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Chapter 2-text Summary - book "Financial Markets and

Institutions"
Fin Inst & Mkts (Clemson University)

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Chapter 2: Determinants of Interest Rates

 Nominal Interest Rates: interest rates actually observed in financial markets

o Directly affect the value of most securities traded in the money and capital
markets, both home and abroad
o Changes in interest rates influence the performance and decision making for
individual investors, businesses and governmental units alike
 Loanable Funds Theory
o Definition of 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
o Interest rates play a major part in the determination of the value of financial
instruments
o The loanable funds theory views the level of interest rates as resulting from
factors that affect the supply and demand for loanable funds
o Suppliers choose between consumption and saving (vacation now or later)
 Interest rate Savings
 1% Dream vacation (saved $1,0000)
 5% Medium vacation (save $5000)
 10% No vacation (save $10,000)
o It categorizes financial market participants (consumers, businesses,
governments and foreign participants) as net suppliers or demanders of
funds
o The quantity of loanable funds supplied increases as interest rates rise
o Factors held constant, more funds are supplied as interest rates increase
o Household sector is the largest supplier of loanable funds in the US
o Households supply funds when they have excess income or wan to reallocate
their asset portfolio holdings
o Households determine their supply of loanable funds not only on the basis of
general level of interest rates and their total wealth, but also on the risk of
securities investments
o The greater perceived risk, the less households are willing to invest
o Also depends on their immediate spending needs
 Ex: medical/educational fees reduce supply of funds
o Higher interest rates will also result in higher supplies of funds from the U.S.
business sector
o Governments sometimes supply loanable funds
 Ex: during financial crisis, Federal government lent out funds to
businesses and consumers to rescue economy
o Foreign investors increasingly view US financial markets as alternatives to
their domestic financial markets
 When interest rates are high, foreign investors increase their supply
of funds to US markets
 Higher foreign households are major suppliers (add graph)

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 Demand for Loanable Funds

o Demand for loanable funds: used to describe the total net demand for funds
by fund users
o Quantity of loanable demands funds is higher as interests rates fall
o More funds are demanded as interest rates decrease
o Non-financial businesses
o Interest rate cheap, borrow more
o Ex: Retailer- TJ Maxx
o Interest Rate Investment
 1% $10,000 revamp product line
 5% $5,0000 slightly revamp products
 10% $1,0000 only required maintenance
o businesses demand funds to finance investments in long-term assets and for
short-term working capital needs
o governments also borrow heavily in the markets for loanable funds

 Equilibrium Interest Rate

o Quantity of funds supplied is positively related to interest rates, which
quantity of funds demanded is inversely related to interest rates
o E is the equilibrium rate for financial security

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o If rate of interest is set higher than E, the financial system has surplus of
loanable funds, as a result some suppliers of funds will lower the interest
rate at which they are willing to lend and the demanders of funds will absorb
the loanable funds surplus
 Factors that cause the Supply Curve to Shift
1. Wealth
 As households and businesses become elathyier, the adboslute dollar
value available for investment purposes increases
 The supply of loanable funds increases, or the supply curve shifts
down and to the right
2. Risk
 As risk decreases, it becomes more attractive to suppliers of funds
 Conversely^
3. Near-Term Spending Needs
 When people have few things they need to spend money on, the
absolute dollar value of funds available to invest increases
 Holding all other factors constant, increase supply of funds by
decreasing the equilibrium interest rate and increasing the
equilibrium quantity of funds traded
 Conversely ^
4. Monetary Policy
 Monetary expansion: the Federal Reserve puts money into the
economy, quantity goes up and interest rate goes down
 Monetary contraction: the Federal Reserve takes money out of the
economy, quantity goes down and interest rates go up
5. Economic Conditions
 If economic conditions improve supply curve shift causes equilibrium
quantity to increase and interest rate to decrease (see graph)
 If economic conditions deteriorate supply curve shift causes
equilibrium quantity to decrease and interest rate to increase (see
graph)
 Factors that cause the Demand Curve to Shift
1. Utility Derived from Assets Purchased with borrowed funds
a. As the utility (pleasure) or buying increases, people are more likely to
borrow, the value of dollar increases
i. Ex: Car—moving from Arizona to Minnesota pg. 34
2. Economic Conditions
a. If economic conditions improve, quantity increases and interest rate
increases
b. If economic conditions deteriorate, quantity decreases and interest rate
decreases
3. Restrictiveness of Non-Price Conditions

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a. When restrictions decrease, willingness to borrow increases

 Ex: Down payment, collateral, loan to value, financial ratios- cash/assets,
debt/assets
o When a business gets a long, lender may say they have to keep a
certain cash/asset on them
 Loosened non-price conditions (shifts demand curve up)
o Quantity increase, rate increase
 Tighten non-price conditions (quantity decrease, rate decrease)
o Ex: post 2008 crisis
o Last 3 or 4 years it has been loosening
4. Economic Conditions
a. Growth in economy, willingness to borrow increases
b. State and local governments are more likely to repair and improve decaying
infrastructure when the local economy is strong
 Shift in both supply and demand curves

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Determinants of Interest Rates for Individual Securities

 Inflation: the continual increase in the price level of a basket of goods and services.
o The higher the level of inflation, the higher will be the level of interest rates
o Increase in inflation, increase in interest rate
 Real Risk Free Rate: interest rate that would exist on a risk-free security if no inflation
were expected (also called real interest rate)
o The real risk free rate on an investment is the percentage change in the buying
power of a dollar
o The higher society’s reference to consumer today, the higher the real risk free
rate will be
o Risk free security and no inflation measures relative time preference for
consuming now vs. later
o Risk Free rate goes up, interest rate goes up (people don’t value the future that
much. The more the people want things now, the more interest rate goes up)
o Fisher Effect
 Theorizes that the nominal interest rates observed in financial market
must compensate investors for any reduced punishing power on funds
due to inflationary price changes and an additional premium above the
expected rate of inflation for forgoing present consumption
 Default of Credit Risk: risk that a security issuer will default on a security
o If credit risk increase, interest rate increases
 Liquidity Risk: risk that a security cannot be sold at a predictable price with low
transaction costs at short notice.
 Liquidity rate increases, interest rate increases
 Greater liquidity (lower liquidity risk) lower interest rate
 Term to maturity: length of time a security has until maturity
 Term to maturity increases, interest rate increases
 Special Provisions or Covenants: provisions that impact the security holder beneficially
or adversely and as such are reflected in the interest rates on securities that contain
such provisions
 Taxability
o Example: interest payments on municipal securities are free of certain taxes
o Favors investors, interest rate decreases
 Convertibility
o Can convert from bond to stock
o Example: security holder can convert a bond into 10 shares of stock
o Favors the bond holder (investor), interest rate decreases
 Callability
o Example: issuer has option to retire bond prior to maturity at a pre-set price
o Favors issuer, interest rate increase

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