Chapter two
Interest Rate determination
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1. THE LEVEL OF
INTEREST RATES
What are Interest Rates?
The acts of saving and lending, borrowing and investing are
intimately linked through the financial system. And one
factor that significantly influences and ties all of them
together is the rate of interest.
The rate of interest is the price a borrower must pay to secure
scarce loanable funds from a lender for an agreed-upon
period.
Thus interest rate is;
Rental price for money.
Penalty to borrowers for consuming before earning.
Reward to savers for postponing consumption.
Expressed in terms of annual rates.
As with any price, interest rates serve to allocate resources.
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Functions of interest rate
It helps guarantee that current savings will flow into investment to
promote economic growth.
It rations the available supply of credit( loanable funds) to Inv’t
projects with the highest expected returns.
It brings into balance the supply of money with the public’s
demand for money.
It is also an important tool of government policy through its
influence on the volume of saving and investment.
Reduce interest rate if the economy is growing too slowly and
unemployment is rising. Increase interest rate if the economy is
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experiencing rapid inflation
The Real Rate of Interest
It is the rate of interest determined by the returns earned on
investments in productive assets in the economy and by
individuals’ time preference for consumption
The real interest rate is determined in the absence of
inflation and, as a result, it more accurately reflects the true
cost of borrowing.
Producers seek financing for real assets. Expected rate of
interest is upper limit on interest rate producers can pay for
financing.
Savers require compensation for deferring consumption.
Time value of consumption is lower limit on interest rate at
which savers will provide financing.
Real rate occurs at equilibrium between desired real
investment and desired saving. 5
Determinants of the Real Rate of Interest
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Loanable Funds Theory
Loanable funds (LFs) theory of interest rates argues that
the risk-free interest rate is determined by the interplay of two
forces: the demand for and supply of loanable funds.
The DD for LFs consists of credit demands from domestic
businesses, consumers, and governments and also borrowing
in the domestic market by foreigners
The SS of LFs stems from four sources: domestic savings,
money creation by the banking system, and lending in the
domestic market by foreigners
Supply of loanable funds—
All sources of funds available to invest in financial claims
Demand for loanable funds—
All uses of funds raised from issuing financial claims
Equilibrium interest rate Copyright© 2006 John Wiley & Sons, Inc. 7
Supply of loanable funds—
All sources of funds available to invest in financial claims:
Domestic Saving
Consumer savings most saving is done by households
and is simply the difference between current income and
current consumption..
Business savings:
Government budget surpluses: occurs when current
revenues exceed current expenditures.
Dishoarding of Money Balances
Creation of Credit by the Domestic Banking System
Foreign Lending to the Domestic Funds Market
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Demand for Loanable Funds
All uses of funds raised from issuing financial claims:
Consumer DD for LFs: consumers are not highly responsive
to the rate of interest when they seek credit but focus on the
down payment, maturity, and size of installment payments. This
implies that consumer demand for credit is relatively inelastic
with respect to the rate of interest
Business inv’t DD for LFs The credit demands of domestic
businesses generally are more responsive to changes in the rate
of interest because it affects their expected rate of return
Government demand for LFs is a growing factor in the
financial markets but does not depend significantly on the level
of interest rates rather on response to social needs and the public
welfare
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Equilibrium Interest Rate
If competitive forces operate in financial sector, laws of supply
and demand will bring rates into equilibrium.
Equilibrium is temporary or dynamic: Any force that shifts
supply or demand will tend to change interest rates.
The interest rate tends toward the equilibrium point at which the
SS of LFs equals the DD for LFs
If the interest rate is temporarily above equilibrium, the SS of LFs
exceeds the total DD for LFs, and the rate of interest will be bid
down.
On the other hand, if the interest rate is temporarily below
equilibrium, LFs dd will exceed the SS. The interest rate will be
bid up by borrowers until it settles at equilibrium once again.
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Loanable Funds Theory
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Loanable Funds Theory
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Loanable Funds Theory
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Price Expectations and Interest Rates
Unanticipated inflation benefits borrowers at
expense of lenders.
Lenders charge added interest to offset anticipated
decreases in purchasing power.
Expected inflation is embodied in nominal interest
rates: The Fisher Effect.
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Fisher Effect
The exact Fisher equation is:
(1 + i ) = (1 + r )(1 + Pe )
where
i = the observed nominal rate of interest,
r = the real rate of interest,
Pe = the expected annual rate of inflation.
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Fisher Effect, cont.
From the Fisher equation, we derive the nominal
(contract) rate:
i = r + Pe + (r * Pe )
We see that a lender gets compensated for:
rental of purchasing power
anticipated loss of purchasing power on the principal
anticipated loss of purchasing power on the interest
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Fisher Effect: Example
1-year $1000 loan
Parties agree on 3% rental rate for money and
5% expected rate of inflation.
Items to pay Calculation Amount
Principal $1,000.00
Rent on money $1,000 x 3% 30.00
PP loss on principal $1,000 x 5% 50.00
PP loss on interest $1,000 x 3% x 5% 1.50
– Total Compensation $1,081.50
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Simplified Fisher Equation
The third term in the Fisher equation is
negligible, so it is commonly dropped. The
resulting equation is
i = r + Pe
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2. THE STRUCTURE OF
INTEREST RATES
Factors that Influence Interest Rate Differences
Term to Maturity.
Default Risk.
Tax Treatment.
Marketability.
Call or Put Features.
Convertibility.
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Term (Maturity) Structure
One factor that influences the interest rate on a bond is its
term to maturity: Bonds with identical risk, liquidity, and
tax characteristics may have different interest rates because
the time remaining to maturity is different.
These May be studied visually by plotting a yield curve at
a point in time. It is A plot of the yields on bonds with
differing terms to maturity but the same risk, liquidity, and
tax
A yield curve is a smooth line, which shows the
relationship between maturity and a security's yield at a
point in time.
The yield curve may be ascending (normal), flat, or
descending (inverted).
Several theories explain the shape of the yield curve. 21
Term (Maturity) Structure
When yield curves slope upward, the long-term interest rates
are above the short-term interest rates;
when yield curves are flat, short- and long- term interest
rates are the same; and
when yield curves are inverted, long-term interest rates are
below short-term interest rates.
Yield curves can also have more complicated shapes
Three theories have been put forward to explain the term
structure of interest rates,
(1) the expectations hypothesis (theory),
(2) the segmented markets theory, and
(3) the preferred habitat theory.
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The Expectations Theory
The shape of the yield curve is determined solely
by expectations of future interest rate movements,
and changes in these expectations lead to changes
in the shape of the yield curve .
Ascending: future interest rates are expected to
increase.
Descending: future interest rates are expected to
decrease.
Long-term interest rates represent the geometric
average of current and expected future (implied,
forward) interest rates.
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The expectations hypothesis
It states that interest rate on a long-term bond will equal an
average of short-term interest rates that people expect to occur
over the life of the long-term bond. For example, if people
expect that short-term interest rates will be 10 percent on
average over the coming five years, the expectations hypothesis
predicts that the interest rate on bonds with five years to
maturity will be 10 percent too.
If bonds with different maturities are perfect substitutes, the
expected return on these bonds must be equal.
To see how the assumption that bonds with different maturities
are perfect substitutes leads to the expectations hypothesis, let us
consider the following two investment strategies:
1. Purchase a one-year bond, and when it matures in one year,
purchase another one-year bond.
2. Purchase a two-year bond and hold it until maturity. 24
Because both strategies must have the same expected return if
people are holding one-and two-year bonds, the interest rate on the
two-year bond must equal the average of the two one-year interest
rates.
For example, let’s say that the current interest rate on one-year bond
is 9% and 11% for the next year, the expected return will be (9% +
11%)/2 = 10% per year. You will be willing to hold both the one-and
two-year bonds only if the expected return per year of the two-year
bond equals this. We can make this argument more general.
Using the definitions
it = today' s (time t ) int erest rateon a one − period bond
i e t +1 = int erest rateon a one − periodbond exp ected for next period (time t − 1)
i2t = today' s (time t ) int erest rateon the two − period bond
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the expected return over the two periods from investing $1 in the
two-period bond and holding it for the two periods can be calculated
as
(1 + i2t )(1+ i2t )−1 =1 + 2i2t + (i2t ) 2
−1
After the second period, the $1 investment is worth (1 + i2t) (1+i2t).
Subtracting the $1 initial investment gives the rate of return. Since
(i2t)2 is extremely small, the expected return will be 2i2t
With the other strategy, in which one-period bonds are bought, the
expected return on the $1 investment over the two periods is
(1+it) (1+iet+1) – 1
After the first period, the $1 investment becomes 1+it and this is
reinvested in the one-period bond for the next period, yielding an
amount (1 + it) (1 + iet+1). Subtracting the $1initial investment gives the
expected return and this can be simplified to it + iet+1
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Cont…
Both bonds will be held only if these expected returns are equal, that
is, when
2i2t = it + iet+1
Solving for i2t in terms of the one-period rates, we have
it + i e t +1
i2t =
2
which tells us that the two-period rate must equal the average of the
two one-period rates. We can conduct the same steps for bonds with a
longer maturity
it + i et +1 + i et + 2 + ... + i et + ( n −1)
int =
n
Equation 2 states that the n-period interest rate equals the average of
the one-period interest rates expected to occur over the n-period life of
the bond. This is a restatement of the expectations hypothesis in more
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Liquidity Premium Theory
Long-term securities have greater risk and
investors require greater premiums to give
up liquidity.
Long-term securities have greater price
variability.
Long-term securities have less marketability.
The liquidity premium explains an upward
sloping yield curve.
Liquidity premiums change over time.
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Market Segmentation Theory
Segmented markets theory: markets for different-maturity
bonds are completely separate and segmented. The interest
rate for each bond with a different maturity is then determined
by the SS of DD for that bond with no effects form expected
returns on other bonds with other maturities.
The key assumption in the segmented markets theory is that
bonds of different maturities are not substitutes at all,
The expected return from holding a bond of one maturity has no
effect on the demand for a bond of another maturity.
This theory of the term structure is at the opposite extreme to
the expectations hypothesis, which assumes that bonds of
different maturities are perfect substitutes.
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Cont…
The argument for why bonds of different maturities are not
substitutes is that investors are concerned with the expected returns
only for bonds of the maturity they prefer.
This might occur because they have a particular holding period
in mind, and if they match the maturity of the bond to the desired
holding period, they can obtain a certain return with no risk at all.
For example, people who have a short holding period would
prefer to hold short-term bonds. Conversely, if you were putting
funds a way for your young child to go to college, your desired
holding period might be much longer, and you would want to hold
longer-term bonds.
In the segmented markets theory, differing yield curve patterns
are accounted for by supply and demand differences associated
with bonds of different maturities.
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Cont…
Maturity preferences by investors may
affect security prices (yields), explaining
variations in yields by time
Market participants have strong preferences
for securities of particular maturity and buy
and sell securities consistent with their
maturity preferences.
If market participants do not trade outside
their maturity preferences, then
discontinuities are possible in the yield
curve. 31
Preferred Habitat Theory
It assumes that bonds of different maturities are substitutes but not
perfect,
which means that the expected return on one bond does influence
the expected return on a bond of a different maturity, but it allows
investors to prefer one bond maturity over another.
If investors have preference for bonds of one maturity over
another, then we say that they have a preferred habitat
they prefer bonds of one maturity over another, they will be
willing to buy bonds that do not have the preferred maturity only
if they earn a somewhat higher expected return
The Preferred Habitat Theory allows market participants to trade
outside of their preferred maturity if adequately compensated for
the additional risk.
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Which Theory is Right?
Day-to-day changes in the term structure
are most consistent with the Preferred
Habitat Theory.
However, in the long-run, expectations of
future interest rates and liquidity premiums
are important components of the position
and shape of the yield curve.
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Yield Curves and the Business Cycle
Interest rates are directly related to the level of
economic activity.
An ascending yield curve notes the market
expectations of economic expansion and/or
inflation.
A descending yield curve forecasts lower rates
possibly related to slower economic growth or
lower inflation rates.
Security markets respond to updated new
information and expectations and reflect their
reactions in security prices and yields.
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Uses of the Yield Curve
At any point in time, the slope of the yield curve
can be used to assess the general expectations of
borrowers and lenders about future interest rates!
Investors can use the yield curve to identify under-
priced securities for their portfolios.
Issuers may use the yield curve to price their
securities.
Investors use the yield curve for a strategy known
as riding the yield curve.
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Default Risk
It is the probability of the borrower not
honoring the security contract
Losses may range from “interest a few days
late” to a complete loss of principal.
Risk averse investors want adequate
compensation for expected default losses.
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Default Risk, cont.
Investors charge a default risk premium
(above riskless or less risky securities) for
added risk assumed
DRP = i - irf
The default risk premium (DRP) is the
difference between the promised or nominal
rate and the yield on a comparable (same
term) riskless security (Treasury security).
Investors are satisfied if the default risk
premium is equal to the expected default
loss.
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Default Risk, cont.
Default risk premiums increase (widen) in
periods of recession and decrease in
economic expansion
In good times, risky security prices are bid
up; yields move nearer that of riskless
securities.
With increased economic pessimism,
investors sell risky securities and buy
“quality” widening the DRP.
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Default Risk, cont.
Credit rating agencies measure and grade
relative default risk security issuers
Cash flow, level of debt, profitability, and
variability of earnings are indicators of
default riskiness.
As conditions change, rating agencies
alter rating of businesses and
governmental debtors.
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Tax Effects on Yields
The taxation of security gains and income
affects the yield differences among securities
The after-tax return, iat, is found by multiplying
the pre-tax return by one minus the marginal
tax rate.
iat = ibt(1-t)
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Impact of Marketability on Interest Yields
Marketability -- The costs and rapidity with
which investors can resell a security.
Cost of trade.
Physical transfer cost.
Search costs.
Information costs.
Securities with good marketability have
higher prices (in demand) and lower yields.
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Contract Options and Yields
Varied option provisions may explain yield
differences between securities
An option is a contract provision which
gives the holder the right, but not the
obligation, to buy,sell, redeem, or convert
an asset at some specified price within a
defined future time period.
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Contract Options and Yields
A call option permits the issuer (borrower) to call
(refund) the obligation before maturity
Borrowers will “call” if interest rates decline.
Investors in callable securities bear the risk of
losing their high-yielding security.
With increased call risk, investors demand a call
interest premium (CIP).
CIP = ic - inc
A callable bond, ic, will be priced to yield a higher
return (by the CIP) than a noncallable, inc, bond.
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Contract Options and Yields
A put option permits the investor (lender) to
terminate the contract at a designated price before
maturity
Investors are likely to “put” their security or loan
back to the borrower during periods of increasing
interest rates. The difference in interest rates
between putable and nonputable contracts is called
the put interest discount (PID).
PID = ip - inp
The yield on a putable bond, ip, will be lower than
the yield on the nonputable bond, inp, by the PIP.
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Contract Options and Yields
A conversion option permits the investor to
convert a security contract into another security
Convertible bonds generally have lower yields,
icon, than nonconvertibles, incon.
The conversion yield discount (CYD) is the
difference between the yields on convertibles
relative to nonconvertibles.
CYD = icon - incon. Investors accept the lower yield
on convertible bonds because they have an
opportunity for increased rates of return through
conversion.
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