Topic 2 - Flow Of $ And IR Flashcards
Describe sectoral balances?
Domestic:
Households
Corporations
Governments
Expanded:
Rest of the world
Financial corporations
Describe inter sectoral financial flows?
Net lenders:
Households
Net borrowers:
Non-financial corporations
Government (depends on if it is in surplus or deficit)
Rest of the world (depends, but generally AU borrows)
Financial corporations
What are interest rates?
- the cost of borrowing money
- the return from lending funds
- the opportunity cost of holding funds
- time value of money
We acknowledge differing IR rates offered by institutions but are more concerned with the aggregate IR
- refer to calculation sheet
Be able to calculate simple & compound interest
FV = PV + I
I = PV x i x t
COMPOUND
FV = PV (1 + i) t
What is simple interest?
The flat interest on a principle sum.
Assets return based on per annum and = 12 months or less.
What is compounded interest?
It means the interest is reinvested, now the principle is compounding.
The more compounding the higher the returns on an asset.
What is a nominal interest rate?
Nominal is less than the effective rate because it does not take into account compounding periods
What is effective interest rate?
Takes into account the higher interest paid as a result of having it being compounded more than once a year.
IMPT* use effective interest formula when comparing securities with different compounding periods.
What are the main determinants of interest rates?
Initially this is limited to the LOANABLE funds theory
There are many interest rates on offer.
LOANABLE funds theory: supply of funds for loaning depends on what the interest rate is doing (they are inversely related).
High interest = means greater returns from lending and an incentive to save
Opportunity cost of holding money is high (better lend it and get higher returns)
HOWEVER
Demands for loans will decrease because it is expensive.
ALTERNATIVELY
If interest rates drop them more lending by corporations and households occurs
Name two factors that determine changes in the IR?
Inflationary expectations
Central bank action
Describe inflationary expectations?
If inflation goes up, suppliers of LOANABLE funds will want a higher rate of interest to maintain their real return. Demand will increase because demanders of funds still Need to maintain pre-investment plans. Supply down, demand up.
(To demonstrate draw a graph with IR on vertical axis and quantity of funds on horizontal axis) see page 21 of topic 2
Describe central bank action effects on interest rate?
Central banks will sell bonds to decrease the cash flow in the economy (take money out of circulation).
Determinants of the structure of interest rates?
2 types:
Risk structure - the greater the risk, the higher the returns.
Term structure - longer term investments should have higher returns because they have greater risk.
What are the 2 main determinants of IR based on risk?
LIQUIDITY RISK:
If the asset cannot be traded quickly the investor is unable to realise cash quickly.
CREDIT/DEFAULT RISK:
The risk that borrowers will not repay commitments.
Describe the TERM STRUCTURE of IR?
This involves the yield curve.
Interest rates change with the time to maturity : short term is lower return, longer terms have higher risk and higher interest rates.
Normal curve: positive relationship
Inverse yield curve: negative relationship
Flat curve: no change
Humped yield curve: times of uncertainty
