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Chapter 2 - Determinants of Interest Rates Nominal Interest Rates – the interest rates actually observed in financial markets -
Directly affect the value (price) of m ost securities traded in the money and capital mar kets
rece ived at some future Time Value of Money – the basic notion that a dollar received today is worth more than a dollar received 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 n
-n
FV = P [1 - (1 + r) ] / r
PV = P (1 + r)
Annuity payments – a series of equal cash flows received (constant payment) at fixed intervals over the investment horizon FV = R (1 + r)
the return earned or paid over a 12-month period taking any within-year compounding interest into account n
EAR = (1 + j/w) – 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
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
i j = 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 e xpected 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
