Chapter 2 - Determinants of Interest Rates Nominal Interest Rates the interest rates actually observed in financial markets - Directly

y affect the value (price) of most securities traded in the money and capital markets Time Value of Money the basic notion that a dollar received today is worth more than a dollar received at some future date. - Consume now than later because of the effect of interest rates - Specifically assumes that any interest or other return earned on a dollar invested today over any given period of time is immediately reinvested (compounded) Compound Interest interest earned on an investment Simple Interest interest earned on an investment is is reinvested not reinvested n FV = P ( 1 + i ) FV = P (1 + i) Lump Sum Payment a single cash flow occurs at the beginning and end of the investment horizon with no other cash flows exchanged FV = P [1 - (1 + r)n ] / r PV = P (1 + r)-n Annuity payments a series of equal cash flows received (constant payment) at fixed intervals over the investment horizon FV = R (1 + r)
PV

FV

interest rate interest rate INCREASE in INT. RATE

FV / PV
Increasing rate
Decreasing rate

Periods increase

FV PV

increase decrease

increases

Effective Annual Return (EAR) / Equivalent Annual Return - the return earned or paid over a 12-month period taking any within-year compounding interest into account EAR = (1 + j/w)n 1 What causes movement on interest rates? Loanable Funds Theory - a theory of interest rate determination that views equilibrium interest rates in financial markets as a result of the supply and demand for loanable funds Supply of Loanable Funds - commonly used to describe funds provided to the financial markets by net suppliers of funds - quantity supplied increases as the interest rates increase - household sector - the largest supplier of loanable funds o supply when they have excess income or want to reallocate their asset portfolio holdings o the greater the perceived risk of securities investments, the less households are willing to invest Factors Impact on Supply Impact on Equilibrium IR interest rate inc movement along the supply curve direct total wealth dec shift supply curve inverse risk of financial security dec shift supply curve direct near-term spending needs dec shift supply curve direct monetary expansion inc shift supply curve inverse economic conditions inc shift supply curve inverse (direct) as factor increase, EIR increase . (inverse) as factor decrease, EIR increase Demand of Loanable Funds - describe the total net demand for funds by fund users - quantity demanded is higher as interest falls - the better the overall economic conditions, the greater demand Factors Interest rate
Utility derived from asset purchased wd borrowed funds

Restrictiveness of nonprice conditions Economic conditions

Impact on Demand Movement along demand curve shift demand curve shift demand curve shift demand curve

Impact on Equilibrium IR

direct direct inverse direct

Equilibrium Interest Rate Aggregate supply of loanable funds the sum of quantity supplied by the separate fund sectors (household, businesses, governments, foreign agents) Aggregate demand of loanable funds the sum of quantity demanded by the demanding sectors Factors that causes supply and demand curves to shift Supply of Funds Wealth Risk Near-Term Spending Needs Monetary Expansion Economic Conditions Demand of Funds Utility Derived from Assets Purchased with Borrowed Funds

Restrictiveness on Nonprice Conditions on Borrowed Funds Economic Conditions

Factors Affecting Nominal Interest Rates Inflation (IP) the continual increase in the price of a basket of goods and services the higher level of actual or expected inflations, the higher the level of interest rates will be Real Interest Rate (RIR) nominal interest rate that would exist on a security if no inflation were expected the percentage change in the buying power of a dollar Fisher Effect nominal interest rates observed in financial markets must compensate investors for (1) any reduced purchasing power on funds lent due to inflationary price changes and (2) an additional premium above the expected rate of inflation for forgoing present consumption RIR = I Expected (IP) i = RIR + Expected (IP) + [RIR x Expected (IP)] Default Risk (DRP) risk that a security issuer will default on the security by missing an interest or principal payment Liquidity Risk (LRP) risk that a security cannot be sold at a predictable price with low transaction cost at short notice illiquid investors add liquidity risk premium (LRP) to the interest rate on the security Special Provisions or Covenants (SCP) provisions (taxability, convertibility, callability) that impact the security holder beneficially or adversely and as such are reflected in the interest rates on securities that contain such provisions Time to Maturity (MP) length of time a security has until maturity term of structure of interest rates (yield curve) compares the interest rates on securities, assuming that all characteristics except maturity are the same maturity premium the change in required interest rates as the maturity of a security changes o the difference between required yield on long- and short-term securities

ij = f (IP, RIR, DRP, LRP, SCP, MP)

fair interest rate

Real Interest Rate the interest rate that would exist on a security if no inflation were expected over the holding period of a security - the percentage change in the buying power of a dollar Term Structure of Interest Rates Unbiased Expectations Theory Liquidity Premium Theory Market Segmentation Theory