Chapter Two

Determinants of
Interest Rates
Interest Rate Fundamentals

 Nominal interest rates: the interest rates

actually observed in financial markets
 Costs or benefits, depending on whether you are
a borrower or a lender
 Used to determine time value of money (i.e. future
versus present value of securities)
 Two components:
 Opportunity cost

 Adjustments for individual security characteristics

Time Value of Money
 Capitalization and discounting are two ways to express
the same phenomenon
 Future value
Capitalization: $X(1 + r)N

V V Time
0 N

 Present value
Discounting: $X/(1+r)N
 Relation between Interest Rates
and Present and Future Values
Present
Value
(PV)
Future
Value
(FV)

Interest Rate

Interest Rate
Real Riskless Interest Rates

 Additional purchasing power required to forego

current consumption
 What causes differences in nominal and real
interest rates?
 If you wish to earn a 3% real return and prices
are expected to increase by 2%, what rate must
you charge? The answer is 5% = 3% + 2%.
 Fisher effect postulates that nominal interest
rates contain a premium for expected inflation.
Annual Percentage Rate (APR)

 Interest rate when banks lend money to borrowers

with an impression that customers can borrow
cheaply
 Calculated on many consumer loans, credit cards
and mortgages
 Nominal interest rate quoted by the banks, but is not
the actual interest rate
 Does not include the effects of intra-year
compounding
 Standard cost of borrowing, often used by borrowers
when comparing lenders and loan options
 Always lower than effective annual cost (EAR)
Effective Annual Rate (EAR)

 Interest rate when banks pay customers who

deposit money allowing them to earn a higher
rate
 Applicable to deposit accounts
 The effective return assuming that interest paid
is reinvested at the same rate
 Include the effects of intra-year compounding
 Used when comparing investments with different
compounding periods per year
 Always higher than annual percentage rate
(APR)
Basis Points
 Yields are quoted as a percentage with two
decimal places (e.g. 11.82%). With this
quote, the smallest possible change is 0.01%
(i.e. 0.0001). This amount, 1% of 1%, is
called a basis point. When 11.82% rises to
11.94%, we say rate increases by 12 basis
points.
Example
 A bank offers a 10% APR.
 Monthly rate (i.e. compounding twelve times
a year) is 10%/12 = 0.833%
 EAR = (1 + APR/n)n – 1 = (1 + 0.1/12)12 – 1 =
(1.00833)12 – 1 = 0.1047 =
 APR = 10.00%
 EAR = 10.47%
Example
 $A earns interest at a rate r% per annum. If interest
is paid m times a year, then you will receive m
payments with a periodic rate r/m each time. At the
end of the year, you have A(1 + r/m)m.
 Compounding interest on $100 at 4%
Interest payment frequency Sum at the end of one year
Annual $104
Semi-annual $104.04
Monthly $104.0742
Weekly $104.0795
Daily $104.0808
Loanable Funds Theory
 Loanable funds theory explains real interest
rates and their movements
 Views level of real interest rates as resulting
from factors that affect the supply of and
demand for loanable funds
 Supply of loanable funds = demand for bonds
 Demand for loanable funds = supply of bonds
 Categorizes financial market participants – e.g.
consumers, businesses, governments, and
foreign participants – as net suppliers or
demanders of funds
Supply and Demand for Loanable
Funds

Demand (Ld) = Supply (Bs) Supply (Ls) = Demand (Bd)

Interest
Rate (i)

Loanable Funds L($)

Quantity of Bonds B(Q)
Net Supply & Demand of Funds
Household: Largest Supplier of
Loanable Funds
Their savings are determined by:
1. Interest rates and tax policy

2. Income and wealth: the greater the wealth or

income, the greater the amount saved
3. Attitudes about saving versus borrowing

4. Credit availability: the greater the amount of

easily obtainable consumer credit the lower
the need to save
5. Job security and belief in soundness of
entitlements
Foreigners Invest in Canada

Foreign funds supplied are determined by:

1. Relative interest rates and returns on global
investments
2. Expected exchange rate changes

3. Safe haven status of Canadian investments

4. Foreign central bank investments in Canada

Government Sector: Demand for
Funds

 Governments borrow heavily in the

markets for loanable funds
 $900 million starting in 2019
 In Canada
 National debt is expected to exceed $1
trillion each year beginning in 2020
 National debt (and interest payments on the
national debt) have to be financed in large part
by additional borrowing
Business: Demand for Most Funds

 Level of interest rates:

 When the cost of loanable funds is high (i.e.
interest rates are high), businesses finance
internally
 Expected future profitability vs. risk:
 The greater the number of profitable projects
available to businesses, the greater the
demand for loanable funds
 Expected economic growth
Effect on Interest Rates from a Shift in
the Supply Curve for Loanable Funds
Effect on Interest Rates from a Shift in
the Demand Curve for Loanable Funds
Bond Market and Interest Rate

 Bond supply curve slopes upward; and bond

demand curve slopes downward
Prices of Bonds, P Interest rate, i (%)
D S
(P increases ↑) D1 (Interest increases ↓)
$900 11.1%

P* =$850 i* = 17.6%

$800 25.0%

S1
Quantity of Bonds, B
Factors that Affect the Supply of
and Demand for Loanable Funds
for a Financial Security
Determinants of Interest Rates
for Individual Securities
ij* = f(IP, RFR, DRPj, LRPj, SCPj, MPj)
 First two factors are common to all
financial securities (i.e. risk-free interest
rate), while the others can be unique to
each individual security
 Inflation (IP): IP = [(CPIt+1 – CPIt)/CPIt] x 100
 Real interest rate (R) and Fisher effect:
R = i – Expected (IP)
Determinants of Interest Rates
for Individual Securities

 Default risk premium (DRP)

DRPj = ijt – iTt
ijt = interest rate on security issued by a non-
Treasury issuer (issuer j) of maturity m at time t
iTt = interest rate on security issued by the Treasury
of maturity m at time t
 Liquidity risk (LRP)
 Special provisions (SCP)
 Term to maturity (MP)
Default Risk Analysis of Interest
Rate
 Default risk: possibility of not collecting the
promised amount of interest and principal at
the agreed time
Bond Rating Security Equivalent Risk Default
(Moody’s) Yield Risk-free Rate* Premium Rate
Aaa 4.11% 3.39% 0.72% 0.60%
Aa 4.75% 3.39% 1.36% 1.50%
A 4.77% 3.39% 1.38% 2.91%
Baa 6.09% 3.39% 2.70% 10.29%

 Risk premium increases as default probability rises

*10-year Treasury-bond yield
Yield Curves
 A graphical representation of the relationship
between interest rates (yields) on particular
securities and their terms to maturity
YTM (1): upward sloping
(%) (2): mildly upward sloping
(3): flat

(4): Downward sloping

Term to maturity (years)

Term Structure Facts to be
Explained
 (1) Interest rates for different maturities move
together
 (2) Yield curves tend to have steep slope when
short-rates are low, and slope downward when
short rates are high
 (3) Yield curve is typically upward sloping
 Three theories of term structure
 (A) Pure expectations theory: (1) & (2) OK, not (3)
 (B) Market segmentation theory: (3) OK, not (1) & (2)
 (C) Liquidity preference theory combining (A) and (B):
(1), (2) and (3) OK
Pure (Unbiased) Expectations
Theory
 Key assumption: bonds of different maturities
are perfect substitutes
 Implication: expected returns on bonds of
different maturities are equal
 Investment strategies for two-period horizon:
 (1) Buy $1 of one-year bond and when it
matures buy another one-year bond
 (2) Buy $1 of two-year bond and hold it
A One-year Forward – Forward
Rate in One Year
Pure Expectations Theory
 Expected return from strategy 1: [(1+z1)(1+f2)]
 Expected return from strategy 2: [(1+z2)(1+z2)]
 From implication above, expected returns of two
strategies are equal, then (1+z2)(1+z2) = (1+z2)2 =
(1+z1)(1+f2) solving for (1+z2) = [(1+z1)(1+f2)]0.5
 Today’s one-year rate is 3.6% and expect the 1-year rate
to be 5.4% next year, you will not go for a 2-year security
unless it produces at least $1.09194 = $1×(1.036)(1.054)
 Investing $1 to get a future value of $1.09194 in two
years implies a yield of 4.496% = [(1.036)(1.054)]0.5 – 1
per year, which is the geometric average of 3.6% and
5.4%
Different Paths for a 3-year
Investment
Example
 Given: 1-year rate Z1 = 4%
2-year rate Z2 = 5% 3-year rate Z3 = 6%
 What is the expected forward rate two years
from today?
 Since (1 + 0.05)2 × (1 + f3) = (1 + 0.06)3 , then
solve for f3 giving [(1.06)3/(1.05)2] – 1 =
1.0803 – 1 = 0.0803
Market Segmentation Theory
 Key assumption: bonds of different maturities are not
substitutes at all
 Implication: markets are completely segmented. Interest
rate at each maturity determined separately
 People typically prefer short holding periods and thus have
higher demand for short-term bonds, which have higher
price and lower interest rates than long bonds
 Explains fact 3 that yield curve is usually upward sloping
 This theory does not explain fact 1 or fact 2 because it
assumes long and short rates are determined
independently
Market Segmentation Yield Curve
 The supply and demand for securities at a
particular maturity determine the yield for that
maturity.
Dl
yield

Sl
Sm Dm
Ss DS

Years to maturity
Liquidity Preference Theory
 Key assumption: bonds of different maturities
are substitutes, but are not perfect substitutes
 Implication: modifies pure expectations theory
with features of market segmentation theory
 Investors prefer short rather than long bonds →
must be paid a risk (liquidity) premium, LN, to
hold long-term bonds
 Results in following modification: long-term
interest rates will be averages of the expected
short-term rates plus a positive term premium
 (1+RNt)=[(1+R1t)(1+f2)(1+f3)… (1+N-1fN)]1/N + LN
PUET vs. LPT