Interest Rates in the

Financial System
Chapter 3
1

Addis Ababa University School of Commerce 12/5

2 Interest Rates
 An interest rate is the price paid by a borrower to a lender for the use of
resources that will be used during some time period and then returned -
the cost of Money
 It is compensation to the lender for forgoing other useful investments tha
could have been made with the loaned asset – Opportunity cost
 Interest rates include base rates and risk premiums
 Would you be more likely to buy a house/car when interest rates are high
or low?
 Nominal, Risk-Free
Free and Real Rates
o Nominal Rate:: the actual monetary price that borrowers pay to lenders to
use their money
 Include all the risk factors, plus the time value of the money itself
o The risk-free rate is approximately the yield on short-term
short Treasury bills
 Includes the pure rate and an allowance for inflation
 Same as the base rate discussed earlier
 Viewed as current minimum interest rate
 No investment that does have risk can offer a lower rate

3
 The Real Rate of Interest

 The real interest rate is current (nominal) interest rate less

inflation adjustment
 Tells investors whether or not they are getting ahead
 If you earn a current rate of 8% on investment and inflation is 10%, you
are losing purchasing power on investment
 The Real Risk-Free Rate
 Implies that both the inflation adjustment and the risk premium are
zero
 = the pure interest rate

4
5 Other different types of interest
 Simple Interest:: interest on principal only
 Compound Interest: accumulated interest will earn interest
 Fixed and Floating Rates of Interest
 While the interest rates remain constant in the case of Fixed Rate of Loans, the
Floating Loan Rate is variable .
 After vs. Before-Tax Interest Rate
6 Theories of Interest Rates

 Fisher’s Law

 Loanable Funds Theory

 Pure Expectations Theory

 Segmented markets theory

 Liquidity Preference Theory

7
Fisher’s Law
 It is the prediction that an x percentage point change in the inflation rate
will cause an identical x percentage point change in the nominal interest
rate.
 States that nominal interest rates (i) are a function of the real interest rate
(r) and a premium (p) for inflation expectations.
 Fisher’s Equation:
r=i–p Or i=r+p
 But the more accurate formula to calculate the nominal or real interest rate
is
(1 + i) = (1 + r)(1 + p)
8
Fisher’s Law
 According to the International Fisher’s Effect, countries with higher expecte
inflation rates have higher interest rates.
 With no government interference nominal rates vary by inflation differenti
or ih - if = ph - pf

E.g.. Assume that a bank is willing to make a loan to you of Br1,000 for one yea
a real rate of interest of 3 per cent. The bank expects a 10 per cent rate of
inflation over the next twelve months.
 Calculate:
 The nominal interest rate
 What the bank will want after a year
 The Loanable Funds Theory
Loanable funds are the funds available in the financial system for lending
 Interest rates set by supply and demand of loanable funds in debt market
Supply—funds
funds from those willing to lend money
 Lenders (investors) buy debt securities such as bills, notes and bonds
 Supply of borrowed funds depends on their willingness to invest their
savings
 Affected by changes in the economy

9
 The Loanable Funds Theory
 Demand—people, companies and governments desiring to
borrow money
 Borrowers sell bonds, etc.
 Demand for borrowed funds depends on
 Opportunities available to use these funds
 Attitudes of people and businesses about using credit
 If people feel good about the economy they will go on vacation, buy houses and
cars, etc.
 Businesses will borrow for expansion and new projects

10
 The Loanable Funds Theory
 The price—the interest rate
 Borrowers will borrow more when interest rates low
 Lenders will lend more (buy more bonds) when interest rates high
 Assumes a downward-sloping demand curve and an upward-sloping supply
curve in the loanable funds market i.e
 As interest rates rise demand falls
 As interest rates rise supply increases

11
 The Loanable Funds Theory
12
Figure 3.1
13 The Loanable Funds Theory
 Equilibrum of the loanable funds market occurs when savings capital
(supply) is equal to the investment capital (demand).
 The particular price that brings the loanable funds market into
equilibrium is the interest rate.
 In other words, loanable funds theory determines the equilibrium
interest rate of a particular loan.
loan
14
Pure Expectations Theory
 This theory assumes that present long-term
long interest rates depend entire
on future short-term rates.
 Lenders are taken to be equally happy to hold short-term
short or long-term
securities. Their choice between them will depend only on relative intere
rates.
 Securities of different maturities are perfect substitutes.
 For instance, a series of five one-year
year bonds is a perfect substitute for a five-year
five bon
 Assuming that lenders have perfect information, long-term interest rates
will be approximately an average of the known future short-term rates.
{LTint = ( it + it+1 + it+2 + …+ it+(n-1)) / n}

 Or LTint = [(1 + it)(1 + it+1) ….(1 + it+(n-1))]1/n - 1

 Pure Expectations Theory
 Numerical example
 One-year
year interest rate over the next five years
are expected to be 5%, 6%, 7%, 8%, and 9%
 Interest rate on two-year
year bond today:
(5% + 6%)/2 = 5.5%
 Interest rate for five-year
year bond today:
(5% + 6% + 7% + 8% + 9%)/5 = 7%
 Interest rate for one- to five-year
year bonds today:
5%, 5.5%, 6%, 6.5% and 7%
 Pure Expectations Theory (Example)
16
 We assume that lenders know that short-term
short rates over the next four years will be:
year 1: 8 per cent
year 2: 10 per cent
year 3: 11 per cent
year 4: 12 per cent
 Then, Br1,000 invested in a one-year
year bond, with the proceeds being invested in a further one-ye
one
bond in the subsequent years, will produce the following results:
Principal Interest rate Interest Capital + interest
year 1 Br1,000 8 per cent Br80 Br1,080
year 2 Br1,080 10 per cent Br108 Br1,188
year 3 Br1,188 11 per cent Br131 Br1,319
year 4 Br1,319 12 per cent Br158 Br1,477
Required : Calculate the interest rates on two-year,
year, three-year
three and four-year bonds.
 Segmented markets
market theory
17

 Assumes that securities in different maturity ranges are viewed by vario

market participants as being imperfect substitutes (i.e. investors will op
within some chosen maturity range - Markets are completely segmented
 Rejects pure expectations theory assumption that all bonds are perfect
substitutes (Bonds of different maturities are not substitutes at all)
 The choice of long-term
term versus short-term
short securities is predetermined
according to need rather than expectations of future interest rates
 Pension funds & life insurance companies may generally prefer LT investments th
coincide with their LT liabilities
 Commercial banks may generally prefer ST investments to coincide with their ST
liabilities
 The Liquidity Preference Theory
18
 Assumes securities of different maturities are substitutes, but are not perfect
substitutes
 Modifies Pure Expectations Theory with features of Market Segmentation The
 Investors prefer shorter-term instruments which have greater liquidity, and le
maturity and interest rate risk,, and, therefore, require compensation for inves
longer term . (Interest rate increases as terms to maturity increases)
 This compensation is called ‘liquidity premium’ - lpnt
 And the longer the period of time they have to give up, the more they need
compensated.
 Long-term
term securities are more sensitive to interest rate changes than short
securities
 The Liquidity Preference Theory
19

 LTint= [( it + it+1 + it+2 + …+ it+(n-1)) / n] + lpnt

Numerical example:
Using the example given on pure expectation theory, calculate the interest rates on two-year, three-year and
four-year
year bonds applying the liquidity preference theory. Assume liquidity premium for one-one to four-yea
bonds: 0%, 0.25%, 0.5%, and 0.75%
20 Factors that affect interest rates
 The Base Interest Rate
 Default risk (also called Credit Risk)
 Liquidity
 Tax status
 Term to maturity
 Inflation
 Special contract provisions such as embedded options
21 Factors that affect interest rates
1. The Base Interest Rate
 risk-free
free treasury securities for given maturity

2. Default risk
 occurs when the issuer of the bond is unable or unwilling to make interest payments whe
promised.
 The spread between the interest rates on securities with default risk and default-free
default
securities, called the risk premium,, indicates how much additional interest people must e
in order to be willing to hold that risky securities.
 Default risk premium = risky security yield – treasury security yield of same maturity
 A bond with default risk will always have a positive risk premium, and an increase in its
default risk will raise the risk premium.
22
Factors that affect interest rates
3. Liquidity
 The more liquid an asset is, the more desirable it is (holding everything else constant).
 A liquid investment is easily converted to cash at minimum transactions cost
 Investors pay more (lower yield) for liquid investment
 Liquidity risk premium to compensate the fact that some securities cannot be converted to cash
short notice at a “reasonable” price.

4. Tax status
 Tax status of income or gain on security impacts the security yield
 Investors are concerned with after-tax
tax return or yield
 Investors require higher yields for higher taxed securities
 iat = ibt(1 – T)
23
Factors that affect interest rates
5. Term to maturity
 Interest rates typically vary by maturity
 The longer the maturity of a security, the greater its price sensitivity to a
change in market yields and the more interest rate.
 Maturity Risk Premium: premium charged to compensate the risk stemming from
probability of adverse movements in the interest rates that might cause capital losses.

6. Inflation
Inflation Premium: A premium equal to expected inflation that investors add
to the real-risk-free rate of return.
24
7. Embedded Options
 Call options
 benefit issuers by enabling them to buy back the bonds before maturity
specified price
 Call features are exercised when interest rates have declined
 Investors demand higher yield on callable bonds, especially when rates
expected to fall in the future
 Conversion options
 benefit investors by allowing them to convert the security into a specif
number of common stock shares
 Investors will accept a lower yield for convertible securities because
investor returns include expected return on equity participation
25
Estimating the Appropriate Yield
r = r* + DRP + LP + MRP + IP + CALLP - COND
Where:
r = Nominal (quoted) Interest Rate
r* = Real Risk Free Rate of Interest
DRP = default risk premium
LP = liquidity premium
MRP = Maturity Risk Premium
IP = Inflation premium
CALLP = call feature premium
COND = convertibility discount
26
Numerical example

 Real Risk free rate of return is 2.2%

 Inflation is 2.75% on all types of securities
 Maturity risk premium is 1.5%
 Liquidity risk premium on long-termterm bonds is 3%
 Default risk premium is 1.6% and 2.5% on short term and long-term
long
securities respectively
 Call premium on callable bonds is 1.2%
 Convertibility discount on convertible bonds is 2.5%
 Government securities do not have liquidity risks.
27 Numerical example

 Treasury bill rate

 Commercial papers rate
 Long-term
term government bonds rate
 Non-callable, non-convertible
convertible corporate bonds rate
 Callable corporate bonds rate
 Convertible corporate bonds rate
28

End of Chapter 3

Addis Ababa University School of Commerce 12/5