DETERMINANTS OF

INTEREST RATES
CHAPTER 2
 Time Value of Money (TVM) and
Interest Rates
• The TVM concept assumes that interest earned
over given period of time is immediatelly
reinvested: Compounded
• Suppose you invest $ 1000
• Simple interest:
– For 1 year at 12% interest rate;
Value in 1 year:
1000+1000x(0.12)= $1120
– For 2 years at 12% int. Rate;
Value in 2 years:
1000+1000x(0.12)+1000x(0.12)=$1240
• Compound Interest.
– Value in 1 year:
1000+1000x(0.12)= $1120
Value in 2 years:
1000+1000x(0.12)+1000x(0.12)+1000x(0.12)x
(0.12)=$1254.4
• Alternatively TVM can be used to convert
the value of Future cash flow into their
Present Values.
• Payments:
– Lump-sum payment
– Annuity
• For Lump-sum FV  PV (1  r ) t
FV  PV ( FVIFr ,t )
payments;
PV  FV /(1  r ) t
PV  FV ( PVIFr ,t )

 (1  r ) t 
• For Annuities  r
 1 
FVA  PMT  
 r 

 

FVA  PMT ( FVIFA r ,t )

 1 
 1  
(1  r ) t
PVA  PMT  
 r 

 

PVA  PMT ( PVIFA r ,t )
• There is a negative relationship between
the interest rates and Present Value.
• There is a positive relationship between
the interest rates and Future Value
 Effective Annual Return
• The annual interest rate used in the TVM
equations are the simple (nominal or 12
month) interest rate.
• However if the interest is paid and
compounded more than once a year, the true
annual rate will be the effective (equivalent)
annual rate (EAR = Effective Annual Rate)

EAR  (1  r )  1
c
• Example: What is the EAR on the 16%
simple return compounded semiannully?
• r =0.16/2=0.08
• EAR=(1+0.08)2 -1 = 0.01664 =16.64%
• What if it is compounded quarterly?
• r =0.16/4=0.04
• EAR=(1+0.04)4 -1 = 0.01698 =16.98%
 Loanable Funds Theory
• It is the theory of interest rates determination
that views equilibrium interest rates in financial
markets as a result of supply and demand for
loanable funds
• The supply of loanable funds: Net supplier of
funds (households)
• The demand of loanable funds: Net demanders
of funds (corporations and government)
Interest
Rate Supply

Demand

Q*
Quantity of Loanable Funds Demand and Supply
 Factors that cause the supply and
demand curves for loanable funds shift
Factors Supply of Equilibrium
Funds Int. rate
Wealth increases Increases Decreases

Risk decreases Increases Decreases

Near-term spending needs Increases Decreases

decreases
Monetary expansion increases Increases Decreases

Economic conditions (The flow Increases Decreases

of foreign funds) increases
Factors Demand of Equilibrium
Funds Int. rate

Utility derived from assets Increases Increases

purchased with borrowed
funds increases
The lack of restrictiveness Increases Increases
of non-price conditions
(fees, collateral and etc.)
on borrowed funds.

Economic conditions Increases Increases

(economic growth)
Determinants of Interest Rates for Individual
Securities

1) Inflation rate: As actual or expected

inflation rate increases, interest rate
increases.
• Inflation ( IP) = CPI t+1 –CPI t / CPIt x 100%
• 2)The real interest rates: It is the rate on a
security if no inflation is expected over the
holding period
• Fisher Effect;
• i = Expected (IP) + RIR
• we can rearrange the nominal interest rate equation to show the
determinants of the real interest rate as follows:

• RIR = I – Expected (IP)

Keterangan rumus:

i = Interest
Expected (IP) = Expected rate of
Inflation

RIR = Real Interest Rate

• Example: One year T-bill rate in 2012 was
4.53% and inflation for the year was
2.80%. If investors expected the same
inflation rate, the according to the Fisher
effect the real interest rate for 2012;
4.53%-2.80% = 1.73%
• If one-year T-bill rate was 1.89% while the
inflation rate was 3.30%. The real rate;
1.89%-3.30% = -1.41 %
3) Default (Credit) Risk: It is the risk that a
security issuer will default on making its
promised interest and principal payments.
As default risk increases, interest rate
increases
DRP (Default Risk Premiums) = ijt-iTt

where

ijt interest rate on a security issued by a non-Treasury issuer (issuer j ) of maturity m at time t

iTt interest rate on a security issued by the U.S. Treasury of maturity m at time t
• Example: 10-year Treasury interest rate
was 4.70%
Aaa rated corporate debt interest rate was
5.58%
Baa rated corporate debt interest rate was
6.70%
Average DRP:
DRPAaa= 5.58%-4.70% = 0.88%
DRPBaa=6.70%-4.70% = 2%
4) Liquidity Risk: If a security is illiquid, the
investors add liquidity risk premium (LRP)
to the interest rate on the security.
5) Special Provisions and Covenants: Such
as taxability, convertability and collability
affect the interest rates.
As special provisions that provide benefits
to the security holder increases, interest
rate decreases.
6) Term to Maturity: Term structure of
interest rates (yield curve)
Maturuiy premium (MP) is the difference
between the long and short-term securities
of the same characteristics except
maturity.
• Yield curve: Relationship btw YTM and
time to maturity.
• Yields may rise with maturity (up-ward
sloping yield curve: the most common
yield curve)
Yields may fall with maturity(Inverted or
downward sloping yield curve)
Flat yield curve: Yields are unaffected by
the time to maturity

İJ=f(IP,RIR,DRPJ, LRPJ, SCPJ, MPJ)

Term Structure of Interest Rates
• Explanations for the shape of the yield
curve fall into 3 theories
1) Unbiased Expectations Theory
2) Liquidity Preferences Theory
3) Market Segmentation Theory
 1. Unbiased Expectations Theory
• According to this theory, yield curve reflects the
market’ s current expectations of future S-T
rates.
• Suppose an investor has a 4-year investment
horizon
– Buy a 4-year bond and earn current yield on this
bond, 1R4
– Invest in 4 sucessive one-year bonds. You know the
1-year spot rate but form expectations on the future
rates on 1-year bond for 3 years, 1R1, E(2r1), E(3r1),
E(4r1)
• Example: Suppose that the current 1-year
rate (spot rate), 1R1=1.94%.
• Expected one-year T-Bond rates over the
following 3 years are;
E(2r1)=3%, E(3r1)=3.74%, E(4r1)=4.10%
• Using the unbiased exp. theory current
rates for two, three and four year maturity
T-Bonds should be;
• 1R2=[(1+0.0194)(1+0.03)]1/2-1=2.47%

• 1R3=[(1+0.0194)(1+0.03)(1+0.0374)]1/3-
1=2.89%

• 1R4=[(1+0.0194)(1+0.03)(1+0.0374)
(1+0.041]1/4-1=3.19%
 2. Liquidity Premium Theory
• It is based on the idea that investors will
hold L-T maturities only if they are offered
at a premium to compensate for future
uncertainity with security’s value.
• It states that L-T rates are equal to
geometric average of current and
expected S-T rates and liquidity risk
premium.
• Example: Suppose that the current 1-year
rate (spot rate), 1R1=1.94%.
Expected one-year T-Bond rates over the
following 3 years are;
E(2r1)=3%, E(3r1)=3.74%, E(4r1)=4.10%
In addition, investors charge a liquidity
premium such that;
L2=0.10%, L3=0.20%, L4=0.30%,
• Current rates for 1,2,3 and 4 year maturity
Treasury securities;
• 1R1=1.94%
• 1R2=[(1+0.0194)(1+0.03+0.001)]1/2-1 = 2.52%
• 1R3=[(1+0.0194)(1+0.03+0.001)
(1+0.0374+0.002)]1/3-1=2.99%
• 1R4=[(1+0.0194)(1+0.03+0.001)
(1+0.0374+0.002)(1+0.041+0.003]1/4-
1=3.34%
 Market Segmentation Theory
• Individual investors and FIs have spesific
maturity preferences, and to get them to hold
maturities other than their prefered requires a
higher interest rate (maturity premium).
• For exp banks might prefer to hold S-T T-Bonds
because S-T nature of their deposits. Insurance
companies might prefer to hold L-T T-Bonds
because L-T nature of their liabilities (such as
life insurance policies)
 Forecasting Interest Rates
• Upward sloping yield curve suggests that the
market expects future S-T interest rate to
increase. So that this theory can be used to
forecast interest rates.
• “Forward rate” is the expected or implied rate on
a S-T security. The market’s expectations of
forward rates can be derived directly from
existing or actual rates on securities currently
traded in the spot market.
• 1R2=[(1+ 1R1)(1+ 2f1)]1/2-1

• 2f1=[(1+ 1R2)2/(1+ 1R1)]-1

• Example: The existing (current) one-year,
two-year, three-year and four-year zero
coupon Treasury security rates;
• 1R1=4.32%, 1R2=4.31%, 1R3=4.29%,
1R4=4.34%
• Using the unbiased exp. theory, forward
rates on zero coupon T-Bonds for years 2,
3 and 4 are;
• 2f1=[(1.0431)2/(1.0432)1]-1=4.30%
• 3f1=[(1.0429)3/(1.0431)2]-1=4.25%
• 4f1=[(1.0434)4/(1.0429)3]-1=4.49%