DETERMINANTS OF INTEREST RATE

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PROF. AMRUTA R. GAIKAR

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Nominal Interest Rate

Nominal Interest Rates are determined by:
v

Real rate f interest Expected Inflation Maturity Risk Default Risk Liquidity Risk

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Real Interest Rate

Compensates for the lenders lost opportunity to consume. The minimum rate Im willing to accept in this market (over and above inflation) that convinces me to invest rather than spend my money. The real rate of interest, by definition, would be risk free . In this market, risk free can drive the real rate of interest to zero.

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Expected Inflation

Inflation erodes the purchasing power of money.

Example: If you loan someone $1,000 and they pay it back one year later with 10% interest, you will have $1,100. But if prices have increased by 5%, then something that would have cost $1,000 at the outset of the loan will now cost $1,000(1.05) = $1,050.

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Nominal Risk-Free Rate

The real rate of interest, plus The inflation risk premium

Example: The T-Bill Current Yield: 2.125% So, if inflation rate is 1.80%, then Real Rate of return is 2.125 1.80 or .325%

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Maturity Risk

If interest rates rise, lenders may find that their loans are earning rates that are lower than what they could get on new loans.

The risk of this occurring is higher for longer maturity loans.

Lenders will demand a premium to cover this risk depending on if they think long term rates will go up or down.

10 years Treasury Note yielding 2.84% (0.7% premium over T-Bill rate)

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Default Risk

For most securities, there is some risk that the borrower will not repay the interest and/or principal on time, or at all. The greater the chance of default, the greater the interest rate the investor demands and the issuer must pay. (risk/return trade-off) Example: Junk bonds have a high risk of default and requires a high default risk premium. Current yield 12.20%

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Liquidity Risk

Investments that are easy to sell without losing value are more liquid. Illiquid securities have a higher interest rate premium to compensate the lender for the inconvenience of not being able to sell the bond easily. Mortgage backed securities became illiquid! market collapse! Cause of

Term Structure of Interest Rate

The relationship between maturity and yield.

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The Yield Curve is the plot of current interest yields versus time to maturity. Unbiased expectation theory

Forward rate calculations Forward rate = Expected short rates Different maturities are perfect substitutes

Expectation Theory

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The Expectation theory hypothesises that investors expectation alone shape the yield curve. This theory assumes that the yield on a longterm bond is an average of the short-term yields that are expected to prevail over the life of the long-term bond. Its validity rests on the assumption that investors are indifferent to any variation in risks associated with different maturities. They consider long term and short-term bonds to be perfect substitutes for one another, and, therefore, move freely from one maturity to another always looking for highest expected return.

This implies that when all investors expect the rates to i) rise, the yield curve would slope upward ii) remain unchanged, the yield would be horizontal or iii) fall, the yield curve would slope downward.

Liquidity Preference Theory

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Lenders prefer short-term securities over long term securities, unless the yield on the longer-term securities are high enough to compensate for the greater interest rate risk.

Risk is related to variability of return or dispersion of market value. So interest rate risk increases with term to maturity of a bond. The long-term bonds have more interest rate risk than short term bonds because of their long duration and because their interest elasticity is larger. As a result, the prices of long-term bonds fluctuate more than the prices of short-term bonds. The large price fluctuations are the basis of liquidity premium hypothesis.

Thus, generally, lenders are averse to long-term securities (because of the higher risk involved), and borrowers are averse to short-term securities. These aversions on the part of lenders and borrowers influence the term structure of interest rates. However, the term

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Market Segmentation Theory

According to market segmentation theory, interest rates for various maturities are determined by demand and supply conditions in the relevant segments of the market. Investors are not indifferent to difference in maturities. Instead they have definite maturity preferences, which are based largely on the nature of their business.

Uses of Term Structure

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Forecast interest rates

The market provides a consensus forecast of expected future interest rates theory dominates the shape of the yield curve

Expectations

Forecast recessions
Flat

or inverted yield curves have been a good predictor of recessions.

Investment and financing decisions

Lenders/borrowers

attempt to time investment/financing based on expectations shown by the yield curve

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Monetary Policy

Monetary policy is the set of actions a government takes usually through some form of a central bank that influences the economy. A government has several options at its disposal and most concentrate on establishing short-term interest rates intended to expand or contract the economy, depending on the latest inflation concerns. By influencing the demand for currency through interest rates, the central bank attempts to maintain a favorable environment for economic growth as well as the preservation of value for the currency.

Role played by Central Bank

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Direct purchase of foreign currency the central bank buys foreign currency and holds it in reserve to be sold at a time when it wants to decrease the supply of its own currency. Foreign currency is a common security for central banks to hold as it can easily be converted back to native currency. Reverse Operations or Repos Repos are contracts for the temporary lending of money and are traded on the Repo market. Repos are an agreement between the buyer and seller with a fixed maturity (usually one week or one month).

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Factors affecting Market Interest Rate

There are many interest rates in the market and they do not always move in the same direction or to the same extent. Therefore, it is sometimes useful to select one rate to represent the short-term market. It is commonly believed that four factors are dominant in determining interest rate levels.

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These are: 1) 2)

Economic Condition Monetary Policy

Bank rate Open market operations Cash Reserve Ratio Supply of Money

Money Supply

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The money supply is controlled by the Fed through: Open-market operations Changing the reserve requirements Changing the discount rate

Thus the quantity of money supplied does not depend on the

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Money Demand

Money demand is determined by several factors. According to the theory of liquidity preference, one of the most important factors is the interest rate. People choose to hold money because money can be used to buy other goods and services. The opportunity cost of holding money is the interest that could be earned on interest-earning assets.

Equilibrium in the Money Market

According to the theory of liquidity preference:

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The interest rate adjusts to balance the supply and demand for money.

There is one interest rate, called the equilibrium interest rate, at which the quantity of money demanded equals the quantity of money supplied.

Harcourt, Inc. items and derived items copyright 2001 by Harcourt, Inc.

Equilibrium in the Money Market...

Intere st Ra te Mon supp ey ly

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r Equilibrium 1
interest rate

r 2
0
d 1

Quantity by fixedthe

d 2

Mon dema ey nd Quantity of Mon

Measures of Money Supply

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