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Chapter 2 Money, Credit, and the Determination of Interest Rates Chapter 2 Learning Objectives Understand how the supply and demand for money and credit affect (and are affected by) the economy and the general level of interest rates Understand how yields on individual debt instruments are determined Understand why securities of different maturities may have different yields The General Level of Interest Rates Interest rate on an instrument reflects general market rates and the risk of the specific instrument Equation of Exchange MV = PT M = money supply V = stable velocity of circulation P = passive price level T = stable volume of trade Fisher Equation i=r+p Determining Interest Rates LIQUIDITY EFFECT – Money supply goes up – Demand for bonds goes up – Interest rates go down INCOME EFFECT – Income goes up – Demand for credit goes up – Interest rates go up Risks In Real Estate Finance DEFAULT RISK – Risk that the borrower will not repay the mortgage per the contract CALLABILITY RISK – Borrower may repay the debt before maturity MATURITY RISK – Other things held constant, the longer the maturity the greater the change in value for a given change in interest rates Risks In Real Estate Finance MARKETABILITY RISK – Risk that the asset doesn’t trade in a large, organized market INFLATION RISK – Risk in loss of purchasing power INTEREST RATE RISK – Risk of loss due to changes in market interest rates – Fixed-income assets are most susceptible The Yield Curve Relates maturity and yield at the same point in time Explaining the structure of the yield curve: – Liquidity Premium Theory – Market Segmentation Theory – Expectations Theory – the long-term rate for some period is the average of the short-term rates over that period Explaining the Yield Curve LIQUIDITY PREMIUM – Premium paid for liquidity SEGMENTED MARKETS – Market divided into distinct segments EXPECTATIONS THEORY – Current rates are the average of expected future rates – The current two-year rate is the average of the current one-year rate and the one-year rate a year from now