The variability short-term and long-term interest rate is a prominent feature
of the
economy. Interest rates change in response to a variety of economic events, such as changes in federal policy, crises in domestic and international financial
markets, and changes in the prospects
for
long term economics growth and
inflation. However, economic events such as these tend to be irregular.
There is
a more regular variability of interest rate associated with the business cycle, the
expansions
and
contractions
that
the economy experience overtime. For example, short-term interest rate rise in expansions and fall in recessions. Long
term
interest rate do not appear to co-vary much with the level of economic
output.
The term cyclical volatility of interest rate refers to the variability
of
interest rate over periods that correspond to the length of the typical business cycle. In this article, we will example some facts and theory about the cyclical volatility of
short-term and long-term interest rate. Why should we care about interest rate volatility? How do short term
and
long time
interest rate
behave
over the
business cycle! What determines the cyclical volatility of interest rate associated with different maturities of government bonds? These questions
are
important to ask
and
answer as we seek
a fuller understanding of the dynamic of the business cycle in market economic.
2.1.7 WHY DOES INTEREST
RATE VOLATILITY
MATTER?
The variability of interest rates affects decision about how to save and invest. Investors differ in their willingness to hold risky
assets such as stocks and bound. When the returns to holding stocks and bonds are highly
volatile, investors who
rely on these assets to provide for their consumption face a relatively large
chance of having low consumption at any given time. For example, before retirement, people receive a steady stream of income that helps to buffer the changes in wealth associated with changes in the returns on their investment
portfolios.
This steady
return from working helps than maintain a relatively
steady level of
consumption. After
retirement, people no longer
have steady stream of income from working (though it will in part, be replaced
by pension income and social security). So a less volatile investment portfolio is called for the lower volatility of
investment returns allows return to maintain a
relatively
even level of consumption overtime,
young
investors, who are saving for retirement, are better
able
to absorb the risk of holding
assets with highly volatile price and returns. They can
weight than portfolio more heavily toward risky stocks and bonds
because they are recurring a steady return from working. For holding these risk or assets, the young
investor will
be rewarded with a higher average return on their investment.
Just as individuals care about managing risk in their investment portfolios, so do
firms. To manage risk, firm must pay attention to interest rate volatility and the
composition of their portfolios. Many business firms hold portfolios containing large numbers of assets and, thus are interested in qualifying the risk of losing large sum of money. As risk in the economy change, the expected gain and losses from the investment portfolio change. Measuring the risk involves knowing how volatile prices of return on assets change together overtime. The volatility of interest rates is likely to be an important component in quantifying risk and guiding the investment decisions of these institutions. Interest rate volatility also has implications for how the prices of certain types of assets are determined. Options are assets that give investors the right, but not the obligation, to buy (call options) or sell (put options) other assets (such as stocks or bonds) at a perspecified time in the future. For options purchased on interest bearing securities, modern finance theory demonstrates that.........................
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