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02 Determination of Interest Rates - GRC
02 Determination of Interest Rates - GRC
Chapter Objectives
▪ Apply the loanable funds theory to explain why interest rates change.
▪ Identify the most relevant factors that affect interest rate movements.
▪ Explain how to forecast interest rates
Definition of Terms
▪ nominal interest rates- the interest rates actually observed in financial
markets.
▪ loanable funds theory- a theory of interest rate determination that views
equilibrium interest rates in financial markets as a result of the supply and
demand for loanable funds.
▪ inflation- the continual increase in the price level of a basket of goods and
services.
▪ real interest rate- the interest rate that would exist on a default free security if
no inflation were expected.
▪ default risk-the risk that a security issuer will default on that security by being
late on or missing an interest or principal payment.
▪ liquidity risk- the risk that a security can be sold at a predictable price with
low transaction costs on short notice.
▪ term structure of interest rates- a comparison of market yields on securities,
assuming all characteristics except maturity are the same.
▪ forward rate- an expected rate (quoted today) on a security that originates at
some point in the future.
▪ compound interest- interest earned on an investment is reinvested.
▪ simple interest- interest earned on an investment is not reinvested.
▪ lump sum payment- a single cash flow occurs at the beginning and end of the
investment horizon with no other cash flows exchanged.
▪ annuity- a series of equal cash flows received at fixed intervals over the
investment horizon
▪ effective or equivalent annual return - rate earned over a 12-month period
taking the compounding of interest into account.
LECTURE NOTES | 02 DETERMINATION OF INTEREST RATES | GRC
INTEREST RATE FUNDAMENTALS
An interest rate reflects the rate of return that a creditor receives when lending
money, or the rate that a borrower pays when borrowing money. Because interest
rates change over time, so does the rate earned by the creditors who provide loans
and the rate paid by the borrowers who obtain loans.
Interest rate movements have a direct influence on the market values of debt
securities, such as money market securities, bonds, and mortgages. They also have
an indirect influence on equity security values because they can affect economic
conditions, and therefore influence the cash inflows to corporations.
▪ Since interest rates represent the cost of borrowing, they directly affect
corporate cash outflow payments on debt.
▪ Interest rate movements also affect the value of most financial institutions.
They influence the cost of funds to depository institutions and the interest
received on some loans by financial institutions.
▪ Since financial institutions commonly invest in securities, the market value
of their investment portfolios is affected by interest rate movements.
▪ Managers of financial institutions attempt to anticipate interest rate
movements and commonly restructure their assets and liabilities to
capitalize on their expectations.
▪ Individuals also attempt to anticipate interest rate movements so that they
can estimate the potential cost of borrowing or the potential return from
investing in various debt securities.
Nominal interest rates are the interest rates actually observed in financial markets.
These nominal interest rates (or just interest rates) directly affect the value (price)
of most securities traded in the money and capital markets, both at home and
abroad.
LECTURE NOTES | 02 DETERMINATION OF INTEREST RATES | GRC
Loanable Funds Theory demand a greater quantity of loanable funds at a given point in time if interest
▪ The Loanable Funds Theory suggests that the market interest rate is rates are lower
determined by the factors that control supply of and demand for loanable
funds. Exhibit 2.2 Relationship between Interest Rates and Business Demand (Db)
▪ Can be used to explain: for Loanable Funds at a Given Point in Time
o Movements in the general level of interest rates in a particular country
o Why interest rates among debt securities of a given country vary
Exhibit 2.1 Relationship between Interest Rates and Household Demand (Dh)
for Loanable Funds at a Given Point in Time
Government Demand for Loanable Funds
▪ Governments demand loanable funds when planned expenditures are not
covered by incoming revenues.
▪ Government and its agencies issue Treasury securities and federal agency
securities. These securities constitute government debt.
▪ Government demand is said to be interest inelastic — insensitive to interest
rates. Expenditures and tax policies are independent of the level of interest
rates. (Exhibit 2.3)
In many cases, both supply and demand for loanable funds are changing. Given an
initial equilibrium situation, the equilibrium interest rate should rise when DA>SA.
and fall when DA<SA.
LECTURE NOTES | 02 DETERMINATION OF INTEREST RATES | GRC
Equilibrium Interest Rate — Graphical Presentation Factors That Affect Interest Rates
▪ Combining aggregate demand and aggregate supply curves (Exhibits 2.5 and
2.6) allows comparison of total amount demanded to total amount supplied Impact of economic growth on interest rates:
▪ At equilibrium interest rate i, the supply of loanable funds is equal to the ▪ Puts upward pressure on interest rates by shifting demand for loanable funds
demand for loanable funds. (Exhibit 2.7) outward. (Exhibits 2.8 & 2.9)
▪ At interest rate above i, there is a surplus of loanable funds. (the greater the ▪ When economic conditions become more favorable:
interest income that will be earned, the more people would want to supply o businesses’ expected cash flows for their proposed projects will
funds) increase. More of these projects will then have expected returns that
▪ At interest rate below i, there is a shortage of loanable funds. exceed a business’s particular required rate of return (the hurdle rate).
▪ The short-age of funds will cause the interest rate to increase, resulting in two As additional projects become acceptable as a result of the more
reactions. favorable economic forecasts, demand for loanable funds will
o First, more savers will enter the market to supply loanable funds increase, causing an outward shift (to the right) in the demand curve.
because the reward (interest rate) is now higher. o The improvement in economic conditions may also affect the supply-
o Second, some potential borrowers will decide not to demand loan-able of-loanable-funds schedule, but it is difficult to know in which
funds at the higher interest rate. direction it will shift.
o Once the interest rate rises to i, the quantity of loanable funds supplied ▪ If the increased expansion by businesses leads to more income
has increased and the quantity of loanable funds demanded has for construction crews and other workers, the quantity of
decreased to the extent that a shortage no longer exists. Thus, an savings (loanable funds supplied) could increase regardless of
equilibrium position is achieved once again. the interest rate, causing an outward shift in the supply
schedule.
▪ Conversely, the increased income may be used for
Exhibit 2.7 Interest Rate Equilibrium consumption rather than savings.
▪ Thus, there is no assurance that the volume of savings will
actually increase. Even if such a shift in the supply-of-
loanable-funds schedule does occur, it will likely be of smaller
magnitude than the shift in the demand schedule. Overall, the
expected impact of the increased expansion by businesses is
an outward shift in the demand curve but no obvious change
in the supply schedule.
▪ Just as economic growth puts upward pressure on interest rates, an economic
slowdown puts downward pressure on the equilibrium interest rate.
LECTURE NOTES | 02 DETERMINATION OF INTEREST RATES | GRC
Real Interest Rates This relationship between interest rates and expected inflation is often
A real interest rate is the interest rate that would exist on a security if no referred to as the Fisher effect. The difference between the nominal
inflation were expected over the holding period (e.g., a year) of a security. The interest rate and the expected inflation rate is referred to as the real interest
real interest rate on an investment is the percentage change in the buying rate because it measures the rate of interest earned by a saver after
power of a dollar. As such, it measures society’s relative time preference for adjusting for the expected loss in purchasing power (due to expected
consuming today rather than tomorrow. The higher society’s preference to inflation) over the time period of concern.
consume today (i.e., the higher its time value of money or rate of time
preference), the higher the real interest rate (RIR) will be. Example: Calculations of Real Interest Rates
The one-year Treasury bill rate in 2007 averaged 4.53 percent and
▪ Fisher effect: i = E(INF) + iR inflation (measured by the consumer price index) for the year was 4.10
where i = nominal or quoted rate of interest percent. If investors had expected the same inflation rate as that actually
E(INF) = expected inflation rate realized (i.e., 4.10 percent), then according to the Fisher effect the real
iR = real interest rate interest rate for 2007 was:
The relationship among the real interest rate (iR), the expected rate of 4.53%4.10 % 0.43%
inflation [Expected (INF)], described above, and the nominal interest rate
(i) is often referred to as the Fisher effect. The one-year T-bill rate in 2009 was 0.47 percent, while the CPI for the
year was 2.70 percent. This implies a real interest rate of −2.23 percent,
The Fisher effect theorizes that nominal interest rates observed in financial that is, the real interest rate was actually negative.
markets (e.g., the one-year Treasury bill rate) must compensate investors
for
(1) any reduced purchasing power on funds lent (or principal lent) Keep in mind, however, that because of the Fisher effect, high interest
due to inflationary price changes and rates will not necessarily result in a higher real rate of interest.
LECTURE NOTES | 02 DETERMINATION OF INTEREST RATES | GRC
in the demand curve. Assuming that all other factors are held constant,
interest rates will rise in such a scenario.
▪ Given a finite amount of loanable funds supplied to the market (through
Exhibit 2.10 Impact of an Increase in Inflationary Expectations on Interest savings), excessive government demand for these funds tends to “crowd
Rates out” the private demand (by consumers and corporations) for funds. The
federal government may be willing to pay whatever is necessary to borrow
these funds, but the private sector may not. This impact is known as the
crowding-out effect
▪ Crowding-out Effect: Given a certain amount of loanable funds supplied
to the market, excessive government demand for funds tends to “crowd
out” the private demand for funds. (Exhibit 2.12)
Exhibit 2.12 Flow of Funds between the Federal Government and the Private
Sector
When economic conditions are weak, the Fed (BSP) may believe that it
can stimulate the economy by reducing interest rates, which may
encourage businesses and households to borrow more funds (at the
appealing lower interest rate).
To do so, the Fed increases the money supply in the banking
system. The increase in the supply of loanable funds (represented
as an outward shift in the supply curve) places downward pressure
on interest rates. (this strategy was used to help solve the 2008
crisis)
Exhibit 2.13 Demand and Supply Curves for Loanable Funds Denominated in
U.S. Dollars and Brazilian Real
Factors That Affect the Supply of and Demand for Loanable Funds for a *A “direct” impact on equilibrium interest rates means that as the “factor”
Financial Security increases (decreases) the equilibrium interest rate increases (decreases). An
“inverse” impact means that as the factor increases (decreases) the equilibrium
interest rate decreases (increases).
LECTURE NOTES | 02 DETERMINATION OF INTEREST RATES | GRC
Factors Affecting Nominal Interest Rates (to be discussed in detail in the next Liquidity Risk
succeeding topics) − A highly liquid asset is one that can be sold at a predictable price with low
▪ Inflation —the continual increase in the price level of a basket of goods and transaction costs and thus can be converted into its full market value at short
services. notice. The interest rate on a security reflects its relative liquidity, with highly
▪ Real Interest Rate —nominal interest rate that would exist on a security if no liquid assets carrying the lowest interest rates (all other characteristics
inflation were expected. remaining the same). Likewise, if a security is illiquid, investors add a
▪ Default Risk —risk that a security issuer will default on the security by liquidity risk premium (LRP) to the interest rate on the security.
missing an interest or principal payment. − A different type of liquidity risk premium may also exist if investors dislike
▪ Liquidity Risk —risk that a security cannot be sold at a predictable price with long-term securities because their prices (present values) are more sensitive to
low transaction costs at short notice. interest rate changes than short-term securities. In this case, a higher liquidity
▪ Special Provisions —provisions (e.g., taxability, convertibility, and callability) risk premium may be added to a security with a longer maturity simply
that impact the security holder beneficially or adversely and as such are because of its greater exposure to price risk (loss of capital value) on a security
reflected in the interest rates on securities that contain such provisions. as interest rates change.
▪ Term to Maturity —length of time a security has until maturity.
Special Provisions or Covenants
(inflation and real interest rate is discussed above) Numerous special provisions or covenants that may be written into the contracts
underlying the issuance of a security also affect the interest rates on different
Default or Credit Risk securities. Some of these special provisions include the security’s taxability,
− Default risk is the risk that a security issuer will default on making its convertibility and callability.
promised interest and principal payments to the buyer of a security. − For example, for investors, interest payments on municipal securities are
− The higher the default risk, the higher the interest rate that will be demanded free of federal, state, and local taxes. Thus, the interest rate demanded by a
by the buyer of the security to compensate him or her for this default (or municipal bond holder is smaller than that on a comparable taxable bond
credit) risk exposure. —for example, a Treasury bond, which is taxable at the federal level but
o Treasury securities are regarded as having no default risk since they not at the state or local (city) levels, or a corporate bond, whose interest
are issued by the government, and the probability of the government payments are taxable at the state and local levels as well as federal levels.
defaulting on its debt payments is practically zero given its taxation − In general, special provisions that provide benefits to the security holder
powers and its ability to print currency. (e.g., tax-free status and convertibility) are associated with lower interest
− default or credit risk premium- yhe difference between a quoted interest rate rates, and special provisions that provide benefits to the security issuer
on a security (security j ) and a Treasury security with similar maturity, (e.g., callability, by which an issuer has the option to retire—call—a
liquidity, tax, and other features (such as callability or convertibility) security prior to maturity at a preset price) are associated with higher
interest rates.
DRPj = ijt - iTt
where Term to Maturity
ijt = interest rate on a security issued by a non-Treasury issuer − The term structure of interest rates compares the interest rates on
(issuer j) of maturity m at time t securities, assuming that all characteristics (i.e., default risk, liquidity risk)
iTt = interest rate on a security issued by the government of except maturity are the same. The change in required interest rates as the
maturity m at time t maturity of a security changes is called the maturity premium (MP). The
MP, or the difference between the required yield on long- and short-term
securities of the same characteristics except maturity can be positive,
negative, or zero.
LECTURE NOTES | 02 DETERMINATION OF INTEREST RATES | GRC
Putting the factors that impact interest rates in different markets together, we
can use the following general equation to determine the factors that
functionally impact the fair interest rate (i) j on an individual (jth) financial
security:
ij = f (IP , RIR , DRPj , LRPj , SCPj ,MPj)
where
IP- Inflation premium
RIR- Real interest rate
DRPj- Default risk premium on the jth security
LRPj- Liquidity risk premium on the jth security
SCPj- Special feature premium on the jth security
MPj- Maturity premium on the jth security
The first two factors, IP and RIR, are common to all financial securities, while
the other factors can be unique to each security.
LECTURE NOTES | 02 DETERMINATION OF INTEREST RATES | GRC
Forecasting Interest Rates (Exhibit 2.14)
▪ Net Demand (ND) should be forecast:
Exhibit 2.14 Framework for Forecasting Interest Rates
ND = DA − SA
ND = (Dh + Db + Dm + Dr) − (Sh + Sb + Sm + Sf)