Chap 2 (1) Determination of Interest Rates

Chapter 2: Part 1
Determination of Interest Rates

1. Overview of Interest rates
2. Determination of Interest Rates

Contents
3. Economic forces that affect
Interest rates
4. Forecasting Interest rates

○ What does interest mean?

□ Interest is the price demanded by the lender from
the borrower for the use of borrowed money
□ a fee paid by the borrower to the lender on borrowed
cash as a compensation for forgoing the opportunity
of earning income from other investments that could
have been made with the loaned cash.
□ "opportunity cost’ or "rent of money" – from the
lenders’ perspective
4
○ Why do lenders charge interest rates on loans?

□ Compensation for inflation
□ Compensation for default risk – the chance that
the borrower will not pay back the loan
□ Compensation for the opportunity cost of
waiting to spend your money
5
○ Interest rate? the rate at which interest (or

‘opportunity cost’) accumulates over a period of time.
□ The longer the period for which money is borrowed,
the larger is the interest (or the opportunity cost).
□ The amount lent is called the principal.
□ Interest rate is typically expressed as percentage of
the principal and in annualized terms.
□ From a borrower’s perspective: interest rate is the
cost of capital - the cost that a borrower has to incur
to have access to funds.
Question: How to measure interest rate?
6
○ How to measure Interest rate?
□ Q: (1) A one-year, $1000 face value coupon bond with a

selling price of $1200, coupon rate of 10%. Calculate the
Rate of return of this bond
c = 10%
Yield = (1200-1000)/1000 x 100 = 2%
C + Pt +1 - Pt C Pt +1 - Pt
r= = +
Pt Pt Pt
7
○ How to measure Interest rate?
Interest rate = Interest payment / Principal
Interest rate and Rate of Return ?

Rate of Return
= [Initial value / (Current value−Initial value)]×100
C + Pt +1 - Pt C Pt +1 - Pt
r= = +
Pt Pt Pt
8
Present Value
A dollar paid to you one year from now is less valuable

than a dollar paid to you today
○ Why?
□ A dollar deposited today can earn interest and
become $1 x (1+i) one year from today.
9
Discounting the Future

Let i = .10
In one year $100 X (1+ 0.10) = $110
In two years $110 X (1 + 0.10) = $121
or 100 X (1 + 0.10) 2
In three years $121 X (1 + 0.10) = $133
or 100 X (1 + 0.10)3
In n years
$100 X (1 + i ) n
10
Simple Present Value
PV = today's (present) value

CF = future cash flow (payment)
i = the interest rate
CF
PV = n
(1 + i)
11
Timeline
Cannot directly compare payments scheduled in
different points in the timeline
$100 $100 $100 $100
Year 0 1 2 n
PV 100 100/(1+i) 100/(1+i)2 100/(1+i)n

12
Terms
13
Four Types of Credit Market Instruments
○ Simple Loan
○ Fixed Payment Loan
○ Coupon Bond
○ Discount Bond
14
Yield to Maturity: The interest rate that equates the present

value of cash flow payments received from a debt instrument
with its value today
□ Q: (1) a three-year, $1,000 face value coupon bond
with a price of $1,050 and a coupon rate of 8% or (2) a
two-year, $1,000 face value coupon bond with a price
of $980 and a coupon rate of 6%?
15

○ Simple Loan
If Pete borrows $100 from his sister and next year she wants $110
back from him, what is the yield to maturity on this loan?
110 = 100 x (1+i)
16

○ Simple Loan
PV = amount borrowed = $100
CF = cash flow in one year = $110
n = number of years = 1
$110
$100 =
(1 + i )1
(1 + i ) $100 = $110
$110
(1 + i ) =
$100
i = 0.10 = 10%
For simple loans, the simple interest rate equals the
yield to maturity
17

○ Fixed payment loan
The lender provides the borrower with an amount of funds that the borrower must
repay by making the same payment, consisting of part of the principal and
interest, every period (such as a month) for a set number of years.
Installment loans (such as auto loans) and mortgages are frequently of the fixed-
payment type.
Example: if you borrow $1,000, a fixed payment loan might require you to pay
$126 every year for 25 years.
18

The same cash flow payment every period throughout
the life of the loan
LV = loan value
FP = fixed yearly payment
n = number of years until maturity
FP FP FP FP
LV = + 2
+ 3
+ ...+
1 + i (1 + i ) (1 + i ) (1 + i ) n
19

Example: if you borrow $1,000, a fixed payment loan might require you to pay
$126 every year for 25 years.
126 126 126

1000 = + + ..... +
1+ i *
(1 + i )
* 2
(1 + i * ) 25
20

○ Coupon Bond
Using the same strategy used for the fixed-payment loan:
P = price of coupon bond
C = yearly coupon payment
F = face value of the bond
n = years to maturity date
C C C C F
P= + + + . . . + +
1+i (1+i ) 2 (1+i )3 (1+i ) n (1+i ) n
21

○ Coupon Bond
Example: Find the price of a 10% coupon bond with a face value of $1,000, a
12.25% yield to maturity, and eight years to maturity.
PV = 100/0.1225 x (1-1/(1.1225)^8) + 1000/ (1.1225)^8 = 852.55
22

○ Coupon Bond
Table 1 Yields to Maturity on a 10%-Coupon-Rate Bond Maturing in Ten Years

(Face Value = $1,000)
23

○ Coupon Bond
□ When the coupon bond is priced at its face value, the yield
to maturity equals the coupon rate
□ The price of a coupon bond and the yield to maturity are
negatively related
□ The yield to maturity is greater than the coupon rate when
the bond price is below its face value
24
○ Consol or Perpetuity
□ A bond with no maturity date that does not repay principal but
pays fixed coupon payments forever
P = C / ic
Pc = price of the consol
C = yearly interest payment
ic = yield to maturity of the consol
can rewrite above equation as this : ic = C / Pc
For coupon bonds, this equation gives the current yield, an easy
to calculate approximation to the yield to maturity
25

○ Consol or Perpetuity
Example: What is the yield to maturity on a bond that has a price of $2,000
and pays $100 of interest annually, forever?
ic = 100/2000 = 5%
26

○ Discount Bond
For any one year discount bond
F-P
i=
P
F = Face value of the discount bond
P = current price of the discount bond
The yield to maturity equals the increase
in price over the year divided by the initial price.
As with a coupon bond, the yield to maturity is
negatively related to the current bond price.
27

○ Discount Bond
Example: What is the yield to maturity on a one-year, $1,000 Treasury bill
with a current price of $900?
(1000-900)/9000
28
Exercise
For each of the following situations, write the equation that you would use to
calculate the yield to maturity. You do not have to solve the equations for i;
just write the appropriate equation.
a. A simple loan for $500,000 that requires a. payment of $700,000 in four
years. PV = FV/ (1+i)^n => 500,000 = 700,000/ (1+i)^4
b. A discount bond with a price of $9,000, which has a face value of $10,000
and matures in one year. i = FV - PV) / PV = 10,000-9,000)/9,000
c. A corporate bond with a face value of $1,000, a price of $975, a coupon rate
of 10%, and a maturity of five years. PV = C/(1+i) +... +C/(1+i)^n + FV/(1+i)^n => 975 = 100/(1+i) +...+ 100/(1+i)^5 + 1000/(1+i)^5
d. A student loan of $2,500, which requires payments of $315 per year for 25
years. The payments start in two years. FV = A/(1+i) +...A/(1+i)^n => 2,500 = 315/(1+i) +...+ 315/(1+i)^25
29
Rate of Return
The payments to the owner plus the change in value
expressed as a fraction of the purchase price
C P -P
RET = + t+1 t
Pt Pt
RET = return from holding the bond from time t to time t + 1
Pt = price of bond at time t
Pt+1 = price of the bond at time t + 1
C = coupon payment
C
= current yield = ic
Pt
Pt+1 - Pt
= rate of capital gain = g
Pt
30
Rate of Return and Interest rates
○ The return equals the yield to maturity only if the holding

period equals the time to maturity
○ A rise in interest rates is associated with a fall in bond prices,

resulting in a capital loss if time to maturity is longer than the
holding period
○ The more distant a bondʼs maturity, the greater the size of the
percentage price change associated with an interest-rate
change
31
○ The more distant a bond’s maturity, the lower the rate of

return the occurs as a result of an increase in the
interest rate
○ Even if a bond has a substantial initial interest rate, its
return can be negative if interest rates rise
32
○ The more distant a bond’s maturity, the lower the rate of

return the occurs as a result of an increase in the
interest rate
○ Even if a bond has a substantial initial interest rate, its
return can be negative if interest rates rise
33
34
Interest-rate Risk
○ Prices and returns for long-term bonds are more volatile

than those for shorter-term bonds
○ There is no interest-rate risk for any bond whose time to
maturity matches the holding period
35
Real and Nominal Interest rates
○ Nominal interest rate makes no allowance for inflation

○ Real interest rate is adjusted for changes in price level,
so it more accurately reflects the cost of borrowing
○ Ex ante real interest rate is adjusted for expected
changes in the price level
○ Ex post real interest rate is adjusted for actual changes
in the price level
36
Exercises
1. Would a dollar tomorrow be worth more to you today when the

interest rate is 20% or when it is 10%? No because we know PV = FV/(1+i)^n => So PV and i is inversely
proportional => 10% will be worth more
2. You have just won $20 million in the state lottery, which
promises to pay you $1 million (tax free) every year for the next
20 years. Have you really won $20 million? FV = 1/(1+i) +.. 1/ (1+i)^20 < 20 million
3. If the interest rate is 10%, what is the present value of a
security that pays you $1,100 next year, $1,210 the year after, and
$1,331 the year after that? PV = 1,100/1.1 + 1,210/1.1^2 + 1,331/1.1^3 = 3000
37
Exercises
4. If the security in Problem 3 sold for $3,500, is the yield to

maturity greater or less than 10%? Why? 3500-3000/3000 = 16.67% >10%
5. Write down the formula that is used to calculate the yield to

maturity on a 20-year 10% coupon bond with $1,000 face value
c = 10%*1000 = 100
that sells for $2,000. PV = PV coupon + PV Par = 100/i (1-1/(1+i)^20) + 1000/(1+i)^20
6. What is the yield to maturity on a $1,000-face-value discount

bond maturing in one year that sells for $800?
i = (1000-800)/800 = 25%
38
Exercises
7. What is the yield to maturity on a simple loan for $1 million
that requires a repayment of $2 million in five years’ time?
8. To pay for college, you have just taken out a $1,000
government loan that makes you pay $126 per year for 25 years.
However, you don’t have to start making these payments until
you graduate from college two years from now. Why is the yield to
maturity necessarily less than 12%, the yield to maturity on a
normal $1,000 fixed-payment loan in which you pay $126 per
year for 25 years?
39
7. PV = FV / (1+i)^n => 1 = 2/(1+i)^5 => i = 14.87%
8. 1000 = 126/i * (1-1/(1+i)^25 = 11.83%
This is the case because the first payment due begins at a future date.
2. Determination of Interest rates

2.1. Bond Market Model
2.2. Loanable Funds Model
2.3. Liquidity Preference Framework
Determining the Quantity Demanded of an Asset
○ Wealth—the total resources owned by the individual,

including all assets
○ Expected Return—the return expected over the next period on

one asset relative to alternative assets
○ Risk—the degree of uncertainty associated with the return on

one asset relative to alternative assets
○ Liquidity—the ease and speed with which an asset can be
turned into cash relative to alternative assets
41
increase because
increase
decrease
increase
theory of portfolio choice, which tells us how much of an asset people will want to hold in their portfolios
42
43
2.1 Determination of Interest rates
Supply and Demand for Bonds
44
○ Wealth—in an expansion with growing wealth, the Shifts in the Demand for Bonds
demand curve for bonds shifts to the right
○ Expected Returns—higher expected interest rates
in the future lower the expected return for long-
term bonds, shifting the demand curve to the left
○ Expected Inflation—an increase in the expected
rate of inflations lowers the expected return for
bonds, causing the demand curve to shift to the left
○ Risk—an increase in the riskiness of bonds causes

the demand curve to shift to the left
○ Liquidity—increased liquidity of bonds results in
the demand curve shifting right
45
Shifts in the Supply of Bonds

○ Expected profitability of investment
opportunities—in an expansion, the supply
curve shifts to the right
○ Business taxes – an increase in taxes shifts the
supply curve for bonds to the right
○ Expected inflation—an increase in expected
inflation shifts the supply curve for bonds to the
right
○ Government budget—increased budget deficits
shift the supply curve to the right
46
Supply and Demand for Bonds
• At lower prices (higher interest rates), ceteris

paribus, the quantity demanded of bonds is
higher—an inverse relationship
• At lower prices (higher interest rates), ceteris
paribus, the quantity supplied of bonds is lower—a
positive relationship
47
A Change in Expected Inflation
48
A Change in Expected Inflation
49
A Business Cycle Expansion
50
A Business Cycle Expansion
51
Loanable funds theory suggests that the market

interest rate is determined by the factors that affect
the supply of and demand for loanable funds
□ Can be used to explain movements in the
general level of interest rates of a particular
country
□ Can be used to explain why interest rates among
debt securities of a given country vary
53
Demand and supply of Demand and supply of

Bonds approach Loanable funds approach
Good? Bonds The use of Funds
Buyer? Investor (lender) who The firm (borrower) raising
buys a bond funds
Seller? Firm (borrower) who Investor (lender) supplying
issues a bond funds
Price? The bond price The interest rate
54
Demand for loanable funds
55
Demand for loanable funds
Determination Demand for I/r

funds
Expected Inflation
Expected profitability
Government budget
deficits
56
○ Business demand for loanable funds

□ Businesses demand loanable funds to invest in fixed
assets and short-term assets
□ Businesses evaluate projects using net present value
(NPV):
n
CFt
NPV = -INV +
t =1
å
(1 + k ) t
Ø Projects with a positive NPV are accepted

□ There is an inverse relationship between interest
rates and business demand for loanable funds
57
○ Government demand for loanable funds

□ Governments demand funds when planned
expenditures are not covered by incoming
revenues
Ø Municipalities issue municipal bonds
Ø The federal government issues Treasury
securities and federal agency securities
□ Government demand for loanable funds is
interest-inelastic
58
○ Aggregate demand for loanable funds

□ The sum of the quantities demanded by the
separate sectors at any given interest rate is the
aggregate demand for loanable funds
59
Dh Db
Household Demand Business Demand

60
Dg Dm
Federal Government Demand Municipal Government Demand
61
Df
Foreign Demand
62
DA
Aggregate Demand
63
○ Supply of loanable funds

□ Funds are provided to financial markets by
○ Households (net suppliers of funds)
○ Government units and businesses (net borrowers
of funds)
□ Suppliers of loanable funds supply more funds at
higher interest rates
64
Supply of loanable funds
65
Supply of loanable funds
Determination Supply of I/r
Funds
Income
Risk of Fund
Return of Fund
Liquidity
66

□ Foreign households, governments, and corporations
supply funds by purchasing Treasury securities
○ Foreign households have a high savings rate
□ The supply is influenced by monetary policy implemented
by the Federal Reserve System
○ The Fed controls the amount of reserves held by
depository institutions
67

□ The supply curve can shift in response to
economic conditions
○ Households would save more funds during a
strong economy
68
SA
Aggregate Supply
69
○ Equilibrium interest rate - algebraic

□ The aggregate demand can be written as
DA = Dh + Db + Dg + Dm + Df
□ The aggregate supply can be written as
SA = Sh + Sb + Sg + Sm + S f
70
SA
DA
Equilibrium Interest Rate - Graphic
71
International Capital Market
72
Large Open Economy
73
Supply and Demand in the market for Money
○ Keynes’s analysis is his assumption that people use two main categories of
assets to store their wealth:
□ Money
□ Bonds
LIQUIDITY PREFERENCE FRAMEWORK
Analyse the changes in Income, Price Level, Money Supply
Demand and Supply of Bonds
Analyse the changes in Expected Inflation
74
75
76
77
The increase of … Change in Change in interest

Demand/Supply at rate
each IR
Income Demand é
Price Level Demand é
Money Supply Supply ê
78
Money and Interest Rates
Liquidity Effect: An increase in the money supply (everything else remaining
equal) lowers interest rates
1. Income Effect: The income effect of an increase in the money supply is a rise
in interest rates in response to the higher level of income.
2. Price-Level Effect: The price-level effect from an increase in the money

supply is a rise in interest rates in response to the rise in price level.
3. Expected-Inflation Effect: The expected-inflation effect of an increase in the

money supply is a rise in interest rates in response to the rise in the expected
inflation rate.
79
80
81
3. Economic Forces That
Affect Interest Rates
3. Economic Forces That Affect Interest Rates
○ Economic growth
□ Shifts the demand schedule outward (to the
right)
□ There is no obvious impact on the supply
schedule
Ø Supply could increase if income increases as
a result of the expansion
□ The combined effect is an increase in the
equilibrium interest rate
83
Loanable Funds Theory
SA
i2
DA2
DA
Impact of Economic Expansion
84
○ Inflation
□ Shifts the supply schedule inward (to the left)
○ Households increase consumption now if
inflation is expected to increase
□ Shifts the demand schedule outward (to the
right)
○ Households and businesses borrow more to
purchase products before prices rise
85
Loanable Funds Theory
SA2 SA
i2
DA2
DA
Impact of Expected Increase in Inflation
86
○ Fisher effect
□ Nominal interest payments compensate savers
for:
○ Reduced purchasing power
○ A premium for forgoing present consumption
□ The relationship between interest rates and
expected inflation is often referred to as the
Fisher effect
87
○ Fisher effect
□ Fisher effect equation:
i = E (INF ) + i R
□ The difference between the nominal interest
rate and the expected inflation rate is the real
interest rate:
i R = i - E (INF )
88
○ Money supply
□ If the Fed increases the money supply, the supply
of loanable funds increases
Ø If inflationary expectations are affected, the
demand for loanable funds may also increase
□ If the Fed reduces the money supply, the supply
of loanable funds decreases
□ During 2001, the Fed increased the growth of the
money supply several times
89
○ Money supply
□ September 11
○ Firms cut back on expansion plans
○ Households cut back on borrowing plans
○ The demand of loanable funds declined
□ The weak economy in 2001–2002
○ Reduced demand for loanable funds
○ The Fed increased the money supply growth
○ Interest rates reached very low levels
90
○ Budget deficit
□ A high deficit means a high demand for loanable funds by
the government
Ø Shifts the demand schedule outward (to the right)
Ø Interest rates increase
□ The government may be willing to pay whatever is
necessary to borrow funds, but the private sector may not
Ø Crowding-out effect
□ The supply schedule may shift outward if the government
creates more jobs by spending more funds than it collects
from the public
91
○ Foreign flows of funds

□ The interest rate for a currency is determined by the
demand for and supply of that currency
Ø Impacted by the economic forces that affect the
equilibrium interest rate in a given country, such
as: (1) Economic growth; (2) Inflation
□ Shifts in the flows of funds between countries cause
adjustments in the supply of funds available in each
country
92
○ Explaining the variation in interest rates over time

□ Late 1970s: high interest rates as a result of strong
economy and inflationary expectations
□ Early 1980s: recession led to a decline in interest rates
□ Late 1980s: interest rates increased in response to a strong
economy
□ Early 1990s: interest rates declined as a result of a weak
economy
□ 1994: interest rates increased as economic growth
increased
○ Drifted lower for next several years despite strong
economic growth, partly due to the U.S. budget
surplus
93
4. Forecasting Interest Rates
○ It is difficult to predict the precise change in the

interest rate due to a particular event
□ Being able to assess the direction of supply or
demand schedule shifts can help in
understanding why rates changed
95
○ To forecast future interest rates, the net demand

for funds (ND) should be forecast:
ND = DA - S A
[
= Dh + Db + Dg + Dm + Df ]
- [S h + Sb + Sg + Sm +S ]
f
96
○ A positive disequilibrium in ND will be corrected by

an increase in interest rates
○ A negative disequilibrium in ND will be corrected
by a decrease in interest rates
97

Chap 2 (1) Determination of Interest Rates

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Chap 2 (1) Determination of Interest Rates

Uploaded by

Copyright:

Available Formats

Chapter 2: Part 1

Determination of Interest Rates

2. Determination of Interest Rates

4. Forecasting Interest rates

○ What does interest mean?

○ Why do lenders charge interest rates on loans?

○ Interest rate? the rate at which interest (or

○ How to measure Interest rate?

□ Q: (1) A one-year, $1000 face value coupon bond with a

Yield = (1200-1000)/1000 x 100 = 2%

○ How to measure Interest rate?

Interest rate = Interest payment / Principal

Interest rate and Rate of Return ?

A dollar paid to you one year from now is less valuable

Discounting the Future

Simple Present Value

PV = today's (present) value

$100 $100 $100 $100

PV 100 100/(1+i) 100/(1+i)2 100/(1+i)n

Four Types of Credit Market Instruments

Yield to Maturity: The interest rate that equates the present

Four Types of Credit Market Instruments

110 = 100 x (1+i)

Four Types of Credit Market Instruments

Four Types of Credit Market Instruments

Four Types of Credit Market Instruments

Four Types of Credit Market Instruments

126 126 126

Four Types of Credit Market Instruments

Four Types of Credit Market Instruments

PV = 100/0.1225 x (1-1/(1.1225)^8) + 1000/ (1.1225)^8 = 852.55

Four Types of Credit Market Instruments

Table 1 Yields to Maturity on a 10%-Coupon-Rate Bond Maturing in Ten Years

Four Types of Credit Market Instruments

Four Types of Credit Market Instruments

Four Types of Credit Market Instruments

Four Types of Credit Market Instruments

○ The return equals the yield to maturity only if the holding

○ A rise in interest rates is associated with a fall in bond prices,

○ The more distant a bond’s maturity, the lower the rate of

○ The more distant a bond’s maturity, the lower the rate of

○ Prices and returns for long-term bonds are more volatile

○ Nominal interest rate makes no allowance for inflation

1. Would a dollar tomorrow be worth more to you today when the

4. If the security in Problem 3 sold for $3,500, is the yield to

5. Write down the formula that is used to calculate the yield to

that sells for $2,000. PV = PV coupon + PV Par = 100/i (1-1/(1+i)^20) + 1000/(1+i)^20

6. What is the yield to maturity on a $1,000-face-value discount

8. 1000 = 126/i * (1-1/(1+i)^25 = 11.83%

2. Determination of Interest rates

○ Wealth—the total resources owned by the individual,

○ Expected Return—the return expected over the next period on

○ Risk—the degree of uncertainty associated with the return on

○ Risk—an increase in the riskiness of bonds causes

Shifts in the Supply of Bonds

• At lower prices (higher interest rates), ceteris

Loanable funds theory suggests that the market

Demand and supply of Demand and supply of

Determination Demand for I/r

○ Business demand for loanable funds

Ø Projects with a positive NPV are accepted

○ Government demand for loanable funds

○ Aggregate demand for loanable funds

Household Demand Business Demand