Session 03-04

Determinants of Interest Rates

Sunny Kumar Singh

Assistant Professor,
K-212, Department of Economics & Finance,
BITS Pilani, Hyderabad Campus,
Phone: +91 - 40 66 303 698
Mobile: +91 - 8009976001
Email: sunny.singh@hyderabad.bits-pilani.ac.in

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Plan of the Presentation
_____________________________________________________________
Topic

 Interest Rates Fundamentals

 Loanable Fund Theory
 Determinants of Interest Rates for Individual Securities
 Term Structure of Interest Rates
 Forecasting Interest Rates
 Time Value of Money and Interest Rates

 Questions & Answers / Discussions?

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Importance of Interest Rate
 Economic decision of the household
 Economic decision of firms and businesses
 Overall performance of the economy

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Interest Rate: An Overview
 Different people mean different things by
“interest rate”: simple interest, yield to
maturity, rate of return, all different concepts.
 Yield to Maturity: Economist’s view of interest
rates
 Measuring Interest rates on different debt
instruments
 The Issue of inflation: Real versus nominal
interest rates
 Rate of return often does not equal the interest
rate
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 India Treasury Bill 91 Day Yield

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Key U.S. Interest Rates

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Loanable Fund Theory
 Loanable funds theory explains interest
rates and interest rate movements
 Views level of interest rates in financial
markets as a result of the supply and
demand for loanable funds
 Domestic and foreign households,
businesses, and governments all supply and
demand loanable funds

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Supply and Demand for Loanable Fund

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Loanable Fund Theory: Determining
Equilibrium Interest Rates

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Factors causing shift in Supply and
Demand for Loanable Funds

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Determinants of Interest Rates for
Individual Securities
 Inflation
 Real risk-free rate
 Default Risk
 Liquidity Risk
 Special Provisions (Taxability, Convertibility,
and Callability)
 Term to Maturity

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Determinants of Interest Rates for
Individual Securities: Inflation

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Determinants of Interest Rates for
Individual Securities

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Determinants of Interest Rates for
Individual Securities

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Determinants of Interest Rates for
Individual Securities: Default Risk

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Term Structure of Interest Rates: The
Yield Curve
 Securities with identical risk, liquidity, and tax
characteristics may have different interest
rates because the time remaining to maturity
is different.
 Yield curve: a plot of the yield on bonds with
differing terms to maturity but the same risk,
liquidity and tax considerations
 Upward-sloping: long-term rates are above
short-term rates
 Flat: short- and long-term rates are the same
 Inverted: long-term rates are below short-term rates
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Term Structure of Interest Rates: The
Yield Curve

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Term Structure of Interest Rates: The
Yield Curve

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Term Structure of Interest Rate: Yield
Curve

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Term Structure of Interest Rate: Yield
Curve

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Term Structure of Interest Rate: Yield
Curve

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Term Structure of Interest Rate

The theory of the term structure of interest

rates must explain the following facts:
1. Interest rates on bonds of different maturities
move together over time.
2. When short-term interest rates are low, yield
curves are more likely to have an upward
slope; when short-term rates are high, yield
curves are more likely to slope downward and
be inverted.
3. Yield curves almost always slope upward.

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Term Structure of Interest Rate

Three theories to explain the three facts:

1. Expectations theory explains the first two facts
but not the third.
2. Segmented markets theory explains the third
fact but not the first two.
3. Liquidity premium theory combines the two
theories to explain all three facts.

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Term Structure of Interest Rate

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Expectations Theory
 The interest rate on a long-term bond will
equal an average of the short-term interest
rates that people expect to occur over the life
of the long-term bond.
 Buyers of bonds do not prefer bonds of one
maturity over another; they will not hold
any quantity of a bond if its expected return
is less than that of another bond with a
different maturity.
 Bond holders consider bonds with different
maturities to be perfect substitutes.
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Expectations Theory

For an investment of $1
it = today's interest rate on a one-period bond
ite1 = interest rate on a one-period bond expected for next period
i2t = today's interest rate on the two-period bond

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Expectations Theory

Expected return over the two periods from investing $1 in the

two-period bond and holding it for the two periods
(1 + i2t )(1 + i2t )  1
 1  2i2t  (i2t ) 2  1
 2i2t  (i2t ) 2
Since (i2t ) 2 is very small
the expected return for holding the two-period bond for two periods is
2i2t

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Expectations Theory

If two one-period bonds are bought with the $1 investment

(1  it )(1  ite1 )  1
1  it  ite1  it (ite1 )  1
it  ite1  it (ite1 )
it (ite1 ) is extremely small
Simplifying we get
it  ite1

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Expectations Theory
Both bonds will be held only if the expected returns are equal
2i2t  it  ite1
it  ite1
i2t 
2
The two-period rate must equal the average of the two one-period rates
For bonds with longer maturities
it  ite1  ite 2  ...  ite ( n 1)
int 
n
The n-period interest rate equals the average of the one-period
interest rates expected to occur over the n-period life of the bond

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Expectations Theory

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Expectations Theory
 Expectations theory explains:
 Why the term structure of interest rates changes
at different times.
 Why interest rates on bonds with different
maturities move together over time (fact 1).
 Why yield curves tend to slope up when short-
term rates are low and slope down when short-
term rates are high (fact 2).
 Cannot explain why yield curves usually
slope upward (fact 3)

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Using Yield Curve to Explain
Expectations Theory

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Segmented Markets Theory
 Bonds of different maturities are not
substitutes at all.
 The interest rate for each bond with a
different maturity is determined by the
demand for and supply of that bond.
 Investors have preferences for bonds of one
maturity over another.
 If investors generally prefer bonds with
shorter maturities that have less interest-rate
risk, then this explains why yield curves
usually slope upward (fact 3).
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Liquidity Premium &
Preferred Habitat Theories
 The interest rate on a long-term bond will
equal an average of short-term interest
rates expected to occur over the life of the
long-term bond plus a liquidity premium
that responds to supply and demand
conditions for that bond.
 Bonds of different maturities are partial
(not perfect) substitutes.

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Liquidity Premium Theory

it  it1
e
 it2
e
 ... it(
e

int  n1)
 lnt
n
where lnt is the liquidity premium for the n-period bond at time t
lnt is always positive
Rises with the term to maturity

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Liquidity Premium Theory

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Preferred Habitat Theory
 Investors have a preference for bonds of
one maturity over another.
 They will be willing to buy bonds of
different maturities only if they earn a
somewhat higher expected return.
 Investors are likely to prefer short-term
bonds over longer-term bonds.

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The Relationship Between the Liquidity
Premium (Preferred Habitat) and
Expectations Theory

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Liquidity Premium &
Preferred Habitat Theories
 Interest rates on different maturity bonds
move together over time; explained by the
first term in the equation
 Yield curves tend to slope upward when short-
term rates are low and to be inverted when
short-term rates are high; explained by the
liquidity premium term in the first case and by
a low expected average in the second case
 Yield curves typically slope upward; explained
by a larger liquidity premium as the term to
maturity lengthens
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Liquidity Premium &
Preferred Habitat Theories

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Time Value of Money and Interest Rates
 Lump Sum Valuation
 Present Value of a Lump Sum
 Future Value of a Lump Sum
 Annuity Valuation
 Present Value of an Annuity
 Future Value of an Annuity
 Effective Annual Return

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Present Value of a Lump Sum

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Future Value of a Lump Sum

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Present Value of an Annuity

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Present Value of an Annuity

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Future Value of an Annuity

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Future Value of an Annuity

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Effective Annual Return
 If interest is paid or compounded more than
once per year, the true annual rate earned or
paid will differ from the simple annual rate.
 Effective or equivalent annual return (EAR) is
the return earned or paid over a 12-month
period taking compounding into account
EAR = (1 + r)c – 1
c = the number of compounding periods per
year

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Effective Annual Return
 Let’s say you’re deciding between two certificates of
deposit (CDs). Option A has a stated interest rate of
7%, compounded semi-annually. Option B has a stated
interest rate of 6.95%, compounded daily. Assume that
both CDs have terms of 10 years. (Note: These rates
and terms are not real and are only being used for this
example. Actual CD terms and rates may be much
shorter and lower.)
 At face value, you might assume Option A is better
because the interest rate is higher. But when you
calculate the EAR, you find out Option B earns more
interest:

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Plan for the Next Session

 Interest Rates and Security Valuation

 Read: Chapter 3, Saunders, Cornett and Erhemjamts

(2022)

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Dedication

When you share your wealth with others, your own wealth shrinks.
When you share your knowledge with others, your own knowledge increases.
~ Chanakyā

These slides are dedicated to you all. You are free

to use it and to distribute it to any student of
economics; but for heaven’s sake, though you all
are students of a business school, do not make
any business out of it!

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