CHAPTER 2

Determinants of Interest Rate

Outline

I. Interest Rate Fundamentals: Chapter Overview

Nominal Interest Rates (or just interest rates)
- actually observed in financial markets
- directly affect the value (price) of most securities traded in the money and capital markets,
both at home and abroad.
Example:
Investment
You decide to invest your P10,000 in a savings account with a nominal interest rate of
5%. After one year, you will earn 5% interest on your initial P10,000, which is P500. To get the
nominal interest rate simply multiply P10,000 x 5%. So, your total savings will be P10,000 +
P500 = P10,500.
Borrowing
If you decide to borrow P5,000 from a bank at a nominal interest rate of 5%, you will
owe the bank P5,250 at the end of the year, which includes P5,000 (the principal amount
borrowed) and P250 in interest. Therefore you need to pay the bank at the amount of P5,250.

1. Federal Funds Federal- funds refer to the reserve balances that banks in the United States
hold at the Federal Reserve.
2. T-Bill (Treasury Bill)- a T-Bill is a short-term debt security issued by the U.S. Department of
the Treasury.
3. AAA-Rated Corporate Debt- AAA-rated corporate debt refers to bonds or debt securities
issued by corporations that have received the highest credit rating from credit rating agencies
such as Moody's, Standard & Poor's, or Fitch.
4.Mortgage Rates- Mortgage rates are the interest rates that financial institutions charge when
they lend money to individuals or families to purchase homes.
II. Loanable Funds Theory
-views the level of interest rates as resulting from factors that affect the supply of and demand
for loanable funds.
-it categorizes financial market participants (consumers, businesses, governments, and foreign
participants) as net suppliers or demanders of funds.

a. Supply of Loanable Funds

– is term commonly used to describe funds provided to the financial markets by net suppliers
of funds.
-In general ,the quantity of loanable funds supplied increases as interest rates rises.

b. Demand for Loanable Funds

-is term used to describe the total net demand for funds by funds users.
-in general, the quantity of loanable funds demanded is higher as interest rates fall.

c. Equilibrium Interest Rate

-is the interest rate at which the supply of and demand for loanable funds in a financial market
are in balance.

d. Factors that cause the Supply and Demand Curves for Loanable Funds to Shift
Supply of Funds
1. Wealth
2. Risk
3. Near-Term Spending Needs
4. Monetary Expansion
5. Economic Conditions
Demand for Funds
1. Utility Derived from Assets Purchased with Borrowed Funds
2. Restrictiveness of Nonprice Conditions on Borrowed Funds
3. Economic Conditions

III. Movement of Interest Rates over Time

Interest rates change over time due to various factors, such as economic conditions and
central bank policies. In a strong economy, central banks may increase rates to curb inflation,
while in a weak economy, rates may be lowered to stimulate growth. Additionally, inflation and
supply and demand for loans play a crucial role in determining interest rates. Investor
sentiment, credit risk, and expectations of future economic conditions also influence the
movement of interest rates.

IV. Determinants of Interest Rates for Individual Securities

1. Inflation
2. Real Risk-Free Rates
3. Default or Credit Risk
4. Liquidity Risk
Formula:

V. Term Structure of Interest Rates

1. Unbiased Expectation Theory
2. Liquidity Premium Theory
3. Market Segmentation Theory

VI. Forecasting Interest Rates

VII. Time Value of Money and Interest Rates
The time value of money is a financial concept that acknowledges the idea that a sum of
money has different values at different points in time. This is primarily due to the potential to
earn interest or invest that money. Interest rates are a critical component in this concept, as
they determine the rate at which money grows or declines in value over time. Higher interest
rates generally imply that money invested or saved today will be worth more in the future,
emphasizing the significance of time in financial decision-making and highlighting the
relationship between time value of money and interest rates.
VIII. Interest Rates
1. Time Value of Money
2. Lump Sum Valuation
3. Annuity Valuation

1. Time Value of Money

2. Lump Sum Valuation

A. Present Value
Formula:
 Example:

B. Future Value
Formula and Example

3.
Annuity Valuation
A. Present Value
Formula and Example:

B. Future Value