged by a country’s central or federal bank on loans and advances to control money supply in the economy and the banking sector. This is typically done on a quarterly basis to control inflation and stabilize the country’s exchange rates. A fluctuation in bank rates triggers a ripple-effect as it impacts every sphere of a country’s economy. For in
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