I’ll give this a shot, but certainly welcome input from someone else w/ more FI experience.
I don’t like the phrasing of the first quote at all. Like yickwong, the first thing that comes to mind is the inverse relationship between bond prices and yield. This part’s pretty straight-forward:
yield = coupon payment / bond price
As that denominator gets bid up, we can clearly observe the resulting decline in yield. So but the quote uses “nominal interest rate” and it’s unclear to me, particularly out of context, whether this is an attempt to convey some broader phenomenon, like, if the demand for bonds rises (i.e. the supply of loanable funds increases), nominal interests rates will generally decline for new issues unless demand for loanable funds increases proportionally. Basic supply and demand here. Is that what this quote’s about? I don’t know.
Second quote, I’m going to have to speculate a little more and invite the derision our brighter AF colleagues.
First let’s define our markets. “Capital market” is awfully vague, so I’ll work under the assumption it means the market for long-term debt securities (specifically, original maturities greater than one year), which stands in contrast to the money market, which we can more precisely define as the market for short-term debt securities like commercial paper, bankers acceptances, and Treasury Bills.
Okay, going out on a limb here, my understanding is that the money market has much higher liquidity than the market for longer-maturity debt securities. Let’s assume for a moment that I’m correct, and that we’re confining our discussion to a developed economy with low-to-moderate inflation, then I wouldn’t expect inflation to be a material concern to money-market participants, who could quote rates in nominal terms and be confident their nominal returns are approximately equivalent to the real return (inflation-adjusted). Moreover, I would expect the money market’s liquidity to furnish us with a more accurate gauge of true borrowing costs, albeit short-term rates for high credit-quality issuers.
Moving along… as we consider longer-maturity debt securities, inflation becomes a more material concern. Each successive fixed coupon payment declines in real value as inflation occurs. I’m banking on the assumption here that investors in this longer-maturity debt market factor expected inflation into their required rate of return, allowing us to derive a true “real interest rate” by adjusting the quoted nominal rates for expected inflation.
yickwong, one nit-picky point. Just to clarify, your formula for calculating the real interest rate is a linear approximation. Here’s the precise calculation, even though they’re close, it’s good to know both and cite them accordingly.
1 + R_nominal = (1 + R_real)*(1 + Inflation)
1 + R_real = (1 + R_nominal)/(1 + Inflation)
R_real = [(1 + R_nominal)/(1 + Inflation)] - 1
minocfa, I sure would like to see the broader context of these two quotes. If you’re up to it, maybe type a bit more of the surrounding text and/or share some of that chapter’s LOS. Quotes like this piss me off, they just convey facts that the reader is supposed to take for granted as being true w/o provision of any further explanation.
Please correct me (politely, please) if I’m mistaken, folks, thanks.