S02 - CH 2 - Determinants of Interest Rate PDF

Chapter 2
Determinants of interest rates

Financial Institutions – FIN 304
CH 17 CH 19
CH 16
CH 15
CH 12 CH 14
CH 2
CH 1
2
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HS
Chapter 2
Determinants of interest
rates
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HS Ch 2 - Determinants of interest rates
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
5
Interest Rate Fundamentals

Financial institution and other firm managers 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.
One model that is commonly used to explain

interest rates and interest rate movements is
The loanable funds theory
6
Loanable Funds Theory
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
7
Loanable Funds Theory

➢ “Supply of loanable funds” describes funds provided to the financial markets
by net suppliers of funds
➢ Generally, the quantity of loanable funds supplied 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)
8
Supply of loanable fund
In general, the quantity of loanable funds

supplied increases as interest rates rise
“Positively related”
With other factors held constant, more funds

are supplied as interest rates increase (the
reward for supplying funds is higher)
9
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)
10
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: Supply
1. As wealth of fund suppliers increases (decreases),
Interest Rate
the supply of loanable funds increases (decreases)
2. As risk of the financial security increases
(decreases), the supply of loanable funds decreases
(increases) Demand
3. As near-term spending needs increase (decrease),
the supply of loanable funds decreases (increases) Quantity of Loanable Fund
11
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:
Supply
4. Monetary Expansion. When monetary
Interest Rate
policy objectives allow the economy to

expand (restrict expansion), the supply of
loanable funds increases (decreases)
5. As economic conditions improve in a
Demand
domestic (foreign) country, the supply of
funds increases (decreases)
Quantity of Loanable Fund
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Factors That Cause the Supply and Demand Curves

for Loanable Funds to Shift
Factors that cause the demand curve for loanable funds to shift include the
following:
1. As the utility derived from an asset purchased with borrowed funds
increases (decreases), the demand for loanable funds increases (decreases)
2. 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)
3. When domestic economic conditions result in a period of growth
(stagnation), the demand for funds increases (decreases)
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Movement Of
Interest Rates Over
Time
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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
✓ 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:
17

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:
18
The one-year Treasury bill rate in 2018 averaged 2.25 percent and inflation
(measured by the consumer price index) for the year was 1.90 percent. If
investors had expected the same inflation rate as that actually realized (i.e.,
1.90 percent), then according to the Fisher effect the real risk-free rate for
2018 was:
2.25% − 1.90% = 0.35%
The one-year T-bill rate in 2019 was 1.75 percent, while the CPI change for
the year was 1.80 percent. This implies a real risk-free rate of −0.05
percent—that is, the real risk-free rate was actually negative.
19

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)
20
In September 2019, the 10-year Treasury interest rate, or yield, was 1.47
percent. On Aaa-rated and Baa-rated corporate debt, interest rates were
2.98 and 3.87 percent, respectively. Thus, the average default risk
premiums on the Aaa-rated and Baa-rated corporate debt were:
DRPAaa = 2.98% − 1.47% = 1.51%
DRPBaa = 3.87% − 1.47% = 2.40%
21

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
22

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
23

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:
24
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Term Structure of
Interest Rates
25
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:
1. Unbiased expectations theory
2. Liquidity premium theory
3. 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
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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)
34
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Time Value of
Money
36
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
37
Time Value of Money and Interest Rates

Types of Interest Rate
Simple Interest earned on an investment is not reinvested.

Interest Rate
Compound Interest earned on an investment is reinvested.

Interest Rate
38
39
Compound Interest Rate

Suppose you have $1,000 to invest for a period of two years. Currently, default risk-free
one-year securities (such as those issued by the U.S. Treasury) are paying a 12 percent
interest rate per year, on the last day of each of the two years over your investment
horizon. If, instead, the annual interest earned is reinvested immediately after it is
received at 12 percent (i.e., interest is compounded), the value of the investment at the
end of the first year is:
Notice that after the first year of the two-year investment horizon, you have $1,120
whether the investment earns simple or compounded interest. With compounded
interest, however, the $120 in interest earned in year 1 is reinvested in year 2. Thus,
the whole $1,120 is carried forward and earns interest in year 2. In this case, the
value of the investment at the end of the two-year investment horizon is
40

The time value of money concept can be used to convert the value of future cash
flows into their current or present values ( PV )
Future Value FV
Is the value of an asset at a specific date. It measures the nominal future sum of
money that a given sum of money is "worth" at a specified time in the future
assuming a certain interest rate.
41

The time value of money concept can be used to convert the value of future cash
flows into their current or present values ( PV )
Present Value PV
is the current worth of a future sum of money or stream of cash flows given a
specified rate of return.
42
Present Value PV at a lump sum payment

The present value function converts cash flows received over a future
investment horizon into an equivalent (present) value as if they were
received at the beginning of the current investment horizon. This is done by
discounting future cash flows back to the present using the current market
interest rate
43

You have been offered a security investment such as a bond that will pay
you $10,000 at the end of six years in exchange for a fixed payment today.
If the appropriate annual interest rate on the investment is 8 percent
compounded annually, the present value of this investment is computed as
follows:
If the annual interest rate on the investment rises to 12 percent, the present
value of this investment becomes:
44

If the annual interest rate on the investment rises to 16 percent, the present
Finally, if the annual interest rate on the investment of 16 percent is

compounded semiannually (that is, you will receive t = 12 (= 6 × 2) total
interest payments, each calculated as r = 8 percent (= 16 percent ÷ 2) times
the principal value in the investment, where r in this case is the semiannual
interest payment) rather than annually, the present value of this investment
becomes:
45
Future Value FV at a lump sum payment
46
You plan to invest $10,000 today in exchange for a fixed payment at the end
of six years. If the appropriate annual interest rate on the investment is 8
percent compounded annually, the future value of this investment is
computed as follows:
If the annual interest rate on the

investment rises to 12 percent, the
future value of this investment
becomes:
47

If the annual interest rate on the investment rises to 16 percent, the future
If the annual interest rate on the investment rises to 16 percent, the future
48
The Role of Time Value in Finance
Basic Patterns of Cash Flow

• Single Amount
A lump-sum amount either currently held or
expected at some future date
• Annuity
A level periodic stream of cash flows
• Mixed Stream
A stream of cash flows that is not an annuity
49
Single Amounts
Future Value of a Single Amount
• The Equation for Future Value
• FVn = future value after n periods
• PV0 = initial principal, or present value when time = 0
• r = annual rate of interest
• n = number of periods (typically years) that the money remains invested
FVn = PV0  (1 + r ) n
(5.1)
50
Single Amounts
Present Value of a Single Amount
• The Equation for Present Value
• FVn = future value after n periods
• PV0 = initial principal, or present value when time = 0
• r = annual rate of interest
• n = number of periods (typically years) that the money remains invested
FVn
PV0 = (5.2)
(1 + r ) n
51
Types of Annuities
• Annuity
A stream of equal periodic cash flows over a
specified time period
These cash flows can be inflows or outflows of
funds
• Ordinary Annuity
An annuity for which the cash flow occurs at
the end of each period
• Annuity Due
An annuity for which the cash flow occurs at
the beginning of each period
52
Fran Abrams is evaluating two annuities. Both annuities pay $1,000 per
year, but annuity A is an ordinary annuity, while annuity B is an annuity
due. To better understand the difference between these annuities, she has
listed their cash flows in Table 5.2. The two annuities differ only in the
timing of their cash flows: The cash flows occur sooner with the annuity
due than with the ordinary annuity.
Although the cash flows of both annuities
in Table 5.2 total $5,000, the annuity due
would have a higher future value than the
ordinary annuity because each of its five
annual cash flows can earn interest for 1
year more than each of the ordinary
annuity’s cash flows.
53
54
Annuities
Finding the Future Value of an Ordinary Annuity
 (1 + r ) − 1 
 n

FVn = CF1    (5.3)

 r 

55
Fran Abrams wishes to determine how much money she will have
after 5 years if she chooses annuity A, the ordinary annuity. She will
deposit the $1,000 annual payments that the annuity provides at the end
of each of the next 5 years into a savings account paying 7% annual
interest. This situation is depicted on the following timeline.
56
 (1 + r ) − 1 
 n

FVn = CF1    (5.3)

 r 

[(1 + 0.07) − 1] 
5
FV5 = $1, 000    = $5, 750.74
 0.07 
57
Annuities
Finding the Present Value of an Ordinary Annuity
 CF1   1 
PV0 =    1 − n 
(5.4)
 r   (1 + r ) 
58
Braden Company, a small producer of plastic toys, wants to
determine the most it should pay for a particular ordinary annuity. The
annuity consists of cash inflows of $700 at the end of each year for 5
years. The firm requires the annuity to provide a minimum return of
4%. The following timeline depicts this situation.
59
 CF1   1 
PV0 =    1 − n 
(5.4)
 r   (1 + r ) 
700 1
PV = × (1- 5 ) = 3,116.28
4% (1+4%)
60
Annuities
Finding the Future Value of an Annuity Due
 (1 + r )n − 1 
  
FVn = CF0     (1 + r ) (5.5)
 r 
The future value of an annuity due is always greater than the future value
of an otherwise identical ordinary annuity
61
Annuities
Finding the Present Value of an Annuity Due
 CF0    1  
PV0 =    1 − n 
 (1 + r ) (5.6)
 r    (1 + r ) 
The present value of an annuity due is always greater than the present
value of an otherwise identical ordinary annuity
62
In Example 5.8 involving Braden Company, we found the present value
of Braden’s $700, 5-year ordinary annuity discounted at 4% to be
$3,116.28. We now assume that Braden’s $700 annual cash inflow
occurs at the start of each year and is thereby an annuity due. The
following timeline illustrates the new situation.
63
In Example 5.8 involving Braden Company, we found the present value
of Braden’s $700, 5-year ordinary annuity discounted at 4% to be
$3,116.28. We now assume that Braden’s $700 annual cash inflow
occurs at the start of each year and is thereby an annuity due. The
following timeline illustrates the new situation.
 CF0    1 

PV0 =    1 − n 
 (1 + r ) (5.6)
 r    (1 + r ) 
700 1
PV = ( )×(1- ) × (1 + 4%) = 3,240.93
4% (1+4%)5
64
Annuities
Finding the Present Value of a Perpetuity
Perpetuity
An annuity with an infinite life, providing continual annual cash flow
PV0 = CF1  r (5.7)

Growing Perpetuity
An annuity with an infinite life, providing continual annual cash flow, with
the cash flow growing at a constant annual rate
 CF1 
PV0 =   (5.8)
r−g
65
Ross Clark wishes to make a lump sum donation today that will provide
an annual stream of cash flows to the university forever. The university
indicated that the annual cash flow required to support an endowed chair is
$400,000 and that it will invest money Ross donates today in assets earning
a 5% return. If Ross wants to give money today so that the university will
begin receiving annual cash flows next year, how large must his
contribution be?
To determine the amount Ross must give the university to fund the chair,
we must calculate the present value of a $400,000 perpetuity discounted at
5%.
66
Using Equation 5.7, we can determine that this present value is $8 million
when the interest rate is 5%:
PV0 = $400,000 ÷ 0.05 = $8,000,000
In other words, to generate $400,000 every year for an indefinite period
requires $8,000,000 today if Ross Clark’s alma mater can earn 5% on its
investments. If the university earns 5% interest annually on the $8,000,000,
it can withdraw $400,000 per year indefinitely without ever touching the
original $8,000,000 donation.
67
Suppose, after consulting with his alma mater, Ross Clark learns that the
university requires the endowment to provide a $400,000 cash flow next
year, but subsequent annual cash flows must grow by 2% per year to
keep up with inflation. How much does Ross need to donate today to
cover this requirement?
Plugging the relevant values into Equation 5.8, we have:
$400, 000
PV0 = = $13,333,333
0.05 − 0.02
68
• Mixed Stream
A stream of unequal periodic cash flows that
reflect no particular pattern
• Future Value of a Mixed Stream

To determine the future value of a mixed
stream of cash flows, compute the future
value of each cash flow at the specified
future date and then add all the individual
future values to find the total future value
69
Shrell Industries, a cabinet manufacturer, expects to receive the
following mixed stream of cash flows over the next 5 years from one of
its small customers.
If Shrell expects to earn 8% on its investments, how
much will it accumulate after 5 years if it
immediately invests these cash flows when they are
received?
This situation is depicted on the following timeline.
70
Mixed Streams
• Present Value of a Mixed Stream
To determine the present value of a mixed stream of cash flows,
compute the present value of each cash flow and then add all the
individual present values to find the total present value
71
Frey Company, a shoe manufacturer, has the opportunity to receive the
following mixed stream of cash flows over the next 5 years.
If the firm must earn at least 9% on its investments,
what is the most it should pay for this
opportunity?
This situation is depicted on the following timeline.
72
• Loan Amortization
• The determination of the equal periodic loan payments necessary to provide
a lender with a specified interest return and to repay the loan principal over a
specified period
• Loan Amortization Schedule
• A schedule of equal payments to repay a loan
• It shows the allocation of each loan payment to interest and principal
 1 
CF1 = ( PV0  r )  1 − n 
(5.13)
 (1 + r ) 
73
Alex May borrows $6,000 from a bank. The bank requires Alex to repay
the loan fully in 4 years by making four end-of-year payments. The interest
rate on the loan is 10%. What is the loan payment that Alex will have to
make each year?
Plugging the appropriate values into Equation 5.13, we have
 1 
CF1 = ($6, 000  0.10)  1 − 4
= $600  0.316987 = $1,892.82
 (1 + 0.10) 
74
Table 5.7 provides a loan amortization schedule that shows the principal
and interest components of each payment. The portion of each payment that
represents interest (column 3) declines over time, and the portion going to
principal repayment (column 4) increases.
Every amortizing loan displays this pattern; as each payment reduces the
principal, the interest component declines, leaving a larger portion of each
subsequent loan payment to repay principal. Notice that after Alex makes
the fourth payment, the remaining loan balance is zero.
75
76
Special Applications of Time Value

Finding an Unknown Number of Periods
 FVn 
log  
n=  PV0 
(5.15)
log (1 + r )
77
Ann Bates wishes to determine how long it will take for her initial $1,000
deposit, earning 8% annual interest, to grow to $2,500.
Applying Equation 5.15, at an 8% annual rate of interest, how many
years, n, will it take for Ann’s $1,000, PV0, to grow to $2,500, FVn?
 $2, 500 
log   0.39794
n=  $1, 000 = = 11.9
log(1.08) 0.03342
Ann will have to wait almost 12 years to reach her savings goal of $2,500.
78
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79

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Chapter 2

Determinants of interest rates

Interest Rate Fundamentals

Interest Rate Fundamentals

One model that is commonly used to explain

The loanable funds theory

Loanable Funds Theory

Loanable funds theory views equilibrium interest

▪ Categorizes financial market participants –

Loanable Funds Theory

Supply of loanable fund

In general, the quantity of loanable funds

With other factors held constant, more funds

Demand for Loanable Funds

Factors That Cause the Supply and Demand Curves for

Factors That Cause the Supply and Demand Curves for

policy objectives allow the economy to

Factors That Cause the Supply and Demand Curves

Determinants of Interest Rates for Individual

Determinants of Interest Rates for Individual

✓ The Fisher effect is often written as the following:

2.25% − 1.90% = 0.35%

Determinants of Interest Rates for Individual

✓ Difference between a quoted interest rate on a security (security j) and a Treasury

DRPAaa = 2.98% − 1.47% = 1.51%

DRPBaa = 3.87% − 1.47% = 2.40%

Determinants of Interest Rates for Individual

Determinants of Interest Rates for Individual

Determinants of Interest Rates for Individual

Term Structure of Interest Rates

Explanations for the shape of the yield curve

Unbiased Expectations Theory

Liquidity Premium Theory

Market Segmentation Theory

Time Value of Money

Time Value of Money and Interest Rates

Simple Interest earned on an investment is not reinvested.

Compound Interest earned on an investment is reinvested.

Compound Interest Rate

Time Value of Money and Interest Rates

Time Value of Money and Interest Rates

Present Value PV at a lump sum payment

Present Value PV at a lump sum payment

Present Value PV at a lump sum payment

Finally, if the annual interest rate on the investment of 16 percent is

Future Value FV at a lump sum payment

Future Value FV at a lump sum payment

If the annual interest rate on the

Future Value FV at a lump sum payment

Basic Patterns of Cash Flow

Finding the Present Value of an Ordinary Annuity

PV0 = CF1  r (5.7)

• Future Value of a Mixed Stream

Special Applications of Time Value

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