Chapter Two

Determinants of
Interest Rates

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Interest Rate Fundamentals

● Nominal interest rates are the interest rates

actually observed in financial markets
● Directly affect the value (price) of most securities
traded in the money and capital markets
● Changes in interest rates influence the
performance and decision making for individual
investors, businesses, and governmental units

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Key U.S. Interest Rates, 1972-2019

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Loanable Funds Theory

● Changes in interest rates impact security values

● FIs spend much time and effort trying to identify factors
that determine the level of interest rates at any moment
in time, as well as what causes interest rate movements
over time
● Loanable funds theory views equilibrium interest
rates in financial markets as a result of the supply
of and demand for loanable funds
● Categorizes financial market participants – consumers,
businesses, governments, and foreign participants – as
net suppliers or demanders of funds

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 Supply of Loanable Funds

● “Supply of loanable funds” describes funds provided

to the financial markets by net suppliers of funds
● Generally, the quantity of loanable funds supplied

●
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increases as interest rates rise
Household sector (consumer sector) is one of the largest
suppliers of loanable funds in the U.S. ($84.66t in 2019)
● Business sector often has excess cash that it can invest for
short periods of time ($28.06t for nonfinancial and $98.47t for
financial business in 2019)
● Governments may supply loanable funds ($5.66t in 2019)
● Foreign investors view U.S. markets as alternatives to their
domestic financial markets ($27.20t in 2019)
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Supply of and Demand for
Loanable Funds

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 Demand for Loanable Funds

● “Demand for loanable funds” describes the total net

demand for funds by fund users
● In general, the quantity of loanable funds demanded is
higher as interest rates fall
● Household demand reflects financing purchases of homes,
durable goods, and nondurable goods ($16.05t in 2019)
● Businesses demand funds to finance investments in long-term
assets and for short-term working capital needs ($66.46t for
nonfinancial and $111.87t for financial in 2019)
● Governments also borrow heavily ($28.86t in 2019)
● Foreign participants, mostly from the business sector, borrow in
U.S. financial markets ($20.81t in 2019)
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 Factors That Cause the Supply and
Demand Curves for Loanable
Funds to Shift
● Factors that cause the supply curve of loanable funds to
shift, at any given interest rate:
As wealth of fund suppliers increases (decreases), the
supply of loanable funds increases (decreases)
As risk of the financial security increases (decreases), the
supply of loanable funds decreases (increases)
As near-term spending needs increase (decrease), the
supply of loanable funds increases (decreases)
When monetary policy objectives allow the economy to
expand (restrict expansion), the supply of loanable funds
increases (decreases)
As economic conditions improve in a domestic (foreign)
country, the supply of funds increases (decreases)
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Factors That Affect the Supply of and
Demand for Loanable Funds for a
Financial Security

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 Factors That Cause the Supply and
Demand Curves for Loanable
Funds to Shift (Continued)
● Factors that cause the demand curve for loanable funds to
shift include the following:
As the utility derived from an asset purchased with
borrowed funds increases (decreases), the demand for
loanable funds increases (decreases)
As the restrictiveness of nonprice conditions on
borrowed funds decreases (increases), the demand for
loanable funds increases (decreases)
Nonprice conditions may include fees, collateral, or requirements or
restrictions on the use of funds (i.e., restrictive covenants)
When domestic economic conditions result in a period of
growth (stagnation), the demand for funds increases
(decreases)
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Determinants of Interest Rates for
Individual Securities: Inflation
Inflation is the continual increase in the price level of a
basket of goods and services
The higher the level of actual or expected inflation, the higher
will be the level of interest rates

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In the U.S., inflation is measured using indexes
Consumer price index (CPI)
Producer price index (PPI)
Annual inflation rate using the CPI index between years t
and t+1 would be equal to:

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Determinants of Interest Rates for
Individual Securities: Real Risk-
Free Rate
A real risk-free rate is the interest rate that would exist
on a risk-free security if no inflation were expected over
the holding period of a security
The higher society’s preference to consume today, the higher
the real risk-free rate (RFR)

Relationship among the real risk-free rate (RFR), the

expected rate of inflation [E(IP)], and the nominal interest
rate (i) is referred to as the Fisher effect
The Fisher effect is often written as the following:

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Determinants of Interest Rates for
Individual Securities: Default Risk
Default risk is the risk that a security issuer will fail to
make its promised interest and principal payments to the
buyer of a security
The higher the default risk, the higher the interest rate that will
be demanded by the buyer of the security to compensate him
or her for this default (or credit) risk exposure
Difference between a quoted interest rate on a security
(security j) and a Treasury security with similar maturity,
liquidity, tax, and other features (such as callability or
convertibility) is called a default or credit risk premium
(DRPj)

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Determinants of Interest Rates for
Individual Securities: Liquidity Risk
Liquidity risk is the risk that a security can be sold at a
predictable price with low transaction costs on short
notice
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
If a security is illiquid, investors add a liquidity risk premium
(LRP) to the interest rate on the security that reflects its
relative liquidity
LRP might also be thought of as an “illiquidity” premium
LRP may also exist if investors dislike long-term securities
because their prices (present values) are more sensitive to
interest rate changes than short-term securities
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Determinants of Interest Rates for
Individual Securities: Special
Provisions or Covenants
Special provisions or covenants that may be written into
the contract underlying a security also affect the interest
rates on different securities
Some of these provisions include the security’s taxability,
convertibility, and callability
For investors, interest payments on municipal securities are
free of federal, state, and local taxes
A convertible (special) feature of a security offers the holder
the opportunity to exchange one security for another type of the
issuer’s securities at a preset price
In general, special provisions that provide benefits to the
security holder (e.g., tax-free status and convertibility) are
associated with lower interest rates
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Determinants of Interest Rates for
Individual Securities: Term to
Maturity
The term structure of interest rates is a comparison of
market yields on securities, assuming all characteristics
except maturity are the same
Change in required interest rates as the maturity of a security
changes is called the maturity premium (MP)
The MP can be positive, negative, or zero

The following general equation can be used to determine

the factors that functionally impact the fair interest rate
(ij*) on an individual (jth) financial security:

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Common Shapes for Yield Curves
on Treasury Securities

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Term Structure of Interest Rates

Relationship between a security’s interest rate and its

remaining term to maturity (i.e., the term structure of
interest rates) can take a number of different shapes

Explanations for the shape of the yield curve fall

predominately into three theories:
Unbiased expectations theory
Liquidity premium theory
Market segmentation theory

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Explanations for the Shape of the
Term Structure of Interest Rates

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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

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Liquidity Premium Theory

● A weakness of the unbiased expectations theory is

that it assumes that investors are risk neutral
● Liquidity premium theory is an extension of the
unbiased expectations theory
● Based on the idea that investors will hold long-term maturities
only if they are offered at a premium to compensate for future
uncertainty in a security’s value, which increases with an
asset’s maturity

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Market Segmentation Theory

● Market segmentation theory argues that individual

investors and FIs have specific maturity preferences,
and to get them to hold securities with maturities other
than their most preferred requires a higher interest
rate (maturity premium)
● Does not consider securities with different maturities as
perfect substitutes
● Individual investors and FIs have preferred investment
horizons (habitats) dictated by the nature of the liabilities
they hold (i.e., investors have complete risk aversion for
securities outside their maturity preferences)

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Market Segmentation and
Determination of the Slope of the
Yield Curve

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 Time Value of Money

● Time value of money is the basic notion that a dollar

received today is worth more than a dollar received at
some future date
● Two forms of time value of money calculations are
commonly used in finance for security valuation
purposes:
1. Value of a lump sum
● A lump sum payment is a single cash payment received at the
beginning or end of some investment horizon
2. Value of annuity payments
● Annuity payments are a series of equal cash flows received at
fixed intervals over the entire investment horizon

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Lump Sum Valuation

● Present Value of a Lump Sum

● Future Value of a Lump Sump

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Annuity Valuation

● Present Value of an Annuity

● Future Value of an Annuity

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