LECTURE NOTES | 02 DETERMINATION OF INTEREST RATES | GRC

DETERMINATION OF INTEREST RATES

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.
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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.
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Loanable Funds Theory Exhibit 2.2 Relationship between Interest Rates and Business Demand (Db) for
▪ The Loanable Funds Theory suggests that the market interest rate is determined Loanable Funds at a Given Point in Time
by the factors that control supply of and demand for loanable funds.
▪ Can be used to explain:
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

Household Demand for Loanable Funds

▪ Households demand loanable funds to finance housing expenditures as well as
the purchase of automobiles and household items.
▪ Inverse relationship between the interest rate and the quantity of loanable funds
demanded (Exhibit 2.1)
▪ At any moment in time, households (in aggregate) demand a greater quantity of
loanable funds at lower rates of interest; in other words, they are willing to
borrow more money at lower interest rates.

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)

Exhibit 2.3 Impact of Increased Government Deficit on the Government

Demand for Loanable Funds

Business Demand for Loanable Funds

▪ Businesses need funds to invest in long-term assets. Business investment in new
projects should be greater when interest rates are low, as the cost of financing
potential projects should be low. Consequently, businesses will demand a
greater quantity of loanable funds at a given point in time if interest rates are
lower
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Foreign Demand for Loanable Funds
▪ A country’s demand for foreign funds depends on the interest rate differential Exhibit 2.5 Determination of the Aggregate Demand Curve for Loanable Funds
between the two.
▪ The greater the differential, the greater the demand for foreign funds.
▪ The quantity of U.S. loanable funds demanded by foreign governments will be
inversely related to U.S. interest rates. (Exhibit 2.4)

Exhibit 2.4 Impact of Increased Foreign Interest Rates on the Foreign Demand
for U.S. Loanable Funds

Aggregate Demand for Loanable Funds

▪ The sum of the quantities demanded by the separate sectors at any given interest
rate. (Exhibit 2.5)
▪ Because most of these sectors are likely to demand a larger quantity of funds at
lower interest rates (other things being equal), it follows that the aggregate
demand for loanable funds is inversely related to the prevailing interest rate. If
the demand schedule of any sector changes, the aggregate demand schedule will
also be affected.

Supply of Loanable Funds
The term “supply of loanable funds” is commonly used to refer to funds provided to
financial markets by savers.
▪ Suppliers of loanable funds are willing to supply more funds at a given point in
time if the interest rate (the reward for supplying funds) is higher, other things
being equal. This means that the supply-of-loanable-funds schedule (also called
the supply curve) is upward sloping.
▪ Households are largest supplier, but some supplied by government units.
o More supply at higher interest rates.
o Supply by buying securities.
▪ Aggregate supply of funds — Is the combination of all sector supply schedules
along with the supply of funds provided by the Fed’s monetary policy. (Exhibit
2.6)
▪ The steep slope of the aggregate supply curve in Exhibit 2.6 means that it is
interest-inelastic. The quantity of loanable funds demanded is normally
expected to be more elastic (more sensitive to interest rates) —than the quantity
of loanable funds supplied.
Exhibit 2.6 Aggregate Supply Curve for Loanable Funds
LECTURE NOTES | 02 DETERMINATION OF INTEREST RATES | GRC
Equilibrium Interest Rate – Algebraic Presentation
(similar logic applies in law of supply and demand)
The equilibrium interest rate is the rate that equates the aggregate demand for funds
(aggregate quantity of funds demanded) with the aggregate supply of loanable funds
If interest rates were extremely low at a given point in time, DA (aggregate demand)
would likely exceed SA (aggregate supply) because the low interest rate would be
appealing to borrowers, but not to savers. Conversely, if interest rates were very high
at a given point in time, DA would likely be less than SA because the high interest
rate would be appealing to savers, but not to borrowers.
At any given point in time, there should be an interest rate level that is equally
appealing to borrowers and savers in aggregate.
▪ Aggregate Demand for funds (DA)
DA = Dh + Db + Dg + Dm + Df
Dh = household demand for loanable funds
Db = business demand for loanable funds
Dg = federal government demand for loanable funds
Dm = municipal government demand for loanable funds
Df = foreign demand for loanable funds
▪ Aggregate Supply of funds (S A)
SA = Sh + Sb + Sg + Sm + Sf
Sh = household supply for loanable funds
Sb = business supply for loanable funds
Sg = federal government supply for loanable funds
Sm = municipal government supply for loanable funds
Sf = foreign supply for loanable funds
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.
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Equilibrium Interest Rate — Graphical Presentation
▪ Combining aggregate demand and aggregate supply curves (Exhibits 2.5 and
2.6) allows comparison of total amount demanded to total amount supplied
▪ At equilibrium interest rate i, the supply of loanable funds is equal to the demand
for loanable funds. (Exhibit 2.7)
▪ At interest rate above i, there is a surplus of loanable funds. (the greater the
interest income that will be earned, the more people would want to supply funds)
▪ At interest rate below i, there is a shortage of loanable funds.
▪ The short-age of funds will cause the interest rate to increase, resulting in two
reactions.
o First, more savers will enter the market to supply loanable funds
because the reward (interest rate) is now higher.
o Second, some potential borrowers will decide not to demand loan-able
funds at the higher interest rate.
o Once the interest rate rises to i, the quantity of loanable funds supplied
has increased and the quantity of loanable funds demanded has
decreased to the extent that a shortage no longer exists. Thus, an
equilibrium position is achieved once again.

Exhibit 2.7 Interest Rate Equilibrium

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Factors That Affect Interest Rates
Exhibit 2.8 Impact of Increased Expansion by Firms
Impact of economic growth on interest rates:
▪ Puts upward pressure on interest rates by shifting demand for loanable funds
outward. (Exhibits 2.8 & 2.9)
▪ When economic conditions become more favorable:
o businesses’ expected cash flows for their proposed projects will
increase. More of these projects will then have expected returns that
exceed a business’s particular required rate of return (the hurdle rate).
As additional projects become acceptable as a result of the more
favorable economic forecasts, demand for loanable funds will increase,
causing an outward shift (to the right) in the demand curve.
o The improvement in economic conditions may also affect the supply-
of-loanable-funds schedule, but it is difficult to know in which direction
it will shift.
▪ If the increased expansion by businesses leads to more income
for construction crews and other workers, the quantity of Exhibit 2.9 Impact of an Economic Slowdown
savings (loanable funds supplied) could increase regardless of
the interest rate, causing an outward shift in the supply
schedule.
▪ Conversely, the increased income may be used for 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.
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Impact of inflation on interest rates:
▪ Another factor that affects interest rates is the actual or expected inflation rate
in the economy.
▪ Specifically, the higher the level of actual or expected inflation, the higher will
be the level of interest rates.
▪ The intuition behind the positive relationship between interest rates and inflation
rates is that an investor who buys a financial asset must earn a higher interest
rate when inflation increases to compensate for the increased cost of forgoing
consumption of real goods and services today and buying these more highly
priced goods and services in the future (the higher the rate of inflation, the more
expensive the same basket of goods and services will be in the future.)
▪ Inflation puts upward pressure on interest rates by shifting supply of funds
inward and demand for funds outward. (Exhibit 2.10)
Real Interest Rates
A real interest rate is the interest rate that would exist on a security if no inflation
were expected over the holding period (e.g., a year) of a security. The real
interest rate on an investment is the percentage change in the buying power of a
dollar. As such, it measures society’s relative time preference for consuming
today rather than tomorrow. The higher society’s preference to 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.
▪ Fisher effect: i = E(INF) + iR
where i = nominal or quoted rate of interest
E(INF) = expected inflation rate
iR = real interest rate
The relationship among the real interest rate (iR), the expected rate of
inflation [Expected (INF)], described above, and the nominal interest rate
(i) is often referred to as the Fisher effect.
The Fisher effect theorizes that nominal interest rates observed in financial
markets (e.g., the one-year Treasury bill rate) must compensate investors
for
(1) any reduced purchasing power on funds lent (or principal lent)
due to inflationary price changes and
(2) an additional premium above the expected rate of inflation for
forgoing present consumption (which reflects the real interest
rate discussed above).
When an investor purchases a security that pays interest, the nominal
interest rate exceeds the real interest rate because of inflation.
Irving Fisher (research more about this interesting man) proposed that the
nominal interest rate (the interest rate quoted by a financial institution) on
savings must be sufficient to compensate savers in two ways.
▪ First, it must compensate for a saver’s reduced purchasing power
because of anticipated inflation over the period in which funds are
saved.
▪ Second, it must provide an additional premium to savers for
forgoing present consumption.
This relationship between interest rates and expected inflation is often
referred to as the Fisher effect. The difference between the nominal interest
rate and the expected inflation rate is referred to as the real interest rate
because it measures the rate of interest earned by a saver after adjusting for
the expected loss in purchasing power (due to expected inflation) over the
time period of concern.
Example: Calculations of Real Interest Rates
The one-year Treasury bill rate in 2007 averaged 4.53 percent and
inflation (measured by the consumer price index) for the year was 4.10
percent. If investors had expected the same inflation rate as that actually
realized (i.e., 4.10 percent), then according to the Fisher effect the real
interest rate for 2007 was:
4.53%4.10 % 0.43%
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,
that is, the real interest rate was actually negative.
Keep in mind, however, that because of the Fisher effect, high interest
rates will not necessarily result in a higher real rate of interest.
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Exhibit 2.10 Impact of an Increase in Inflationary Expectations on Interest out” the private demand (by consumers and corporations) for funds. The
Rates 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

Impact of Monetary Policy on Interest Rates

When the Fed (BSP) reduces (increases) the money supply, it reduces
(increases) the supply of loanable funds, putting upward (downward)
pressure on interest rates.

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)

Impact of the Budget Deficit on Interest Rates

Impact of Foreign Flows of Funds on Interest Rates
▪ A higher government deficit increases the quantity of loanable funds Interest rate for a certain currency is determined by the demand for funds in
demanded at any prevailing interest rate, which represents an outward shift
that currency and the supply of funds available in that currency. (Exhibit
in the demand curve. Assuming that all other factors are held constant, 2.13) The interest rate of one currency typically differs from the interest
interest rates will rise in such a scenario. rates of other currencies.
▪ Given a finite amount of loanable funds supplied to the market (through
savings), excessive government demand for these funds tends to “crowd
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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
Financial Security
*A “direct” impact on equilibrium interest rates means that as the “factor”
increases (decreases) the equilibrium interest rate increases (decreases). An
“inverse” impact means that as the factor increases (decreases) the equilibrium
interest rate decreases (increases).

Factors Affecting Nominal Interest Rates (to be discussed in detail in the next
succeeding topics)
▪ Inflation —the continual increase in the price level of a basket of goods and
services.
▪ Real Interest Rate —nominal interest rate that would exist on a security if no
inflation were expected.
▪ Default Risk —risk that a security issuer will default on the security by missing
an interest or principal payment.
▪ Liquidity Risk —risk that a security cannot be sold at a predictable price with
low transaction costs at short notice.
▪ Special Provisions —provisions (e.g., taxability, convertibility, and callability)
that impact the security holder beneficially or adversely and as such are reflected
in the interest rates on securities that contain such provisions.
▪ Term to Maturity —length of time a security has until maturity.
(inflation and real interest rate is discussed above)
Default or Credit Risk
− Default risk is the risk that a security issuer will default on making its promised
interest and principal payments to the buyer of a security.
− The higher the default risk, the higher the interest rate that will be demanded by
the buyer of the security to compensate him or her for this default (or credit) risk
exposure.
o Treasury securities are regarded as having no default risk since they are
issued by the government, and the probability of the government
defaulting on its debt payments is practically zero given its taxation
powers and its ability to print currency.
− default or credit risk premium- yhe difference between a quoted interest rate
on a security (security j ) and a Treasury security with similar maturity, liquidity,
tax, and other features (such as callability or convertibility)
DRPj = 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 government of maturity
m at time t
LECTURE NOTES | 02 DETERMINATION OF INTEREST RATES | GRC
Liquidity Risk
− A highly liquid asset is one that can be sold at a predictable price with low
transaction costs and thus can be converted into its full market value at short
notice. The interest rate on a security reflects its relative liquidity, with highly
liquid assets carrying the lowest interest rates (all other characteristics remaining
the same). Likewise, if a security is illiquid, investors add a liquidity risk
premium (LRP) to the interest rate on the security.
− A different type of liquidity risk premium may also exist if investors dislike
long-term securities because their prices (present values) are more sensitive to
interest rate changes than short-term securities. In this case, a higher liquidity
risk premium may be added to a security with a longer maturity simply because
of its greater exposure to price risk (loss of capital value) on a security as interest
rates change.
Special Provisions or Covenants
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
securities. Some of these special provisions include the security’s taxability,
convertibility and callability.
− For example, for investors, interest payments on municipal securities are
free of federal, state, and local taxes. Thus, the interest rate demanded by a
municipal bond holder is smaller than that on a comparable taxable bond—
for example, a Treasury bond, which is taxable at the federal level but not
at the state or local (city) levels, or a corporate bond, whose interest
payments are taxable at the state and local levels as well as federal levels.
− In general, special provisions that provide benefits to the security holder
(e.g., tax-free status and convertibility) are associated with lower interest
rates, and special provisions that provide benefits to the security issuer (e.g.,
callability, by which an issuer has the option to retire—call—a security prior
to maturity at a preset price) are associated with higher interest rates.
Term to Maturity
− The term structure of interest rates compares the interest rates on
securities, assuming that all characteristics (i.e., default risk, liquidity risk)
except maturity are the same. The change in required interest rates as the
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.
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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.
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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)

▪ Future Demand for Loanable Funds depends on future:

o Foreign demand for U.S. funds
o Household demand for funds
o Business demand for funds
o Government demand for funds

▪ Future Supply of Loanable Funds depends on:

o Future supply by households and others
o Future foreign supply of loanable funds in the U.S.

If the forecasted level of ND is positive or negative, then a disequilibrium will exist

temporarily. If ND is positive, the disequilibrium will be corrected by an upward
adjust-ment in interest rates; if ND is negative, the disequilibrium will be corrected
by a down-ward adjustment. The larger the forecasted magnitude of ND, the larger
the adjustment in interest rates will be
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Self-Assessment
1. Know who the main suppliers of loanable funds are.
2. Know who the main demanders of loanable funds are.
3. Understand how equilibrium interest rates are determined.
4. Examine factors that cause the supply and demand curves for loanable funds to
shift.
5. Examine how interest rates change over time.
6. Know what specific factors determine interest rates.
7. Examine the different theories explaining the term structure of interest rates.
8. Understand how forward rates of interest can be derived from the term
structure of interest rates.
9. Understand how interest rates are used to determine present and future values.