1

DETERMINANTS OF
INTEREST RATES
CHAPTER 2
Time Value of Money (TVM) 2
and Interest Rates
 The TVM concept assumes that interest
earned over given period of time is
immediatelly reinvested: Compounded
 Suppose you invest P1000
 Simple interest:
 For 1 year at 12% interest rate;
Value in 1 year:
1000+1000x(0.12)= P1120
 For 2 years at 12% int. Rate;

Value in 2 years:
1000+1000x(0.12)+1000x(0.12)=P1240
 Compound Interest.
3
 Value in 1 year:
1000+1000x(0.12)= P1120
Value in 2 years:
1000+1000x(0.12)+1000x(0.12)+1000x(0.12)x(0.12)=P1254.4
 4
 Alternatively TVM can be used to convert the
value of Future cash flow into their Present
Values.
 Payments:
Lump-sum payment
Annuity
 5
 ForLump-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   1 
FVA  PMT  r 
 r 
 
FVA  PMT ( FVIFA r ,t )

 1 
1 
 (1  r ) t 
PVA  PMT  
 r 
 
PVA  PMT ( PVIFA r ,t )
Calculation of Present Value of a Lump
6
Sum

Formula:

PV = FV/(1 + r)t
Where: 7
PV=Present value of cash flow
FV=Future value of cash flows (Lump Sum)
received
in t period
r=Interest rate earned per period on an
investment (equals the nominal annual
interest rate, i, divided by the number of
compounding periods per year(e.g., daily,
weekly, quarterly, monthly, semi- annually)
 8
t= number of compounding periods
in the investment horizon (equals the number of

years in the investment horizon times the

number of compounding periods per year)
Example:
9
You have been offered a security investment such
as a bond that will pay you P10,000 at the end of six
years in exchange for a fixed payment today. If the
appropriate annual interest rate on the investment is
8% compounded annually, the present value of this
investment is computed as follows:
PV = FV/(1 + r)t
=P10,000/(1 + .08)6
=P10,000 (0.630170) (Table Factor)
=P6,301.70
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If the annual interest rate on the investment
rises to 12%, the present value of this
investment becomes:
PV=P10,000/(1 + .12)6
=P10,000 (0.506631) (Table Factor)
=P5,066.31
 11
If the annual interest rate on the investment
rises to 16%, the present value of this
investment becomes:
PV=P10,000/(1 + .16)6
=P10,000 (0.410442) (Table Factor)
=P4,104.42
 Finally, if the annual interest rate on the 12
investment of 16% is compounded semi-annually =
t=12 (6 x 2) total interest payments, each
calculated as r= 8% (16%/2) times the principal
value in the investment, where r in this case is the
semi-annual interest payment) rather than annually,
the present value of this investment becomes:
PV= P10,000/(1 + 0.08)12
=P10,000 (0.397114) (Table Factor)
=P3,971.14
Calculation of the Future Value of a Lump Sum
13
Example:
You plan to invest P10,000 today in exchange for a
fixed payment at the end of six years. If the
appropriate annual interest rate on the investment is
8% compounded annually, the future value of this
investment is computed as follows:
 FV=PV(1+r)t =P10,000(1+.08)6
=P10,000(1.586874) (Table Factor)
=P15,868.74
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If the annual interest rate on the investment
rises to 12%, the future value of this investment
becomes:
FV=P10,000 (1 + .12)6
=P10,000 (1.973823) (Table Factor)
=P19,738.23
 15
If the annual interest rate on the investment
rises to 16%, the future value of this investment
becomes:
FV =P10,000 (1 + .16)6
=P10,000 (2.436396) (Table Factor)
=P24,363.96
 Finally, if the annual interest rate on the 16
investment rises to 16% and is compounded semi-
annually rather annually (r=16%/2=8% and
t=6 x 2=12), the future value of this investment
becomes:
FV=P10,000 (1+8%)12
=P10,000 (2.518170) (Table Factor)
=P25,181.70
 17

 There is a negative relationship btw the interest

rates and Present Value.
 There is a positive relationship btw the interest
rates and Future Value
ANNUITY VALUATION
18
Present Value of an Annuity- the present value of an
annuity equation converts a finite series of constant
(or equal) cash flows received on the last day of equal
intervals throughout the investment horizon into an
equivalent (present) value as if they were received at
the beginning of the investment horizon. The time
value of money equation used to calculate this value is
represented as follows:
 Present value (PV) of an annuity stream (PMT)
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received in the future:
Formula:

Where:
P = Present Value of an Annuity Stream
PMT= Amount of each annuity Payment
r = Interest rate (also known as discount rate)
n = Number of periods in which payments will
be made
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21
Future Value of an Annuity 22

Future Value of an Annuity- the future value of

an annuity equation converts a series of equal
cash flows received at equals throughout the
investment horizon into an equivalent future
amount at the end of the investment horizon.
23
Effective Annual Return 24

 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)

EAR  (1  r ) c  1
 25
 Example: What is the EAR on the 16% simple
return compounded semiannually?
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 26

 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)
 27
Interest
Rate Supply

Demand

Q*
Quantity of Loanable Funds Demand and Supply
Factors that cause the supply and demand
curves for loanable funds shift 28

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 of Increases Decreases

foreign funds) increases
Factors Demand of Equilibrium
Funds Int. rate29

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
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Individual Securities

1) Inflation rate: As actual or expected inflation

rate increases, interest rate increases.
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
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 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, then 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
32
issuer will default on making its promised interest
and principal payments.
As default risk increases, interest rate increases
DRP (Default Risk Premiums) = ijt-iTt

Bond rating Agencies

 33

 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%
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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.
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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
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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 37

 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 38

 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)
 39
 Example: Suppose that the current 1-year rate
(spot rate), 1R1=1.94%.
 Expectedone-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;
 40
 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%
The current yield curve will be upward
sloping as shown: 41
 2. Liquidity Premium 42

Theory
 Itis 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.
 43
 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%,
 44
 Current rates for 1,2,3 and 4 year maturity
Treasury securities;
 R1=1.94%
1
 R =[(1+0.0194)(1+0.03+0.001)] 1/2
-1 = 2.52%
1 2
 R3=[(1+0.0194)(1+0.03+0.001)
1
(1+0.0374+0.002)]1/3-1=2.99%
 R4=[(1+0.0194)(1+0.03+0.001)(1+0.0374+0.002)
1
(1+0.041+0.003]1/4-1=3.34%
The current yield curve will be upward
sloping as shown: 45
 Market Segmentation Theory 46

 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 47

 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.
 To find an implied forward rate on a one-year security to be48
issued
one year from today the unbiased expectations theory equation can
be rewritten as follows:
1R2=[(1+ 1 R1)(1+ (2f1))]1/2 -1
Where:

f
2 1 = Expected one-year rate for year 2, or the implied forward one-year rate for
next year

Therefore, 2f1 is the market’s estimate of the expected one-year rate for year 2.
Solving for 2f1 , we get:
2f1=[(1+ 1 R2)2/(1+ 1R1)]-1
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 Example: The existing (current) one-year, two-
year, three-year and four-year zero coupon
Treasury security rates;
 1R1=4.32%, R2=4.31%, 1R3=4.29%, 1R4=4.34%
1
 Using 50on
the unbiased exp. theory, forward rates
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%
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