[Corporate Finance] Foundation of Finance Topics (2): Equilibrium One Period Yields

3. Equilibrium One Period Yields

Overview

This concept relates to the idea that, in a well-functioning market, the yield of a security for a single period will adjust to a point where demand and supply for the security are in balance (equilibrium). It’s crucial in understanding how interest rates and yields are set in financial markets.

Note: The Connection between Interest Rate and Yield

1. Interest Rate: This is the percentage charged by a lender to a borrower for the use of assets. In the case of a savings account or a bond, it's what the bank or the bond issuer pays to the account holder or bondholder. The interest rate essentially sets the "cost" of borrowing money.
2. Yield: In the context of bonds or savings accounts, the yield is effectively the same as the interest rate. It's the return on investment, expressed as a percentage, that investors receive for lending their money. For a bond, the yield is the interest paid by the bond divided by its current market price.

Equilibrium in Simple Terms

Imagine you're looking at the interest rate for a savings account or a bond that you'll hold for just one year – that's essentially a "one period yield." Now, let's talk about Equilibrium:

Applying It to One Period Yields
Supply and Demand: In financial markets, there are people who want to borrow money (demand) and those who want to lend or invest money (supply).
Yield as a Price: The yield (or interest rate) on a bond or savings account can be thought of as the "price" for borrowing or lending money.
Finding Equilibrium: Just like a seesaw, the interest rate (yield) adjusts until the amount of money people want to lend is equal to the amount people want to borrow.

 

Example
High Demand for Loans: Let's say lots of people want to borrow money. If there's not enough money being offered for lending, lenders can charge more (meaning higher interest rates or yields).
Too Much Money to Lend: Conversely, if there's a lot of money available for lending but not enough borrowers, lenders might lower their interest rates to attract more borrowers.

 

Equilibrium Yield

The "equilibrium one period yield" is that specific interest rate where the amount of money people want to lend perfectly matches the amount people want to borrow for that one year (or one period). No one needs to change the interest rate anymore because everyone who wants to borrow or lend money at that rate can do so.

In real life, these rates are constantly adjusting due to changing conditions (like economic data, central bank policies, etc.), but the concept of equilibrium helps us understand why and how these rates change.