Financial Markets and Institutions (2-downloads)

When the interest rate rises, the price of the bond falls, and vice versa.

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Negative T-Bill Rates? 

It Can Happen

We normally assume that interest rates must always

be positive. Negative interest rates would imply that

you are willing to pay more for a bond today than

you will receive for it in the future (as our formula for

yield to maturity on a discount bond demonstrates).

Negative interest rates therefore seem like an impos-

sibility because you would do better by holding cash

that has the same value in the future as it does today.

Events in Japan in the late 1990s and in the

United States during 2008 during the global finan-

cial crisis have demonstrated that this reasoning is

not quite correct. In November 1998, interest rates

on Japanese six-month Treasury bills became nega-

tive, yielding an interest rate of –0.004%. In

September 2008, interest rates on three-month T-bills

fell very slightly below zero for a very brief period.

Negative interest rates are an extremely unusual

event. How could this happen?

As we will see in Chapter 4, the weakness of the

economy and a flight to quality during a financial cri-

sis can drive interest rates to low levels, but these two

factors can’t explain the negative rates. The answer is

that large investors found it more convenient to hold

these Treasury bills as a store of value rather than

holding cash because the bills are denominated in

larger amounts and can be stored electronically. For

that reason, some investors were willing to hold

them, despite their negative rates, even though in

monetary terms the investors would be better off hold-

ing cash. Clearly, the convenience of T-bills goes only

so far, and thus their interest rates can go only a little

bit below zero.

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Part 2 Fundamentals of Financial Markets

The Distinction Between Real and Nominal Interest Rates

So far in our discussion of interest rates, we have ignored the effects of inflation

on the cost of borrowing. What we have up to now been calling the interest rate

makes no allowance for inflation, and it is more precisely referred to as the nominal