Chapter three
Interest rates in the
Financial System
BY G.N 1
Objectives:
At the end of this chapter the student be able to:
✓ Define interest rate.
✓ Differentiate type of interest rate.
✓ List and differentiate theory of interest rate.
✓ Define term structure of interest rates.
✓ List and differentiate term structure theory's.
✓ Familiarized with Factors that affecting structure of
interest rate determinations.
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3. Introduction
• the acts of saving and lending and borrowing and
investment are intimately linked through the
financial system.
• And one factor that significantly influences all of
them 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 up on period. It is the price of credit.
• But unlike other prices in the economy, the rate of
interest is really a ratio of two quantities-the money
cost of borrowing funds to the amount of money
actually borrowed, usually expressed on an annual
percentage basis. BY G.N 3
Definition
✓ An interest rate is the price paid by a borrower to a
lender for the use of resources that will be used
during some time period and then returned the cost of
Money.
✓ It is compensation to the lender for forgoing other
useful investments that could have been made with
the loaned asset – Opportunity cost
✓ Interest rates include base rates and risk premiums
✓ Would you be more likely to buy a house/car when
interest rates are high or low?
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Types of Interest Rates
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Cont’d
Nominal interest Rate: the actual monetary price that
borrowers pay to lenders to use their money.
✓ It is the stated interest rate of a bond or loan, which
signifies the actual monetary price borrowers pay lenders
to use their money, without taking into account the
impact of inflation or deflation over time
✓ The nominal interest rate doesn't take
into account inflation and other factors that will erode
the purchasing power of the investment over time.
✓ The nominal interest rate is the starting point for most
investment decisions and analyses.
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Cont’d
The risk-free rate is approximately the yield on
short-term Treasury bills.
✓Includes the pure rate and an allowance for
inflation
✓Viewed as current minimum interest rate
✓No investment that does have risk can offer
a lower rate
✓the risk-free rate of return does not truly
exist, as every investment carries at least a
small amount of risk.
BY G.N 7
Cont’d
✓A real interest rate is the interest rate that is
added to the projected rate of inflation to
provide the nominal interest rate.
RIR= Nominal Interest Rate - Projected Rate of
Inflation
✓Real interest rates are crucial for making
informed financial decisions, especially in the
context of investments and loans.
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Cont’d
The Effective Annual Interest Rate (EAR) is
the interest rate that is adjusted
for compounding over a given period.
✓Simply put, the effective annual interest rate is
the rate of interest that an investor can earn (or
pay) in a year after taking into consideration
compounding.
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Cont’d
✓Simple Interest: interest on principal only.
✓Compound Interest: accumulated interest will
earn interest.
✓Fixed and Floating Rates of Interest
While the interest rates remain constant in the
case of Fixed Rate of Loans, the Floating Loan
Rate is variable.
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3.1 The theory of interest rates
There is not one interest rate in any economy for there
are thousands of different interest rates in the
financial system. The most influential theories of the
determination of the interest rate are:
1. Fisher’s classical theory: According to this theory
the rate of interest is determined by the interaction
of savings and investment. Interest is regarded as a
reward for savings in classical theory.
In Fisher’s terms interest rate reflects the interaction
of the saver’s marginal rate of time preference and
borrower’s marginal productivity of capital.
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Cont’d
• A chief influence on the saving decision is the
individual’s marginal rate of time preference, which is
the willingness to trade some consumption now for
more future consumption.
• Another influence on the saving decision is income.
Generally, higher current income means the person will
save more, although people with same income may
have different time preferences.
• The third variable affecting saving is the reward for
savings, or the rate of interest on loans that savers
make with their unconsumed income. As the interest
rate rises, each person becomes willing to save more,
given that person’s rate ofBYtime
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preference. 12
Interest rate
S
D
Savings /investment
QE
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Limitation of classical theory
1. The central problem is that the theory ignores several
factors other than saving and investment which affect
interest rates.
2. In addition, the classical theory assumes that interest
rates are the principal determinants of the quantity of
savings available. Today, economists recognize that
income is far more important in determining the
volume of saving.
3. Finally, the classical theory contends that the demand
for borrowed funds comes principally from the
business sector. Today, however, both consumers and
governments are important borrowers, significantly
affecting credit availability
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and cost. 14
2. Loanable funds theory
✓The loanable funds theory is an extension of Fisher’s
theory and proposes that equilibrium rate of interest
reflects demand and supply of funds, which depends on
saver’s willingness to save , borrower’s expectations
regarding the profitability of investing ,and government’s
action regarding money supply.
✓The Fisher’s classical theory neglects certain practical
matters, such as the power of the government (in concert
with depository institutions) to create money and the
government’s often large demand for borrowed funds,
which is frequently immune to the level of the interest
rate.
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Cont’d
✓Also, Fisher’s theory does not consider the
possibility that individuals and firms might
invest in cash balances.
✓Expanding Fisher’s theory to encompass these
situations produces the loanable funds theory
of interest rates.
✓This view argues that the risk–free interest rate
is determined by the interplay of two forces -
the demand and the supply of loanable funds.
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Cont’d
✓ The demand for loanable funds consists of demand for
funds by firms, governments, and households (or
individuals) which carry out a variety of economic
activities with those funds.
✓ This demand is negatively related to the interest rate
(except for the government’s demand, which may
frequently not depend on the level of the interest rate).
✓ The supply of loanable funds stems from firms,
governments, banks and individuals.
✓ Supply is positively related to the level of interest rates,
if all other economic factors remain the same.
✓ With rising rates, firms and individuals save and lend
more, and banks are more eager to extend more loans. 17
Cont’d
The demand for loan-able funds comes mainly
from the following four fields:
✓Business Investment or Firms.
✓Consumers or households,
✓Hoarding
✓Government.
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Cont’d
Source of Supply of Loanable Funds
✓Savings by individuals or households
✓Dishoarding, or the withdrawal of cash from
hoarding
✓Bank credit, or the creation of money by
banks through lending
✓Disinvestment, or the sale of existing assets
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3. Liquidity Preference Theory
• The liquidity preference theory, originally developed by
John Maynard Keynes, analyzes the equilibrium level of
the interest rate through the interaction of the supply of
money and the public’s aggregate demand for holding
money. In the theory of liquidity preference, only two
outlets for investor funds are considered- bonds and
money.
• For Keynes, money is equivalent to currency and
demand deposits, which pay little or no interest but are
liquid and may be used for immediate transactions.
• Bonds include long–term, interest– paying financial
assets that are not liquid and that pose some risk because
their prices vary inverselyBYwith
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the interest rate level. 20
Cont’d
Keynes observed that the public demands money for
three different purposes (motives).
1. The transactions motive represents the demand for
money in order to purchase goods and services.
2. precautionary motive arises because we live in a
world of uncertainty and cannot predict exactly what
expenses or opportunities will arise in the future. The
third motive for holding money-
3. the speculative motive stems from uncertainty about
the future prices of bonds.
The total demand for money in the economy is simply
the sum of transactions, precautionary, and
speculative demands. BY G.N 21
Cont’d
• Although money pays no interest, the demand for money
is a negative function of the interest rate. At a low rate,
people hold a lot of money because they do not lose
much interest by doing so and because the risk of a rise in
rates (and a fall in the value of bonds) may be large.
• With a high interest rate, people desire to hold bonds
rather than money, because the cost of liquidity is
substantial in terms of lost interest payments and because
a decline in the interest rate would lead to gains in the
bonds’ values.
• For Keynes, the supply of money is fully under the
control of the central bank. Moreover, the money supply
is not affected by the level of the interest rate.
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End of lesson one
Thanks!!!!
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term structure of interest rates
• The relationship between yield and maturity is
called term structure of interest rate.
• The term structure of interest rates is the
variation of the yield of bonds with similar risk
profiles with the terms of those bonds.
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Cont’d
The term structure of interest rates has 3
characteristics:
1. The change in yields of different term bonds tends
to move in the same direction.
2. The yields on short-term bonds are more volatile
than long-term bonds.
3. The yields on long-term bonds tend to be higher
than short-term bonds.
The expectations hypothesis has been advanced to
explain the 1st 2 characteristics and the premium
liquidity theory have been advanced to explain the last
characteristic. The market segmentation theory
explains the yield curve in terms of supply and
demand within the individual segments.
BY G.N 26
Theories of the term structure
1. Market Segmentation Theory (MST): posits that the yield
curve is determined by supply and demand for debt instruments
of different maturities. various investors and borrowers are
restricted by law, preference or custom to certain securities.
➢Bond buyers want maturities that will coincide with their
liabilities or when they want the money, while bond issuers
want maturities that will coincide with expected income
streams.
➢ For example banks may prefer to hold relatively short term
US treasury bonds because of their short term nature of their
deposit liabilities ,while insurance companies prefer to hold
long term US treasury bonds because of their long-term nature
of life insurance contractual obligation
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2. Preferred Habitat Theory (PHT) is an extension of
the market segmentation theory, in that it posits that
lenders and borrowers will seek different maturities other
than their preferred or usual maturities (their usual
habitat) if the yield differential is favorable enough to
them.
✓ For instance, if short-term rates are a lot lower than
long-term rates, then bond issuers will issue more
short-term bonds to take advantage of the lower rates
even though they would prefer longer maturities to
match their expected income streams; likewise, lenders
will tend to buy long-term debt if the yield advantage
is significant, even though carrying long-term debt has
increased risks.
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3. Expectations hypothesis ( Pure Expectation Theory,
Unbiased Expectations Theory): states that different
term bonds can be viewed as a series of 1-period
bonds, with yields of each period bond equal to the
expected short-term interest rate for that period.
– Basic Theory: the forward rate represents the
average opinion of the expected future spot rate for
the period in question
– in other words, the forward rate is an unbiased
estimate of the future spot rate.
– It Postulate that no systematic factors other than
expected future short term rates affect forward rates.
BY G.N 29
[Link] premium theory: investors primarily
interested in purchasing short-term securities to reduce
interest rate risk.
• The liquidity premium theory has been advanced to
explain the 3rd characteristic of the term structure of
interest rates: that bonds with longer maturities tend to
have higher yields.
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Cont’d
• Although illiquidity is a risk itself, subsumed
under the liquidity premium theory are the
other risks associated with long-term bonds:
notably interest rate risk and inflation risk.
• Naturally, increased risks will lower demand
for those bonds, thus increasing their yield.
This increase in yield is the risk premium to
compensate buyers of long-term bonds for
their increased risk.
BY G.N 31
Factors affecting structure of interest rate
determinations
Most recently issued Treasury securities are called
on-the -run or current coupon issues.
Issues auction prior to current coupon issues are
called off-the-run issues. They are not as liquid as
the on-the-run issues, therefore they offer higher
yield than the corresponding on-the-run Treasury
issue.
The minimum interest rate that investors will
demand for investing in a non-treasury security is
the yield offered on a comparable maturity for an
on-the-run Treasury securities. This is called base
interest rate or referred to as the benchmark
interest rate.
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Cont’d
The risk premium is the yield spread between a non-
Treasury security and a comparable on –the – run
Treasury security.
The factors that affect the spread includes :
1) The type of the issuer
2) The issuer’s perceived credit worthiness
3) The term or maturity of the instrument
4) Embedded options in a bond issue
5) The taxability of interest income at a federal and
municipal levels
6) Expected liquidity of the issue.
BY G.N 33
Individual Assignment 1 (5%)
1. Compare and contrast interest rate theory, by
giving real world example
2. Compare and contrast term structure theory,
by giving real world example.
3. Who are responsible to determine interest
rates of Ethiopian commercial bank deposit.
4. What are interest rated determination factors
are consider by National bank of Ethiopia.
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End of chapter 3
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