INTEREST RATES DETERMINATION AND STRUCTURE

TABLE OF CONTENTS
Interest rate determination
Loanable funds theory
Level of interest rate in the economy
Liquidity preference theory
Understanding of the term structure of interest rates
Theories of term structure of interest rates
Spot rates and forward rates
Yield curves

Learning Objectives
1. Understand interest rates as one of the key aspects of the financial environment.
2. Explain the variety of interest rates, and their term and structure.
3. Explain the determinants of the level of interest rates.
4. Distinguish the relationship between interest rates and maturity of debt instruments.

INTEREST RATE

 A rate of return paid by a borrower of funds to a lender of them, or a price paid by a borrower for a
service, the right to make use of funds for a specified period.
 One form of yield on financial instruments.

Interest rate at which the banks are lending – the offer rate.
The difference between them is called SPREAD.
It exists between selling and buying rates in local and international money and capital markets.
Interest rate payed for deposits – the bid rate.
SPREAD

 The spread between offer and bid rates provides a cover for administrative costs of the financial
intermediaries and includes their profit.
 The spread is influenced by the degree of competition among financial institutions
 The spread between offer and bid rates provides a cover for administrative costs of the financial
intermediaries and includes their profit.
 The spread between banks borrowing and ending rates to their retail customers is larger in general due
to considerably larger degree of loan default risk.

SPREAD RATE V.S. BASE RATE

SPREAD OF INTEREST = LENDING RATE - DEPOSIT RATE

 This covers operating costs for banks providing loans and deposits.
 A negative spread is where a deposit rate us higher than the lending rate.
  The base rate is the lowest rate at which a bank will charge interest, also known as the repo rate.
 The rate is set by the monetary policy with a view to controlling inflation over the medium-term.
 If the base rises, the rate of interest charged on the loan will rise to preserve the differential. Ifit falls,
so will the rate on the loan.

Risk Premium

An addition to the interest rate demanded by a lender to take into account the risk that the borrower might
default on the loan entirely or may not repay on time (default risk).

FACTORS THAT DETERMINE THE RISK PREMIUM FOR A NON-GOVERNMENT SECURITY

 Perceived credit worthiness o the issuer;

 Provisions of securities such as conversion provision, call provision, put provision;
 interest taxes;
 expected liquidity of a security's issue

IN COMPARISON WITH THE GOVERNMENT SECURITY OF THE SAME MATURITY

INTEREST RATE STRUCTURE

Interest rate structure is the relationships between the various rates of interest in an economy on financial
instruments of different lengths (terms) or of different degrees of risk.

Interest rate structure is assumed as stable and are likely to move in the same direction in the economy.

NOMINAL INTEREST RATE

Nominal interest rates the amount, in percentage terms, of interest payable.

REAL INTEREST RATE

 Real interest rate is the difference between the nominal rate of interest and the expected
rate of inflation.
 It is a measure of the anticipated opportunity cost of borrowing in terms of goods an d services
forgone.

Fisher Effect
 The Fiser Effect combines the real rate of interest and expected inflation to create a (risk-free) nominal
interest
rate.
 Hence, the nominal interest rate is the market interest rate - the rate you either pay or earn

NOMINAL INTEREST RATE REAL INTEREST RATE

The dependence between the real and nominal interest rates is expressed using he following equation:

i = (1 + r) (1 + i ) - 1

where i is the nominal rate of interest, r is the real rate of interest and i , e is the expected rate of inflation.

Example:

Assume that a bank is providing a company with a loan of 1000 thous. Euro for one year at a real rate of
interest of 3%. At the end of the year, it expects to receive back 1030 thous. Euro of purchasing power at
current prices. However, if the bank expects a 10% rate of inflation over the next year, it will want 1133 thous.
Euro back (10% above 1030 thous. Euro). The interest rate required by the bank would be 13.3%.
i = (1 + 0.03)(1 + 0.1) - 1
= (1.03)(1.1) - 1
= 1.133 - 1
= 0.133 or 13.3%

When simplified, the equation becomes: i + r = ie

In the example, this would give 3% plus 10% = 13%. The real rate of return is thus: r = i – I When the
assumption is made that r is stable over time, the equation provides the Fisher effect. It suggests that changes
in shirt-term interest rates occur because of changes in the expected rate of inflation. If a further assumption
is made that expectations about the rate of inflation of market participants are correct, then the key reason
for changes in interest rate is the changes in the current rate of inflation.

Fisher Equation
( l + r ) = (1 + R ) (1 + E ( i ) )
r = nominal interest rate
R = real rate of interest
E (i) = expectd annual rate of inflation

solving for r,
r=R+E(i)+(R*E(I))

Example: Loan Contract Interest Rate

If the borrower and lender agree that R = 6% and E = 7%, then
what would be the contract interest rate for a one-year loan?
Example: Loan Contract Interest Rate

Using the Fisher Equation, the contract is:

r = 0.06 + 0.07 + (0.06 * 0.07) = 0.1342 or 13.42%

2 ECONOMIC THEORIES EXPLAINING THE LEVEL OF REAL INTEREST RATES IN AN ECONOMY

LOANABLE FUNDS THEORY

In the Loanable Funds Theory, the level of interest rates is determined by the supply and demand of loanable
funds available in an economy's credit market.

LOANABLE FUNDS THEORY The term "loanable funds" simply refers to the sums of money offered for lending
and demanded by consumers and investors during a given period. The interest rate in the model is determined
by the interaction between potential borrowers and potential savers.

LONG-TERM INTEREST RATES

Determined by the investment and savings in the economy

SHORT-TERM INTEREST RATES

Determined by an economy's financial and monetary conditions

LIQUIDITY PREFERENCE THEORY

Liquidity Preference Theory, explains how interest rates are determined based on the preferences of
households to hold money balances rather that spending or investing those funds.
Liquidity preference is preference for holding financial wealth in the form of short-term, highly liquid assets
rather than long-term illiquid assets, based principally on the fer that long-term assets will lose capital value
over time.

LIQUIDITY PREFERENCE THEORY

The level of interest rates is determined by the supply and demand for money balances.

LOAN FUNDS THEORY

The level of interest rates is determined by supply and demand, but in credit market

LOANABLE FUNDS THEORY

 According to the loanable funds theory for the economy as a whole: Demand for loanable funds = net
investments net additions to liquid reserves Supply of loanable funds = net savings + increase in the
money supply
 Given the importance of loanable funds and that the major suppliers of loanable funds are commercial
banks, the key role of the financial intermediary in the determination of interest rates is vivid.
 Specific Monetary Policy, it influences the supply of loanable funds from commercial banks and
thereby changes the level of interest rates. As central bank increases (decreases) the supply of credit
available from commercial banks, it decreases (increases) the level of interest rates.
 Time preference describes the extent to which a person is willing to give up the satisfaction obtained
from present consumption in return for increased consumption in the future.

FACTORS THAT AFFECT THE CHANGE OF THE STRUCTURE OF INTEREST RATE

 TIME PERIOD
 DEGREE OF RISK
 TRANSACTION COSTS ASSOCIATED WITH
 DIFFERENT FINANCIAL NSTRUMENTS
 the behavior of the yield curve composition of the maturity structure
 sensitivity of the change in the interest rate, and, default risk included and its relationship with the
yield curve

Term Structure of Interest Rates

The relationship between the yields on comparable securities but different maturities in a graphical way.
YIELD CURVE: Shows the relationships between the interest rates payable on bonds with different lengths of
time to maturity showing the term structure of interest rates.
TERM STRUCTURE THEORIES
THE EXPECTATIONS THEORY/PURE EXPECTATIONS THEORY

Expectation’s theory states that current long-term rates can be used to predict short-term rates of future. It
simplifies the return of one bond as a combination of the return of other bonds.
EXAMPLE: A 3-year bond would yield approximately the same return as three 1-year bonds.
QUESTIONS
Why interest rates tend to decrease recessionary periods?
What is the relationship between yield and liquidity of the securities?

TERM STRUCTURE THEORIES

LIQUIDITY PREFERENCE THEORY

This theory perfects the more commonly accepted understanding of liquidity preferences of investors.
Investors have a general bias towards short-term securities, which have a higher liquidity as compared to long-
term securities, which get one's money tied up for a long time.

Key Points:
 The price change for a long-term debt security is more than that for a short-term debt security.
 Liquidity restrictions on long-term bonds prevent the investor from selling it whenever he wants.
 The investor requires an incentive to compensate for the various risks he is exposed to, primarily price
risk and liquidity risk.
 Less liquidity leads to an increase in yields, while more liquidity lads to falling yields, thus defining the
shape of upward and downward slope curves.
MARKET SEGMENTATION THEORY/ SEGMENTATION THEORY

This theory is related to the supply-demand dynamics of a market. The yield curve shape is governed by the
following aspects:

 Preferences of investors for short term and long-term securities.

 An investor tries to match the maturities of his assets and liabilities.
 Any mismatch can lead to capital loss or income loss.
 Securities with varying maturities form a number of different
supply and demand curves, which then eventually inspire the final
yield curve.
 Low supply and high demand lead to an increase in interest rates.

PREFERRED HABITAT THEORY

This theory states that investor preferences can be flexible, depending on their risk tolerance level. They can
choose to invest in bonds outside their general preference also if they are appropriately compensated for their
risk exposure.
Few main theories that dictates the shape of a yield curve:
Keynesian Economic Theory
Substitutability Theory

QUESTIONS
What factors influence the shape of the yield curve?

ADVANTAGES
 Indicator of the overall health of the economy - An upward sloping and steep curve indicates good
economics health while inverted, flat, and humped curves indicate a slowdown.
 Knowing how interest rates might change in the future, investors are able to make informed decisions.
 It also serves as an indicator of inflation.
 Financial organizations have a heavy dependency on the term structure of interest rates since it helps
in determining rates of lending and savings.
 Yield curves give an idea of how overpriced or underpriced the debt securities may be.

DISADVANTAGES
 Yield curve risk - Investors who hold securities with yields depending on the market interest rates are
exposed to yield curve risk to hedge against which they need to form well- differentiated portfolios.
 Maturity matching to hedge against yield curve risk is not a straightforward tasl and might not give the
desired end results.

Term Structure of Interest

The term structure of interest rates eventually is only a predicted estimation that might not always be
accurate, but it has hardly ever fallen out of place.

Forward interest rates and yield curve

Forward interest rates are rates for periods commencing at points of time in the future. They are implied
by current rates for differing maturities.
The forward rate can be interpreted as the market expectation of the future interest under the assumption
that: the expectations theory of the yield curve is correct and there is no risk premium.
QUESTIONS

What is the meaning of the forward rate in the context of the term structure of interest rates?

The yield curve based on zero coupon bonds is known as the spot yield curve.

It is regarded as more informative than a yield curve that relates redemption yields to maturities of coupon
bearing bonds. The redemption date is not the only maturity date.

Coupon-bearing bonds may have different redemption yields, despite having common redemption dates,
because of differences in the coupon payments.

Yield curves based on coupon-bearing bonds may not provide a single redemption yield corresponding to a
redemption (final matury) date.

The forward yield curve relates forward interest rates to the points of time to which they relate.

QUESTIONS

Why might forward rates consistently overestimate future interest rates?

How liquidity premium affects the estimate of a forward interest rate?

Forward yield curve

 The series of forward rates produces a forward yield curve . The forward yield curve requires the use of
zero-coupon bonds for the calculations.
 This forms also the basis for calculation of short-term interest rate futures - which frequently take the
form of three-month interest rate futures, are instruments suitable for the reduction of the risks of
interest rate changes.
 Three- month interest rate futures are notional commitments to borrow or deposit for a three- month
period that commences on the futures maturity date. They provide means whereby borrowers or
investors can (at least approximately) predetermine interest rates for future periods.