CHAPTER 3

Interest Rate Determination and Bond valuation

Introduction
The financial markets make saving possible by offering the individual saver a wide menu of
choices where funds may be placed at attractive rates of return. By committing funds to one or
more securities, the saver, in effect, becomes a lender of funds. The financial markets also make
borrowing possible by giving the borrower a channel through which securities can be issued to
lenders. And the financial markets make investment and economic growth possible by providing
the funds needed for the purchase of machinery and equipment and the construction of buildings,
highways, and other productive facilities.

Clearly, then, the acts of saving and lending and borrowing and investment are intimately linked
through the financial system. And one factor that significantly influences all of them is the rate
of interest. The rate of interest is the price a borrower must pay to secure scarce loanable funds
from a lender for an agreed up on period. It is the price of credit.
Theory of Interest Rate
There is not one interest rate in any economy for there are thousands of different interest rates in
the financial system. Even Securities issued by the same borrower will often carry a variety of
interest rates. In later sections the most important factors that cause rates to vary among different
securities are examined in detail. In this section our focus is upon those basic forces that
influence the level of all interest rate. We will assume in this section that there is one
fundamental interest rate in the economy known as the pure or risk- free rate of interest, which is
a component of all rates. In this section, we present the three most influential theories of the
determination of the interest rate: Fisher’s theory, loanable funds theory, and Keynes’s liquidity
preference theory.
1.1 Fisher’s Classical Approach
One of the oldest theories concerning the determinants of the risk- free interest rate is the
classical theory of interest rates. Irving Fisher analyzed the determination of the level of the
interest rate in an economy by inquiring why people save (that is, why they do not consume all
their resources) and why others borrow. Saving is the choice between current and future

1
consumption of goods and services. Individuals save some of their current income in order to be
able to consume more in the future.

A chief influence on the saving decision is the individual’s marginal rate of time preference,
which is the willingness to trade some consumption now for more future consumption. The
classical theory of interest assumed that individuals have a definite time preference for current
over future consumption. A rational individual, it was assumed, would always prefer current
enjoyment of goods and services over future enjoyment. Therefore, the only way to encourage an
individual or family to consume less now and save more was to offer a higher rate of interest on
current savings.

Another influence on the saving decision is income. Generally, higher current income means the
person will save more, although people with the same income may have different time
preferences. The third variable affecting saving is the reward for savings, or the rate of interest
on loans that savers make with their unconsumed income. As the interest rate rises, each person
becomes willing to save more, given that person’s rate of time preference.

The total savings (or the total supply of loans) available at any time is the sum of every body’s
savings and a positive function of the interest rate. Business, household, and government saving
are important determinants of interest rates according to the classical theory of interest, but not
the only ones. The other critical rate determining factor in the classical theory is investment
spending by business firms (demand for investment).

Businesses require huge amounts of funds each year for the purchase of equipment, machinery,
and inventories and to support the construction of new buildings and other physical facilities.
Firms will direct borrowed resources to projects in order of their profitability, starting with the
most profitable and proceeding to those with lower gains. The gain from additional projects, as
investment increases, is the marginal productivity of capital, which is negatively related to the
amount of investment. In other words, as the amount of investment grows, additional gains
necessarily falls as more of the less profitable projects are accepted.

2
The maximum that a firm will invest depends on the rate of interest, which is the cost of loans.
The firm will invest only as long as the marginal productivity of capital exceeds or equals the
rate of interest. In other words, firms will accept only projects whose gain is not less than their
cost of financing. Thus, the firms demand for borrowing is negatively related to the interest rate.
If the rate is high, only limited borrowing and investment make sense. At a low rate, more
projects offer a profit, and the firm wants to borrow more.

The classical theory argues that the equilibrium rate of interest is determined by two forces: (1)
the supply of savings, derived mainly from households, and (2) the demand for investment
capital coming mainly from the business sector.

Look at Figure 3-1. The demand curve is downward sloping because the demand for investment
capital is inversely ( negatively ) related to interest rate , whereas the supply curve is upward
sloping because the supply of savings is positively related to interest rate.

Interest rate
S

I
E

D
Savings /investment
QE

Figure 3-1: The Equilibrium rate of interest in the classical Theory

As shown in the figure, the equilibrium rate of interest ( I E ) is found at the intersection of the
demand curve (D) and supply curve ( S) . The equilibrium level of savings (which is the same as

3
the equilibrium level of investment capital) is given as Q E. QE reflects the size of investment
capital or savings at the rate of interest IE.

Limitations of the classical Theory of interest

The classical theory sheds considerable light on the factors affecting interest rates. However, it
has some serious limitations. The central problem is that the theory ignores several factors other
than saving and investment which affect interest rates. For example, commercial banks have the
power to create money by making loans to the public. When borrowers repay their bank loans,
money is destroyed. The amount of money created or destroyed affects the total amount of credit
available in the financial market place and therefore must be considered in any explanation of the
factors determining interest rates.

In addition, the classical theory assumes that interest rates are the principal determinants of the
quantity of savings available. Today, economists recognize that income is far more important in
determining the volume of saving. Finally, the classical theory contends that the demand for
borrowed funds comes principally from the business sector. Today, however, both consumers
and governments are important borrowers, significantly affecting credit availability and cost.

1.2 The Loanable Funds Theory

The Fisher’s classical theory neglects certain practical matters, such as the power of the
government (in concert with depository institutions) to create money and the government’s often
large demand for borrowed funds, which is frequently immune to the level of the interest rate.
Expanding Fisher’s theory to encompass these situations produces the loanable funds theory of
interest rates.

This view argues that the risk–free interest rate is determined by the interplay of two forces the-
demand and the supply of loanable funds. The demand for loanable funds consists of demand for
funds by firms, governments, and households (or individuals) which carry out a variety of
economic activities with those funds. This demand is negatively related to the interest rate
(except for the government’s demand, which may frequently not depend on the level of the
interest rate). The supply of loanable funds stems from firms, governments, banks and
individuals. Supply is positively related to the level of interest rates, if all other economic factors

4
remain the same. With rising rates, firms and individuals save and lend more, and banks are
more eager to extend more loans. (A rising interest rate probably does not significantly affect the
government supply of savings.) The intersection of the supply and demand functions sets the
equilibrium interest rate level and the equilibrium level of loans . In equilibrium, the demand
for funds equals the supply of funds.

1.3 The Liquidity preference theory

The liquidity preference theory, originally developed by John Maynard Keynes, analyzes the
equilibrium level of the interest rate through the interaction of the supply of money and the
public’s aggregate demand for holding money. In the theory of liquidity preference, only two

-
outlets for investor funds are considered bonds and money.

For Keynes, money is equivalent to currency and demand deposits, which pay little or no
interest but are liquid and may be used for immediate transactions. Bonds include long–term,
interest– paying financial assets that are not liquid and that pose some risk because their prices
vary inversely with the interest rate level. Bonds may be liabilities of governments or firms.

Keynes observed that the public demands money for three different purposes (motives). The
transactions motive represents the demand for money in order to purchase goods and services.
Because inflows and outflows of money are not perfectly synchronized in timing or amount,
businesses, households, and governments must keep some money simply to meet daily expenses.
Some money also must be held as a reserve for future emergencies and to cover extra ordinary
expenses. This precautionary motive arises because we live in a world of uncertainty and
cannot predict exactly what expenses or opportunities will arise in the future. The third motive
for holding money- the speculative motive stems from uncertainty about the future prices of
bonds. The total demand for money in the economy is simply the sum of transactions,
precautionary, and speculative demands.

The demand for money is a negative function of the interest rate. At a low rate, people hold a lot
of money because they do not lose much interest by doing so and because the risk of a rise in

5
rates (and a fall in the value of bonds) may be large. With a high interest rate, people desire to
hold bonds rather than money.
For Keynes, the supply of money is fully under the control of the central bank. Moreover, the
money supply is not affected by the level of the interest rate. Thus, the supply of money appears,
in Figure 3-2, as the vertical line, MS.

Rate of interest
Ms Supply of money

iE
Total demand for money

D
O
Quantity of money demanded and supplied
Figure 3-2

As shown in figure 3-2, the equilibrium rate of interest is found at point i E where the quantity of
money demanded by the public equals the quantity of money supplied. Above this equilibrium
rate, the supply of money exceeds the quantity demanded, and some businesses, households, and
units of government will try to dispose of their unwanted money balances by purchasing bonds.
The prices of bonds will rise, driving interest rates down toward equilibrium at i E. On the other
hand, at rates below equilibrium, the quantity of money demanded exceeds the supply. Some
decision makers in the economy will sell their bonds to raise additional cash, driving bond prices
down and interest rates up toward equilibrium.

6
Bond Valuation and yield on a Bond
Overview

Bond valuation refers to the determination of the fair market value of a bond. Under an efficient
market, this value reflects the market price of the bond. The interest rate on a loan is the annual
rate of return promised by the borrower to the lender as a condition for a obtaining the loan.
However, that rate is not necessarily a true reflection of the yield or rate of return actually earned
by the lender during the life of the loan.

2.1. Bond valuation

The true or correct price of a bond equals the present value of all cash flows that the holder of the
bond expects to receive during its life. The cash flows from the bond include the annual interest
payment and its final sales price (or par value for bonds held until maturity). In general, the

correct price for a bond can be expressed as follows:

CF 1 CF 2 CF 3 CF N
+ + +−−−+
VB = ( 1+r )1 ( 1+r )2 ( 1+r )3 ( 1+r ) N

Where VB = the price of the bond

CFt = the cash flow in year t (t=1, 2, 3, - - -, N)
N = maturity of the bond
r = appropriate discount rate

For coupon bonds, because the annual interest payment is constant, the formula can be restated
as:
C C C C M
+ + +−−−−+ +
VB = ( 1+ r )1 ( 1+r )2 ( 1+r )3 (1+ r )N ( 1+ r )N

Where C = annual coupon payment

7
 M = maturity (Par) value
Using the annuity formula, this can be rearranged to give:

1
1−
( 1+r ) N M
⟨ ⟩+
VB == C
r ( 1+r ) N

The above formula assumes that the discount rate is constant through out the
life of the bond. However, if yearly market interest rates differ from year to year,
the formula for VB is:

C C C+ M
+ +−−−+
VB = ( 1+r 1 ) ( 1+r 1 ) (1+r 2 ) ( 1+r 1 ) (1+ r 2 )−−−(1+ r N )
Where rt is the yearly market interest rate (discount rate) for year t.

Example
Suppose an investor purchases a four-year bond with a face value (par value) of Br. 1,000
which pays coupon interest of 10 percent annually. Assume that the one–year rates for the next
four years are: r1 = 0.07; r2 = 0.08; r3= 0.09; r4 = 0.10. What is the value of the bond?

100+ 100 100 1, 100

+ +
VB = 1 . 07 ( 1. 07 ) (1. 08) (1. 07 ) (1. 08 ) (1.09 ) ( 1 .07 )( 1 . 08 ) ( 0 .09 ) (1 .10)
VB = Br. 1053.28

If the bond is perpetual one, then its value is the annual coupon payment ( C ) divided by
market interest rate assuming that the rate is constant through out its life. Let us see how this is
so. Assume VPB denotes the value of the perpetual bond.

C C C M
1
+ 2
+−−−+ +
VPB = ( 1+ r ) ( 1+r ) (1+ r ) ( 1+ r )N
N

8
Using the annuity formula, this can be rearranged to give:

1
⟨1− ⟩
( 1+r ) N M
+
VPB = C
r ( 1+r ) N

Since (1+r)N is a very large number as N goes to infinitive, then

1 M
,
( 1+ r )N ( 1+r )N ≈ 
C
Thus, VPB ≈ r

Example
Suppose you purchased a perpetual bond with par value of Br. 1000 that pays coupon interest of
10 percent annually. Suppose the market interest rate on similar bonds is 8 percent and this rate
is expected to prevail for many years to come. What is the value of the bond?

Annual coupon payment (C) =Br. 1000 X 0.10

C =Br. 100
100
=Br 1, 250
VPB = 0 .08

In the absence of transaction costs, the following relation ships hold true in bond valuation:
1. If coupon interest rate is greater than market interest rate, the bond will be highly
demanded and sells above par value. Such bonds are said to be sold at a premium.
2. If coupon interest rate is less than the market interest rate then the bond will be sold
below par value. This is because the bond is less attractive as its coupon payment is lower
than what the market is paying. Such bonds are said to be sold at a discount.

9
 3. If coupon interest rate equals market interest rate the bond will have neither premium nor
discount and such bonds trade at par.
2.2 Measures of the Rate of Return or Yield
There are different measures of the rate of return or yield on a bond. The following
paragraphs present these different measures:

Coupon Rate
One of the best known measures of the rate of return on a debt security is the coupon rate .
The coupon rate is the contracted rate which the security issuer agrees to pay at the time a
security is issued. If for example , a company issues a bond with a coupon rate printed on its
face of 9 percent , the borrower has promised the investor annual interest payment of 9
percent of the bond’s par value.

The coupon rate is not an adequate measure of the return on a bond or other debt security
unless the investor purchases the security at a price equal to its par value, the borrower makes
all of the promised payments on time, and the investor sells or redeems the bond at its par
value. However, the prices of bonds fluctuate with market conditions; rarely will a bond trade
exactly at par.

Current Yield
Another popular measure of the return on a loan or security is its current yield. This is simply
the ratio of the annual income (coupon interest) generated by the bond to its current market
value. Thus, a bond selling in the market for Br. 1000 and paying an annual coupon payment
of Br. 100 would have a current yield calculated as follows:

Current yield = Annual income = Br. 100= 0.10 or 10%

Market Price of Security Br. 1000

Like the coupon rate, the current yield is usually a poor reflection of the rate of return actually
received by the lender or investor. It ignores the stream of actual and anticipated payments

10
associated with a loan or security and the price at which the investor will be able to sell or
redeem it.

Yield to Maturity
The most widely accepted measure of the rate of return on a bond or security is its yield to
maturity. The yield to maturity is the rate which equates the purchase price of a bond or other
financial asset (P) with the present value of all its expected annual net cash inflows. In general
terms,

CF 1 CF 2 CF N
1
+ 2
+−−−+
P= ( 1+ y ) ( 1+ y ) ( 1+ y ) N

Where y is the Yield to maturity and each CF represents the expected annual cash flows from the
bond, presumed to last for N Years.

Example
Assume an investor is considering the purchase of a bond due to mature in 20 Years, carrying a
10 Percent coupon rate. This security is available for purchase at a current market price of Br.
850. If the bond has par value of Br. 1,000 which will be paid to the investor when the security
reaches maturity, the bond’s yield to maturity, y, may be found by solving,

Br .100 Br .100 Br . 100 Br . 1000

1
+ 2
+−−−+ +
Br. 850 = ( 1+ y ) ( 1+ y ) ( 1+ y )20 ( 1+ y )20

By trial and error, the value of y (Yield to maturity) is found to be 12 percent.

Unlike the current Yield, the yield to maturity measure considers the time distribution of
expected cash flows from a security or other financial asset. Of course, the yield–to-maturity
measure does assume the investor will hold a security until it reaches final maturity. Moreover,
yield to maturity is not an appropriate measure for those securities which are perpetual

11
instruments, and even for some bonds, because the investor may sell them prior to their
termination date. Another Problem is that this measure assumes all cash flowing to the investor
can be reinvested at the computed yield to maturity.

Holding period Yield

A slight modification of the Yield-to-Maturity formula results in a return measure for those
situations where an investor holds a bond security or other financial asset for a time and then
sells it to another investor in advance of the asset’s maturity. This so-called holding Period Yield
is simply,

CF 1 CF 2 CF m
1
+ 2
+−−−+
P = ( 1+ h ) (1+ h ) ( 1+ h )m

Where h is the holding Period Yield, and the total length of the investor’s holding Period covers
m time Periods.

Thus, the holding Period Yield is simply the rate of discount ( h ) equalizing the market price of
a financial asset ( p ) with all net cash flows between the time the asset is purchased and the time
it is sold ( including the selling price ) . If the asset is held to maturity, its holding period yield
equals its yield to maturity.

Example
Suppose an investor is contemplating the purchase of a corporate bond, Br. 1000 par value with a
coupon rate of 10 percent. To simplify the problem, assume the bond pays interest just once each
year. Currently the bond is selling for Br. 900. The investor plans to hold the bond to maturity,
which occurs in five years. What is the holding period yield? What is the yield to maturity?

Solutions
The current market price of the bond is Br. 900 while the par Value is Br.1000.Since the bond is
trading at a discount; the initial guess should be 12 percent (a rate higher than 10 percent). To

12
determine how accurate a guess it is, we need to calculate the present value of the bond’s cash
inflows.

100 100 100 100 1 ,100

1
+ 2
+ 3
+ 4
+ 5
P = ( 1. 12 ) ( 1 .12 ) ( 1 .12 ) ( 1. 12 ) ( 1 .12 )

P = Br. 927.90

This value is higher than br.900. Thus, for the present value of the cash inflows to become 900,
the next trial should be at a higher rate. Let us check it at 14 percent.

100 100 100 100 1100

1
+ 2
+ 3
+ 4
+ 5
p= ( 1. 14 ) ( 1. 14 ) ( 1 .14 ) ( 1. 14 ) ( 1. 14 )
P=Br. 862.70

This value is lower than Br 900. This shows that the holding period yield is between 12 percent
and 14 percent. The use of linear interpolation helps us to determine the bond's approximate
holding period yield. Thus, the holding period yield (h) is:

Discount rate PV of bond

12% 927.90 27.90

2% h 900 65.20
14% 862.70

h= 12% +
( 27 . 90
65 . 20 )
X 2%

h= 12% + 0.86%
h= 12.86%

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Since the bond is held until maturity, the holding period yield is equal to the bond’s yield to
maturity. Hence, the yield to maturity of the bond is 12.86 percent.

Approximate average annual yield

This formula simply assumes that,

Approximate average annual yield=Average annual income from the security
Average amount of funds invested in the security
In the case of a bond, for example, the approximate yield would be composed of annual interest
income plus (minus) the average amount of price appreciation (depreciation) which occurs each
year. The average amount of funds invested can be represented by the simple arithmetic average
of the purchase price and the expected selling price of the security. That is:
Approximate average annual yield= Annual interest income + Price appreciation
(Or depreciation)
Years remaining until
Sold
Purchase price +Selling price
2

To illustrate the use of this formula, suppose an investor is considering the purchase of a bond
with a current market price of Br. 900, a coupon rate of 10 percent, and the bond will be sold or
redeemed in 10 years at an expected price of Br. 1,000. Assume the par value is 1000. The
approximate expected yield would be

Approximate average annual = Br. 100+ (Br.1000-900)

Yield on bond 10 = Br 110
Br.900 +Br 1000 Br 950
2
= 11.58%

Note that the investor expects a price appreciation of Br.100 over the remaining life of this bond
because it sells currently for Br.900 and will be redeemed in 10 years for Br. 1000. The average
gain in price, therefore, is Br.10 per year.

14
The same formula may be used in the case of a bond that is expected to experience a depreciation
in price between time of purchase and time of sale. Suppose an investor wishes to purchase a
Br.1000 par value bond currently selling for Br. 1200 with a coupon rate of 10 percent. If the
bond matures in 10 years and is held to maturity,

Approximate
Average annual = Br.100 + (Br. 1000-Br. 1200)
Yield on bond 10
Br. 1200 +Br. 1000
2
= Br. 80 = 7.27%
Br. 1100

Yield- Price Relationships

The foregoing yield-to-maturity and holding period yield formulas illustrate a number of
important relationships between bond prices and yields or interest rates which prevail in the
financial system. One of these important relationships is:
The prices of a security and its yield or rate of return are inversely related. A rise in
yield implies a decline in price; conversely, a fall in yield is associated with a rise in
the security's price.

Determinants of the Structure of Interest Rate

The Base Interest Rate

The securities issued by the US. department of the treasury, popularly referred to as Treasury
securities or simply treasuries, are backed by the full faith and credit of the US. government.
Consequently, market participants throughout the world view them as having no credit risk. As a
result, historically the interest rates on Treasury securities have served as the bench mark interest
rates throughout the US economy, as well as in international capital markets.
Treasury securities are typically issued on an auction basis according to regular cycles for
securities of specific maturities. Current Treasury practice is to issue all securities with maturities

15
of one year or less as discount securities. These securities are called treasury bills. All securities
with maturities of two years or longer are issued as treasury coupon securities.

The most recently auctioned treasury issues for each maturity are referred to as an on-the-run or
current coupon issues. Issues auctioned prior to the current coupon issues are typically referred
to as off-the-run issues; they are not as liquid as on-the-run issues, and ,therefore, offer a higher
yield than the corresponding an on-the-run treasury issue. The minimum interest rate or base
interest rate that investors will demand for investing in a non-treasury security is the yield
offered on a comparable maturity for an on-the-run treasury security.

The Risk Premium

Market participants talk of interest rates on non-treasury securities as "trading at a spread" to a
particular on-the-run treasury security (or a spread to any particular benchmark interest rate
selected). For example, if the yield on a 15-year non-treasury security is 8% and the yield on a
15-year treasury security is 6%, the spread is 2%. This spread reflects the additional risks the
investor faces by acquiring a security that is not issued by the US government and, therefore, can
be called a risk premium. Thus, we can express the interest rate offered on a non-treasury
security as:

Base interest rate + spread

Or equivalently,
Base interest rate + risk premium

Turning to the spread, the factors that affect it are:

1. The type of issuer
2. The issuer's perceived credit worthiness
3. The term to maturity of the instrument
4. Provisions that grant either the issuer or the investor the option to do something
5. The taxability of the interest received by investors and
6. The expected liquidity of the issue.

16
Types of issuers
Debt securities can be issued by governments, government agencies, municipal governments,
corporations (domestic and foreign) and foreign governments. The risk premium depends on the
nature of the issuing entity.

Perceived credit worthiness of issuer

Default risk or credit risk refers to the risk that the issuer of a bond may be unable to make
timely principal or interest payments. Securities having higher default risk will have a higher risk
premium than securities having lower default risk.

Term to maturity
The volatility of a bond's price is dependent on its maturity. More specifically, with all other
factors constant the longer the maturity of a bond, the greater the price volatility resulting from a
change in market yields. Thus, securities having long term maturities trade at a higher risk
premium than those with short term maturities.

Inclusion of options
It is not uncommon for a bond issue to include a provision that gives either the bond holder
and /or the issuer an option to take some action against the other party. An option that is included
in a bond issue is referred to as an embedded option. Some of the types of options in a bond issue
include call provision, put provision and conversion provisions.

The presence of these embedded options has an effect on the spread of an issue relative to a
Treasury security and the spread relative to otherwise comparable issues that do not have an
embedded option. In general, market participants will require a larger spread over a comparable
treasury security for an issue with an embedded option that is favorable to the issuer (e.g. a call
option) than for an issue without such an option. In contrast, market participants will require a
smaller spread over a comparable treasury security for an issue with an embedded option that is
favorable to the investor (for example, put option and conversion option).

Taxability of interest

17
The interest income generated from security is taxable unless it is exempted by law. The yield on
tax exempt securities is less than those that are not, provided that both have the same maturity.

The yield on a taxable bond after tax is equal to:

After-tax yield = pretax yield X (1-marginal tax rate)

For example, suppose a taxable bond issue offers a yield of 10% and is acquired by an investor facing a
marginal tax rate of 40%. The after- tax yield would then be:

After-tax yield= 0.1 X (1-0.4) =0.06= 6%

Alternatively, we can determine the yield that must be offered on a taxable bond issue to give the same
after tax yield as a tax-exempt issue. This yield is called the equivalent taxable yield and is determined as
follows:

Equivalent taxable yield= tax-exempt yield

(1-marginal tax rate)

For example, consider an investor facing a 40% marginal tax rate who purchases a tax-exempt issue with
a yield of 6% .The equivalent taxable yield is then:

Equivalent taxable yield = 0.06 = 0.1 = 10%

(1-0.4)

Notice that the lower the marginal tax rate, the lower the equivalent taxable yield. Thus, in our previous
example, if the marginal tax rate is 25% rather than 40%, the equivalent taxable yield would be 8% rather
than 10%, as shown below:

Equivalent taxable yield = 0.06 = 0.08 = 8%

(1-0.25)

Expected liquidity of an issue

Bonds trade with different degrees of liquidity. The greater the expected liquidity with which an issue will
trade, the lower the yield that investors would require. Treasury securities are the most liquid securities in

18
the world. The lower yield offered on treasury securities relative to non-treasury securities reflects to a
significant extent, the difference in liquidity. Even with in the Treasury market, some differences in
liquidity occur, because on-the-run issues have greater liquidity than off-the-run issues.

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