Interest Rate Fundamentals

•• Nominal
Nominal interest
interest rates
rates -- the
the interest
interest
rate
rate actually
actually observed
observed in in financial
financial
markets
markets
––directly
directly affect
affect the
the value
value (price)
(price) of
of most
most
securities
securities traded
traded inin the
the market
market
––affect
affect the
the value
value ofof assets
assets and
and liabilities
liabilities of
of
financial
financial institution
institution balance
balance sheets
sheets
 Loanable Funds Theory

•• AA theory
theory of
of interest
interest rate
rate determination
determination that that
views
views equilibrium
equilibrium interest
interest rates
rates in
in financial
financial
markets
markets asas aa result
result of
of the
the supply
supply andand demand
demand
for
for loanable
loanable funds
funds
 Supply of Loanable Funds

Demand Supply
Interest
Rate

Quantity of Loanable Funds

Supplied and Demanded
 Funds Supplied and Demanded by Various
Groups (in billions of Rs)

Funds
FundsSupplied
Supplied Funds
FundsDemanded
Demanded Net
Net

Households
Households Rs30,857.3
Rs30,857.3 Rs12,849.2
Rs12,849.2 Rs18,002.
Rs18,002
Business
Business--nonfinancial
nonfinancial 9,892.5
9,892.5 28,229.9
28,229.9 -18,337.4
-18,337.4
Business
Business--financial
financial 29,508.9
29,508.9 39,484.7
39,484.7 -9,975.8
-9,975.8
Government
Governmentunits
units 10,072.9
10,072.9 4,873.7
4,873.7 5,199.2
5,199.2
Foreign
Foreignparticipants
participants 8,193.8
8,193.8 3,081.9
3,081.9 5,111.9
5,111.9
 KIBOR

• 3 - Month 11.90%
• 6 - Month 11.99%
• 1-Year 12.25%
• 2 - Year 12.90%
• 5 - Year 13.47%
• 10 - Year 14.49%
• 30 - Year 15.28%
 Factors Affecting Nominal Interest
Rates
•• Inflation
Inflation
–– continual
continual increase
increase in
in price
price of
of goods/services
goods/services
•• Real
Real Interest
Interest Rate
Rate
–– nominal
nominal interest
interest rate
rate in
in the
the absence
absence of
of inflation
inflation
•• Default
Default Risk
Risk
–– risk
risk that
that issuer
issuer will
will fail
fail to
to make
make promised
promised payment
payment

(continued)
•• Liquidity
Liquidity Risk
Risk
–– risk
risk that
that aa security
security can
can not
not be
be sold
sold at
at aa
predictable
predictable price
price with
with low
low transaction
transaction cost
cost on
on
short
short notice
notice
•• Special
Special Provisions
Provisions
–– taxability
taxability
–– convertibility
convertibility
–– callability
callability
•• Time
Time to
to Maturity
Maturity
 Default Risk and Interest Rates

The
The risk
risk that
that aa security’s
security’s issuer
issuer will
will default
default
on
on that
that security
security by by being
being late
late on
on or
or missing
missing
an
an interest
interest or
or principal
principal payment
payment

DRP
DRPjj == iijtjt -- iiTtTt

Example:
Example: DRP
DRPAaa = 7.55% - 6.35% = 1.20%
Aaa = 7.55% - 6.35% = 1.20%
DRP
DRPBbb
Bbb
== 8.15%
8.15% -- 6.35%
6.35% =
= 1.80%
1.80%
 Tax Effects: The Tax Exemption of Interest
on Municipal Bonds
Interest
Interest payments
payments on on muncipal
muncipal securities
securities are
are exempt
exempt
from
from federal
federal taxes
taxes and
and possibly
possibly state
state and
and local
local
taxes.
taxes. Therefore,
Therefore, yields
yields on
on “munis”
“munis” are
are generally
generally
lower
lower than
than on
on equivalent
equivalent taxable
taxable bonds
bonds such
such as
as
corporate
corporate bonds.
bonds.

iimm == iicc(1
(1 -- ttss -- ttFF))
Where:
Where: iic == Interest
Interestrate
rateon
onaacorporate
corporatebond
bond
c
iim == Interest
Interestrate
rateon
onaamunicipal
municipalbond
bond
m
tts == State
Stateplus
pluslocal
localtax
taxrate
rate
s
ttF == Federal
Federaltax
taxrate
rate
F
 Term to Maturity and Interest Rates:
Yield Curve
(a) Upward sloping
Yield to (b) Inverted or downward
Maturity sloping
(c) Humped
(a) (d) Flat

(d)

(c)
(b)
Time to Maturity
 Term Structure of Interest Rates
•• Unbiased
Unbiased Expectations
Expectations Theory
Theory
–– atataagiven
givenpoint
pointin
intime,
time,the
theyield
yieldcurve
curvereflects
reflectsthe
the
market’s
market’scurrent
currentexpectations
expectationsofoffuture
futureshort-term
short-term
rates
rates
•• Liquidity
Liquidity Premium
Premium Theory
Theory
–– investors
investorswill
willonly
onlyhold
holdlong-term
long-termmaturities
maturitiesififthey
they
are
areoffered
offeredaapremium
premiumto tocompensate
compensatefor
forfuture
future
uncertainty
uncertaintyin
inaasecurity’s
security’svalue
value
•• Market
Market Segmentation
Segmentation Theory
Theory
–– investors
investorshave
havespecific
specificmaturity
maturitypreferences
preferencesand
andwill
will
demand
demandaahigher
highermaturity
maturitypremium
premium
 Forecasting Interest Rates

Forward
Forward raterate isis an
an expected
expected or or “implied”
“implied” rate
rate
on
on aa security
security that
that isis to
to be
be originated
originated at
at some
some
point
point in
in the
the future
future using
using thethe unbiased
unbiased
expectations
expectations theory
theory
__ __
R
R22 = [(1 + R11)(1 + (f22))]1/2 -- 11
= [(1 + R )(1 + (f ))] 1/2

where
where
ff22 == expected
expectedone-year
one-yearrate
ratefor
foryear
year2,
2,or
orthe
theimplied
implied
forward
forwardone-year
one-yearrate
ratefor
fornext
nextyear
year
 Various Interest Rate Measures
•• Coupon
Coupon rate:
rate: interest
interestrate
rateon
onaabond
bondused
usedto
tocalculate
calculatethe
the
annual
annualcash
cashflows
flowsthe
theissuer
issuerpromises
promisesto topay
paytotobond
bondholder
holder
•• Required
Required Rate Rate of of Return:
Return: interest
interestrate
ratean
aninvestor
investor
should
shouldreceive
receiveon onaasecurity
securitygiven
givenit’s
it’srisk
risk(used
(usedto tocalculate
calculate
the
thefair
fairpresent
presentvalue
valueononaasecurity)
security)
•• Expected
Expected rate rate of
of return:
return: interest
interestrate
ratean
aninvestor
investorwould
would
receive
receiveon onaasecurity
securityififthe
thesecurity
securityisisbought
boughtatatit’s
it’scurrent
current
market
marketprice,
price,receives
receivesall
allexpected
expectedpayments
paymentsand andsells
sellsatatthe
the
end
endofofthe
theinvestment
investmenthorizon
horizon
•• Realized
Realized Rate Rate ofof Return:
Return: actual
actualinterest
interestrate
rateearned
earnedon on
an
aninvestment
investment(ex (expost
postmeasure
measureof ofthe
theinterest
interestrate)
rate)
 Required Rate of Return

~~ ~~ ~~ ~~
FPV
FPV == CFCF11 ++ CF CF22 ++ CF CF33 ++… …++ CF CFnn
(1 + rrr) 11
(1 + rrr)
(1 + rrr) (1 + rrr)
22
(1 + rrr)
(1 + rrr)
33
(1 + rrr)
(1 + rrr)
nn

Where:
Where: rrr
rrr == Required
Requiredraterateof
ofreturn
return
CF
CF11 == Cash
Cashflow
flowprojected
projectedininperiod
periodtt(t(t==1,1,…,
…,n)n)
~~ == Indicates
Indicatesthat
thatprojected
projectedcash
cashflow
flowisisuncertain
uncertain
(due
(dueto
todefault
defaultand
andother
otherrisks)
risks)
nn == Number
Numberof ofperiods
periodsininthe
theinvestment
investmenthorizon
horizon
 Expected Rate of Return

~~ ~~ ~~ ~~
PP == CFCF11 ++ CF CF22 ++ CF CF33 ++… …++ CF CFnn
(1
(1++Err)
Err)1 (1
1
(1++Err)
Err)2 (1
2
(1++Err)
Err)3
3
(1
(1++Err)
Err)n
n

Where:
Where: Err
Err == Expected
Expectedrate
rateof
ofreturn
return
CF
CF11 == Cash
Cashflow
flowprojected
projectedininperiod
periodtt(t(t==1,1,…,
…,n)n)
~~ == Indicates
Indicatesthat
thatprojected
projectedcash
cashflow
flowisisuncertain
uncertain
(due
(dueto
todefault
defaultand
andother
otherrisks)
risks)
nn == Number
Numberof ofperiods
periodsin
inthe
theinvestment
investmenthorizon
horizon
 Realized Rate of Return

The
The actual
actual interest
interest rate
rate earned
earned on
on anan
investment
investment inin aa financial
financial security
security

PP == RCF
RCF11 ++ RCFRCF22 ++ …… ++ RCF
RCFnn
(1 + rr)
(1 + rr)
11
(1 + rr)
(1 + rr)
22
(1 + rr)
(1 + rr)
nn

Where:
Where: RCF
RCF == Realized
Realizedcash
cashflow
flowininperiod
periodtt(t(t==1,1,…,
…,n)
n)
rrrr == Realized
Realizedrate
rateof
ofreturn
returnon
onaasecurity
security
 Bond Valuation

•• The
The valuation
valuation of
of aa bond
bond instrument
instrument employs
employs
time
time value
value of
of money
money concepts
concepts
–– Reflects
Reflectspresent
presentvalue
valueofofall
allcash
cashflows
flowspromised
promisedoror
projected
projecteddiscounted
discountedatatthe
therequired
requiredraterateof
ofreturn
return(rrr)
(rrr)
–– Expected
Expectedrate
rateof
ofreturn
return(Err)
(Err)isisthe
theinterest
interestrate
ratethat
that
equates
equatesthe
thecurrent
currentmarket
marketprice
priceof ofthe
the bond
bondwith
withthe
the
present
presentvalue
valueofofall
allpromised
promisedcashcashflows
flowsreceived
receivedover
overthe
the
life
lifeof
ofthe
thebond
bond
–– Realized
Realizedrate
rateof
ofreturn
return(rr)
(rr)on
onaabond
bondisisthe
theactual
actualreturn
return
earned
earnedononaabond
bondinvestment
investmentthat
thathas
hasalready
alreadytaken
takenplace
place
Summary of Factors that Affect Security Prices and
Price Volatility when Interest Rates Change

•• Interest
InterestRate
Rate
–– negative
negativerelation
relationbetween
betweeninterest
interestrate
ratechanges
changesand
andpresent
presentvalue
value
changes
changes
–– increasing
increasinginterest
interestrates
rates== security
securityprice
pricedecrease
decreaseatataadecreasing
decreasing
rate
rate
•• Time
TimeRemaining
Remainingto
toMaturity
Maturity
–– shorter
shorterthe
thetime
timetotomaturity,
maturity,the
thecloser
closerthe
theprice
priceisistotothe
theface
facevalue
value
of
ofthe
thesecurity
security
–– longer
longertime
timetotomaturity
maturity == larger
largerprice
pricechange
changewhich
whichincreases
increasesatataa
decreasing
decreasingrate
rate
•• Coupon
CouponRate
Rate
–– the
thehigher
higherthe
thecoupon
couponrate,
rate,the
thesmaller
smallerthe
theprice
pricechange
changefor
foraagiven
given
change
changeinininterest
interestrates
rates
 Impact of Interest Rate Changes on
Security Values
Interest
Interest
Rate
Rate
12%

10%

8%

Bond
BondValue
Value
874.50 1,000 1,524.47
 Impact of a Bond’s Maturity
on its Interest Rate Sensitivity
Absolute
AbsoluteValue
Valueofof
Percent
PercentChange
Changein inaa
Bond’s
Bond’sPrice
Pricefor
foraa
Given
GivenChange
Changein in
Interest
InterestRates
Rates

Time to Maturity
 Impact of a Bond’s Coupon Rate
on Its Interest Rate Sensitivity
Interest
Interest
Rate
Rate
High-Coupon Bond

Low-Coupon Bond

Bond Value
 Duration: A Measure of
Interest Rate Sensitivity
The
The weighted-average
weighted-average time
time to
to maturity
maturity on
on an
an
investment
investment
NN NN


 CFt t  tt
CF 
 PVt t  tt
PV
t t==11
(1 + R)
(1 + R)
tt t t==11

D
D == NN == NN


 CF
CFt t 
 PV
PVt t
t t==11
(1 + R)
(1 + R)
tt t t==11
 Features of the Duration Measure

•• Duration
Duration and
and Coupon
Coupon Interest
Interest
–– the
the higher
higher the
the coupon
coupon payment,
payment, the
thelower
lower its
its
duration
duration
•• Duration
Duration and
and Yield
Yield to
to Maturity
Maturity
–– duration
duration decreases
decreases as
as yield
yield to
to maturity
maturity increases
increases
•• Duration
Duration and
and Maturity
Maturity
–– Duration
Duration increases
increases with
with the
the maturity
maturity of
of aa bond
bond but
but
at
at aa decreasing
decreasing rate
rate
 Economic Meaning of Duration

•• Measure
Measure of of the
the average
average life
life of
of aa bond
bond
•• Measure
Measure of of aa bond’s
bond’s interest
interest rate
rate
sensitivity
sensitivity (elasticity)
(elasticity)