Chapter Two

Determination of
Interest Rates

McGraw-Hill/Irwin 2-1 ©2009, The McGraw-Hill Companies, All Rights Reserved

 Learning Objectives

– Examines the link between the time value of

money and interest rate.
– Identify the demanders and suppliers of loanable
funds .
– Examines the factors that cause the shift in quantity
supplied and demanded of lonable funds.
– Examines the factors that determine interest rates.
– Discusses the different theories that explain the
term structure of interest rate.

McGraw-Hill/Irwin 2-2 ©2009, The McGraw-Hill Companies, All Rights Reserved

 Interest Rate Fundamentals

• The change in interest rate influences the

performance and decision making for
investors, this rate is known as:
• Nominal interest rates: the interest rates
actually observed in financial markets
– affect the values (prices) of securities traded in
money and capital markets
– affect the relationships between spot and forward
FX rates
McGraw-Hill/Irwin 2-3 ©2009, The McGraw-Hill Companies, All Rights Reserved
 Time Value of Money and Interest Rates

• The time value of money is based on the

notion that a dollar received today is worth
more than a dollar received at some future
date
• The time value of money assumes that any
interest earned on a dollar invested over any
given period is reinvested again.
• This known as:

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 Time Value of Money and Interest Rates
(Cont.)

– Compound interest: interest earned on an

investment is reinvested

– Simple interest: interest return earned on

an investment is not reinvested

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 Time Value of Money

• The concept of the time value of money can be

used to convert cash flows earned over an
investment horizon into a value of the end of the
investment horizon, this called investment future
value.
• Alternatively, The concept of the time value of
money can be used to convert the value of future
cash flows into their current value, this called
present value of investment.

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 Time Value of Money (Cont.)

• For security valuation purposes: two forms of time

value of money calculations are sued:
– The value of lump sum:
– Lump sum payment: a single cash flow occurs
at the beginning or end of the investment
horizon.
– Annuity: a series of equal cash flows received at
fixed intervals over the investment horizon.

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 Present Value of a Lump Sum

• Discount future payments using current

interest rates to find the present value (PV)
PV = FVt[1/(1 + r)]t = FVt(PVIFr,t)
PV = present value of cash flow
FVt = future value of cash flow (lump sum) received in t
periods
r = interest rate per period
t = number of years in investment horizon
PVIFr,t = present value interest factor of a lump sum

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 Future Value of a Lump Sum

• The future value (FV) of a lump sum

received at the beginning of an
investment horizon
FVt = PV (1 + r)t = PV(FVIFr,t)
FVIFr,t = future value interest factor of a lump
sum

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 Relation between Interest Rates and
Present and Future Values
Present
Value
(PV)
Future
Value
(FV)

Interest Rate

Interest Rate

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 Present Value of an Annuity

• The present value of a finite series of equal

cash flows received on the last day of equal
intervals throughout the investment horizon

PMT = periodic annuity payment

PVIFAr,t = present value interest factor of an annuity

McGraw-Hill/Irwin 2-11 ©2009, The McGraw-Hill Companies, All Rights Reserved

 Future Value of an Annuity

• The future value of a finite series of equal cash

flows received on the last day of equal intervals
throughout the investment horizon

FVIFAr,t = future value interest factor of an annuity

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 Effective Annual Return

• Interest rate used in time value of money

equations is the simple (nominal) interest
rate on the securities.
• But if interest rate is paid or
compounded more than once per year,
the true annual rate of return will differ
from the simple annual rate. This
compounded rate is known as
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 Effective Annual Return (Cont.)

• Effective or equivalent annual return

(EAR) is the return earned or paid over a
12-month period taking compounding
into account
EAR = (1 + r)c – 1
c = the number of compounding periods per year

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 Financial Calculators

• Setting up a financial calculator

– Number of digits shown after decimal point
– Number of compounding periods per year
• Key inputs/outputs (solve for one of five)
N = number of compounding periods
I/Y = annual interest rate
PV = present value (i.e., current price)
PMT = a constant payment every period
FV = future value (i.e., future price)

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 Interest Rate Fundamentals

• Nominal interest rates: the interest rates

actually observed in financial markets
• The change in interest rate influences the
performance and decision making for
investors.
• It also affects the values (prices) of securities
traded in money and capital markets.

McGraw-Hill/Irwin 2-16 ©2009, The McGraw-Hill Companies, All Rights Reserved

 Interest Rate Fundamentals

• Given this, financial institutions and other firm

managers spend much time and effort trying to
identify factors that determine the level of
interest rates at any moment

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 Loanable Funds Theory
• One model that is commonly used to explain
interest rates and interest rate movements is the
lonable fund theory.
• Loanable funds theory is a model used to explain
interest rates and interest rate movements
• Views level of interest rates in financial markets as
a result of the supply and demand for loanable
funds (i.e. as a result from factors that affect the
supply and demand for lonable funds)

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 Loanable Funds Theory (Cont.)
• The supply of lonable fund is a term commonly
used to describe funds provided to the financial
markets by net suppliers of fund.
• The demand of loanable fund is a term commonly
used to describe funds demanded by the user of
fund.
• According to this theory:
• Domestic and foreign households, businesses, and
governments all supply and demand loanable
funds

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 Supply of Loanable Funds

• The quantity of supplied lonable fund increases as the

interest rate increases.
• That is, holding other factors constant, more funds are
supplied as interest rates increase (the reward for
supplying funds is higher)
• Suppliers of lonable funds are:
• Householders:
–The largest suppliers of lonable funds
– they do so when they have excess income or want to
reallocate their asset portfolio holdings.
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 Supply of Loanable Funds (Cont.)

• Their supply of funds is affected by:

– High economic growth
– Increase of total wealth of consumer.
– risk of securities investment
– liquidity needs (i.e. immediate spending needs
such as educational or medical expenditures).

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 Supply of Loanable Funds (Cont.)

• Business sector: also increase their supply

when interest rate is high.
• Their supply of funds is affected by:
– The amount of excess cash they have.
– Perceived risk of securities investment
– liquidity needs (i.e. immediate spending needs).

McGraw-Hill/Irwin 2-22 ©2009, The McGraw-Hill Companies, All Rights Reserved

 Supply of Loanable Funds (Cont.)
• Government: Sometimes generates more cash
inflows more than have budgeted to spend,
which can be loaned to financial market fund
users.

• Foreign investors: increase their supply of fund to

US MKTs when interest rate on US financial assets
is higher than it is on comparable securities in their
home country.
McGraw-Hill/Irwin 2-23 ©2009, The McGraw-Hill Companies, All Rights Reserved
 Supply of Loanable Funds (Cont.)
Their supply of funds is affected by:
– High savings rates, Total wealth, risk of securities
investment , liquidity needs.
– The economic and financial conditions in their
countries relative to US economy.

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 Demand for Loanable Funds

• The quantity of lonable fund demanded is higher as

interest rates fall.
• Holding other factors constant, more funds are
demanded as interest rates decreases (the cost of
borrowing funds is lower)
• Demander for lonable funds are:
• Householders:
– Their demand for fund is reflected in financing
purchase of homes, durable goods (care loans),
nondurable goods (educational and medical loans).
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 Demand for Loanable Funds (Cont.)

• Business sector: to finance long-term

investment in assets and short-term WC by
issuing debts and other financial instruments.
• When interest rates are high, businesses prefer to
finance investment with internally generated
funds.
• The better the economic conditions and the
greater the number of positive NPV projects the
greater the demand is for lonable fund.

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 Demand for Loanable Funds (Cont.)
• Government: borrow heavily by issue debt
instruments to finance temporary imbalance
between revenues and expenditures.
- Lower interest rate and favorable economic conditions
increase their demand for loanable fund.
• Foreign investors:
- interest rate
- economic conditions in their home country, non-price
terms, the general attractiveness of the US dollar
relative to their domestic currency.
McGraw-Hill/Irwin 2-27 ©2009, The McGraw-Hill Companies, All Rights Reserved
 Equilibrium interest rate
• The aggregate supply of loanable funds is the
sum of the quantity supplied by the separate fund
supplying sectors, which is positively related to
interest rate.
• The aggregate demand for loanable funds is the
sum of the quantity demanded by the separate fund
demanding sectors , which is negatively related to
interest rate.

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 Equilibrium interest rate
• The interest rate that equates the aggregate quantity of
loanble funds supplied with aggregate quantity of
loanable funds demanded for a financial securities,
then i* , is the equilibrium interest rate for that
security.
• Whenever the rate of interest is set higher than the
equilibrium rate, there will be a surplus of lonable
funds and less demand,
• so the suppliers will lower the interest rate to attract
more demander to absorb the access amount.

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 Equilibrium interest rate

• Whenever the rate of interest is set lower than the

equilibrium rate, there will be a shortage of loanable
funds.
• So the demander will not be able to obtain the
required fund at current rates, which will result in an
increase in interest rate to attract more suppliers.

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 Supply and Demand of Loanable Funds

Demand Supply
Interest
Rate

Quantity of Loanable Funds

Supplied and Demanded
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 Shifts in Supply and Demand Curves
change Equilibrium Interest Rates
• Identify the fundamental factors that cause the supply
and demand curves for loanable funds to shift.
• Then examine how shifts in the supply and demand
curves for loanable funds determine the
equilibrium interest rate on a specific financial
instrument.
• A shift in the supply or demand curve occurs when the
quantity of a financial security supplied or demanded
changes at every given interest rate in response to a
change in another factor besides the interest rate.

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 Shifts in Supply and Demand Curves
change Equilibrium Interest Rates
• Supply of fund:
• Wealth: as the total wealth of financial MKT
participants increases;
- The amount of dollar value available for investment
purposes increases.
- Then, at every interest rate, the supply of LF increases
(supply curves shifts down or to the right).
- This creates disequilibrium between supply and
demand, as a result,

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 Shifts in Supply and Demand Curves
change Equilibrium Interest Rates (Cont.)
• Wealth:
- To eliminate the imbalance or disequilibrium in this
financial market, the equilibrium interest rate falls,
from i* to i*”, which will increase the quantity of
funds loaned from Q* to Q*”.
• Conversely: as the total wealth of financial MKT
participants decreases;
- The amount of dollar value available for investment
decreases.

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 Shifts in Supply and Demand Curves
change Equilibrium Interest Rates (Cont.)
• Wealth:
- Then, at every interest rate, the supply of LF
decreases (supply curves shifts up or to the left).
- This creates disequilibrium between supply and
demand, as a result,
- The equilibrium interest rate increases, from i* to i*”,
and this results in a decrease the quantity of funds
loaned from Q* to Q*”.

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 Shifts in Supply and Demand Curves change
Equilibrium Interest Rates (Cont.)
• Risk: as the risk of a financial security decreases (i.e.
default risk);
- It becomes more attractive to suppliers of funds.
- Then, at every interest rate, the supply of LF increases
(supply curve shifts down and to the right).
- This results in a decrease in the equilibrium interest
rate from i* to i*”, and this will increase the quantity
of funds loaned from Q* to Q*”.

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 Shifts in Supply and Demand Curves
change Equilibrium Interest Rates (Cont.)
• Risk:
• Conversely: as the risk of a financial security
increases;
- It becomes less attractive to suppliers of funds.
- Then, at every interest rate, the supply of LF
decreases (supply curve shifts up and to the left).
- Accordingly, the equilibrium interest rate increases,
from i* to i*”, which results in a decrease the quantity
of funds loaned from Q* to Q*”.

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 Shifts in Supply and Demand Curves change
Equilibrium Interest Rates (Cont.)
• Near-Term Spending Needs: when participants have
few near –term spending needs;
- The amount of dollar value of funds available for
investment increases.
- At every interest rate, the supply of LF increases
(supply curve shifts down and to the right).
- This results in a decrease in the equilibrium interest
rate , and increasing the quantity of funds loaned.

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 Shifts in Supply and Demand Curves change
Equilibrium Interest Rates (Cont.)

• Near-Term Spending Needs:

• Conversely; when participants have increased near –
term spending needs;
- The amount of dollar value available for investment
decreases.
- Then, at every interest rate, the supply of LF
decreases (supply curve shifts up and to the left).
- Accordingly, the equilibrium interest rate increases,
and the quantity of funds loaned decreases.

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 Shifts in Supply and Demand Curves
change Equilibrium Interest Rates (Cont.)
• Monetary Expansion: When the monetary policy
aims for economic expansion;
- The federal reserve increases the supply of funds in
financial MKTs.
- At every interest rate, the supply of LF increases
(supply curve shifts down and to the right).
- This results in a decrease in the equilibrium interest
rate , and an increase in the quantity of funds loaned.

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 Shifts in Supply and Demand Curves
change Equilibrium Interest Rates (Cont.)
• Monetary Expansion:
• Conversely; when the monetary policy aims to
restrict economic expansion;
- the federal reserve decreases the supply of funds in
financial MKTs.
- Then, at every interest rate, the supply of LF
decreases (supply curve shifts up and to the left).
- Accordingly, the equilibrium interest rate increases,
and the quantity of funds loaned decreases.

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 Shifts in Supply and Demand Curves
change Equilibrium Interest Rates (Cont.)
• Economic Conditions: As the underlying economic
conditions themselves (e.g., the inflation rate, unemployment
rate, economic growth) improve in a country relative to other
countries, the flow of funds to that country increases.
• That is, when the economic conditions in foreign country
decline, the amount of foreign funds flow to domestic
markets increases.
- At every interest rate, the supply of LF increases (supply
curve shifts down and to the right).
- This results in a decrease in the equilibrium interest rate ,
and an increase in the quantity of funds loaned.

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 Shifts in Supply and Demand Curves
change Equilibrium Interest Rates (Cont.)
• Economic Conditions:
• Conversely; when the economic conditions in foreign
country improve;
- The amount of foreign funds flow to domestic
markets decreases.
- Then, at every interest rate, the supply of LF
decreases (supply curve shifts up and to the left).
- Accordingly, the equilibrium interest rate increases,
and the equilibrium quantity of funds loaned
decreases.
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 Shifts in Supply and Demand Curves
change Equilibrium Interest Rates
Increased supply of loanable funds Increased demand for loanable funds
Interest
Interest SS Rate DD* SS
Rate DD DD
SS*

i** E*
i* E
E i*
i** E*

Q* Q** Quantity of Q* Q** Quantity of

Funds Supplied Funds Demanded

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 Shifts in Supply and Demand Curves
change Equilibrium Interest Rates
• Demand for funds:
• Utility Derived from Assets Purchased with
Borrowed funds: as the utility (satisfaction or
pleasure) derived from an assets purchased with
borrowed funds increases;
- The willingness of market participants to borrow
increases, and thus, the dollar value borrowed
increases.
- Then, at every interest rate, the demand for LF
increases (demand curve shifts up and to the right).

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 Shifts in Supply and Demand Curves change
Equilibrium Interest Rates (Cont.)
• Utility Derived from Assets Purchased with
Borrowed funds
- This creates disequilibrium between supply and
demand, as a result,
- the equilibrium interest rate increases, from i* to i*”,
and the quantity of funds loaned increases from Q* to
Q*”.

• Conversely: as the utility derived from an assets

purchased with borrowed funds decreases;
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 Shifts in Supply and Demand Curves
change Equilibrium Interest Rates (Cont.)
- The willingness of market participants to borrow
decreases, and thus, the dollar value borrowed
decreases.
- Then, at every interest rate, the demand for LF
decreases (demand curve shifts down and to the left).
- This creates disequilibrium between supply and
demand, as a result,
- the equilibrium interest rate decreases, from i* to i*”,
and the quantity of funds loaned decreases from Q* to
Q*”.
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 Shifts in Supply and Demand Curves
change Equilibrium Interest Rates
• Restrictivenss on Noprice conditions on Borrowed
funds: as the non-price restrictions put on borrowers
decrease;
- the willingness of market participants to borrow
increases and dollar value borrowed increases.
- Then, at every interest rate, the demand for LF
increases (demand curve shifts up and to the right).
- This creates disequilibrium between supply and
demand, as a result,

McGraw-Hill/Irwin 2-48 ©2009, The McGraw-Hill Companies, All Rights Reserved

 Shifts in Supply and Demand Curves
change Equilibrium Interest Rates (Cont.)
- the equilibrium interest rate increases, from i* to
i*”, and the quantity of funds loaned increases from
Q* to Q*”.
• Conversely: as the non-price restrictions put on
borrowers increase;
- the willingness of market participants to borrow
decreases, and the dollar value borrowed decreases;

McGraw-Hill/Irwin 2-49 ©2009, The McGraw-Hill Companies, All Rights Reserved

 Shifts in Supply and Demand Curves
change Equilibrium Interest Rates (Cont.)
- Then, at every interest rate, the demand for LF
decreases (demand curves shifts down and to the left).
- This creates disequilibrium between supply and
demand, as a result,
- the equilibrium interest rate decreases, from i* to i*”,
and also results in a decrease in the quantity of funds
loaned from Q* to Q*”.

McGraw-Hill/Irwin 2-50 ©2009, The McGraw-Hill Companies, All Rights Reserved

 Shifts in Supply and Demand Curves
change Equilibrium Interest Rates
• Economic Conditions: when the domestic economy
experiences a period of growth;
- market participants are willing to borrow more
heavily.
- Then, at every interest rate, the demand for LF
increases (demand curve shifts up and to the right).
- Then, the equilibrium interest rate increases, from i*
to i*”, the quantity of funds loaned increases from
Q* to Q*”.

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 Shifts in Supply and Demand Curves
change Equilibrium Interest Rates (Cont.)
• Conversely: when the domestic economy experiences
a period of depression (stagnant);
- market participants reduce their demand for funds.
- Then, at every interest rate, the demand of LF
decreases (demand curves shifts down or to the left).
- the equilibrium interest rate decreases, from i* to i*”,
which will decrease the quantity of funds loaned from
Q* to Q*”.

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 Shifts in Supply and Demand Curves
change Equilibrium Interest Rates

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 Determinants of Interest Rates
for Individual Securities

• ij* = f(IP, RIR, DRPj, LRPj, SCPj, MPj)

• Inflation (IP):
- The higher the level of actual or expected
inflation, the higher will be the level of interest
rates.
- The higher the inflation rate, the more the
expensive the same basket of goods and services
will be in the future.
IP =
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 Determinants of Interest Rates
for Individual Securities

• Real Interest Rate (RIR) and the Fisher

effect
RIR = i – Expected (IP)
- It measures society’s relative time preference to
consume today rather than tomorrow; the
higher the preference, the higher the real
interest rate will be.

McGraw-Hill/Irwin 2-55 ©2009, The McGraw-Hill Companies, All Rights Reserved

 Determinants of Interest Rates
for Individual Securities (cont’d)

• Default Risk Premium (DRP)

DRPj = ijt – iTt
ijt = interest rate on security j at time t
iTt = interest rate on similar maturity U.S. Treasury
security at time t
- The higher the default risk, ----------------------------------
----------------------------------------------------------------------
----------------------------------------------------------------------
.

McGraw-Hill/Irwin 2-56 ©2009, The McGraw-Hill Companies, All Rights Reserved

 Determinants of Interest Rates
for Individual Securities (cont’d)

• Liquidity Risk (LRP)

- A highly liquid asset is one that can be sold at a
predictable price with low transaction costs and
thus can be converted into its full market value at
short notice.
- Highly liquid assets carrying the lowest interest
rate.

McGraw-Hill/Irwin 2-57 ©2009, The McGraw-Hill Companies, All Rights Reserved

 Determinants of Interest Rates
for Individual Securities (cont’d)

• Special Provisions (SCP)

- Some special provisions or covenants that may
written into the contracts of securities may affect
the interest rates on different securities.
- Security’s taxability, convertibility, and
callability.
- In general, provisions that provide benefits to the
security holder (issuer) are associated with lower
(higher)interest rate.
McGraw-Hill/Irwin 2-58 ©2009, The McGraw-Hill Companies, All Rights Reserved
 Determinants of Interest Rates
for Individual Securities (cont’d)

• Term to Maturity (MP)

- Interest rate is related to term to maturity; this
relationship is often called the term structure on
interest rate or Yield Curve.
- This relationship compares the interest rates on
securities, assuming that all characteristics (i.e.
default risk, liquidity risk) are the same except
maturity.

McGraw-Hill/Irwin 2-59 ©2009, The McGraw-Hill Companies, All Rights Reserved

 Determinants of Interest Rates
for Individual Securities (cont’d)

• Term to Maturity (MP)

- The change in interest rate as the maturity of a
security changes is called the maturity premium.
- MP, or the difference between the required yield
on long- and short-term securities with same
characteristics except maturity.
- This could be positive, negative or zero.

McGraw-Hill/Irwin 2-60 ©2009, The McGraw-Hill Companies, All Rights Reserved

 Term Structure of Interest Rates:
the Yield Curve
(a) Upward sloping
Yield to (b) Inverted or downward
Maturity sloping
(c) Flat
(a)

(c)

(b)
Time to Maturity

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 Term Structure of Interest Rates

• The relationship between a security’s interest rate and

its remaining term to maturity (the term structure of
interest rates) can take a number of different shapes.
• Three theories are introduced to provide an
explanations for the shape of the yield curve:
- The unbiased expectations theory,
- The liquidity premium theory, and
- The market segmentation theory.

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 Unbiased Expectations Theory

• At a given point in time the yield curve reflects the

market’s current expectations of future short-term
rates.
• The intuition is that, if investors have a 4-Year
investment horizon,
• They could either buy a current 4-year bond and
earn the current or spot yield on a 4-year bond (1R4)
each year if held to maturity, OR,

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 Unbiased Expectations Theory (Cont.)

• Invest in 4 successive 1-year bonds, of which they

only know the current one-year spot rate (1R1), but
form expectations of the unknown future one-year
rates [ E(2r1), E(3r1), and E(4r1)].

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 Unbiased Expectations Theory (Cont.)

• In equilibrium, the return to holding a 4-year bond

to maturity should equal the expected return to
investing in 4 successive 1-year bonds.
• If future 1-year rates (short-term) are expected to
rise (decline) each successive year into the future,
then the yield curve will slope upward (downward).
• If future 1-year rates are expected to remain
constant each successive year into the future, then
the yield curve will remain constant over the
relevant time period.

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 Unbiased Expectations Theory (Cont.)

• Specifically, current long-term interest rates

(1RN) are geometric averages of current (1R1) and
expected future (Nr1) short-term interest rates

1RN = actual N-period rate today

N = term to maturity, N = 1, 2, …, 4, …
1R1 = actual current one-year rate today
E(ir1) = expected one-year rates for years, i = 2 to N

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 Unbiased Expectations Theory (Cont.)

• Example: suppose that the current one-year rate

(one year spot rate) and expected one-year T-bill
rates over the following three years (i.e. 2, 3, and 4
respectively) are as follows: 1R1 = 6%, E (2r1) =
7%, E (3r1) = 7.5%, E (4r1) = 7.85%.
Using the unbiased expectations theory calculate
the current (long-term) rates for one- , two-, three-
, and four-year maturity treasury securities.

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 Unbiased Expectations Theory (Cont.)

• 1R1 =
• 1R2=
• 1R3=
• 1R4=

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 Unbiased Expectations Theory (Cont.)

7.0%

6.8%

6.5%

6%

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 Liquidity Premium Theory

• A weakness of the UET is that:

- UET assumes that investors are equally willing to
invest in short-term and long-term securities, with no
additional reward in form of higher interest rates to
compensate them for any added risk from locking in
their funds in long-term securities.

• It is an extension of the unbiased expectations

theory.

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 Liquidity Premium Theory

• It is based on the assumption that investors will hold

long-term maturities only if they are offered at a
premium to compensate of future uncertainty in a
security’s value, which increases with an asset’s
maturity.

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 Liquidity Premium Theory

• More specifically, in a world of uncertainty,

investors prefer to hold short-term securities,
because these securities provide:
- Greater marketability (due to their more active secondary
market).
- Have less price risk (due to smaller price fluctuations for a
given change in interest rates) than long-term securities.
- They can be converted into cash with little risk of a capital
loss (i.e., a fall in the price of the security below its original
purchase price).

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 Liquidity Premium Theory

• Therefore, to convince investors to hold long-term

securities, they should be offered a liquidity
premium.

• This liquidity premium increase with maturity;

Because the longer the maturity on a security the greater its
risk,

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 Liquidity Premium Theory (Cont.)

• Long-term interest rates are geometric

averages of current and expected future short-
term interest rates plus liquidity risk premiums
that increase with maturity of the security

Lt = liquidity premium for period t

L2 < L3 < …<LN

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 Liquidity Premium Theory (Cont.)

• For example, Panel (c) of Figure 2–9 shows that according to the liquidity
premium theory, an upward-sloping yield curve may reflect investors’
expectations that future short-term rates will be flat, but because liquidity
premiums increase with maturity, the yield curve will nevertheless be upward
sloping.
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 Liquidity Premium Theory (Cont.)

• Example: suppose that the current one-year rate (one

year spot rate) and expected one-year T-bill rates over the
following three years (i.e. 2, 3, and 4 respectively) are as
follows: 1R1 = 6%, E (2r1) = 7%, E (3r1) = 7.5%, E (4r1)
= 7.85%.
• In addition, inventors charge a liquidity premium on
longer-term securities as follows : L2 = 0.10%, L3=
0.20%, L3 = 0.30%, Using the liquidity premium theory,
calculate the current (long-term) rates for one- , two-,
three-, and four-year maturity treasury securities.

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 Liquidity Premium Theory (Cont.)

• 1R1 =
• 1R2=
• 1R3=
• 1R4=

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 Liquidity Premium Theory (Cont.)

7.2%

6.9%

6.55%

6%

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 Market Segmentation Theory

• Both the UET & LPT assume that investors have no

preference when it comes to different maturities and the
risks associate with them.
• Individual investors and FIs have specific maturity
preferences determined by the nature of their liabilities,
and to get them to hold securities with maturities other
than their most preferred requires a higher interest rate
(maturity premium).
• So, securities with different maturities are not a perfect
substitute.

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 Market Segmentation Theory (Cont.)

• Accordingly, Interest rates are determined by

distinct supply and demand conditions within
particular maturity segments (e.g., the short end
and long end of the bond market).
• So, investors and borrowers are generally
unwilling to shift from one maturity sector to
another without adequate compensation in the
form of an interest rate premium.

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 Market Segmentation Theory (Cont.)

• Shows how changes in the supply curve for short- versus long-term bond
segments of the market result in changes in the shape of the yield to curve.

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 Market Segmentation Theory (Cont.)

• The higher the yield on securities, the higher the

demand for them.
• Thus, the shape of the yield curve is determined
by the changes in the supply curve:
- if the supply of securities decreases (increases)
in the short-term market and increases (decreases)
in the long-term market, the slope of the yield
curve becomes steeper (flatter or might even have
sloped downward).

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 Forecasting Interest rate
Implied Forward Rates
• The ability to predict or forecast interest rates is
important to the profitability of FIs and individual
investors, because interest rates affect the value of
investment portfolio.
• To forecast short-term interest rates, the unbiased
expectations hypothesis can be used.
• The forecasted short-term interest rate is known as
forward rate, which is an expected or implied rate
on a short-term security that is to be originated at
some point in the future.

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 Forecasting Interest rate
Implied Forward Rates (Cont.)
• A forward rate (f) is an expected or implied
rate on a short-term security that is to be
originated at some point in the future
• The one-year forward rate for any year N in
the future is:

• Nf1:the markets estimate of the expected one-year

rate for year N.

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