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Fin Mar

The document discusses credit risk and interest rates. It explains that credit risk is the risk of a borrower defaulting, and interest rates are set to compensate lenders for this risk. It then outlines two economic theories that drive interest rates: the loanable funds theory and liquidity preference theory. Finally, it discusses two additional theories that affect term structure - the expectations theory and market segmentation theory. The expectations theory considers pure expectations of future rates as well as liquidity and preferred habitat theories, while market segmentation theory focuses on savings and investment flows.

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Koleen Mae Lindayen
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282 views2 pages

Fin Mar

The document discusses credit risk and interest rates. It explains that credit risk is the risk of a borrower defaulting, and interest rates are set to compensate lenders for this risk. It then outlines two economic theories that drive interest rates: the loanable funds theory and liquidity preference theory. Finally, it discusses two additional theories that affect term structure - the expectations theory and market segmentation theory. The expectations theory considers pure expectations of future rates as well as liquidity and preferred habitat theories, while market segmentation theory focuses on savings and investment flows.

Uploaded by

Koleen Mae Lindayen
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOC, PDF, TXT or read online on Scribd
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WRITTEN REPORT

CREDIT RISK AND INTEREST RATES

Credit risk is one type of business risk. This is the risk that the borrower was not able to repay its
obligation. Such risk is valuated as a factor to determine the cost of lending or financing using debt. It
also affects the valuation of accounts receivable.

Interest are set to compensate the risk of allowing the finances to flow into the financial system. For
lenders, interest rate is called as lending rate or return. For the borrowers, these will serve as cost of
debt.

THEORIES RELATED IN SETTING INTEREST RATES

According to Fabozzi and Drake, there are two economic theories that drives the interest rates and
these are loanable funds theory and liquidity preference theory.

Loanable funds theory was introduced by Knut Wicksell in 1900s and it assumes that it is ideal to supply
funds when the interest are high and vice versa.

Liquidity preference theory was introduced by John Maynard Keynes, says that the interest rates are
dependent on the preference of the household whether they hold or use it for investment.

There are two economic theories that affect the term structure of interest rate, the expectations theory
and market segmentation theory.

Expectation theory is that the interest rates are driven by the expectation of the lender or borrowers in
the risks of the market in the future. It may be a pure expectation theory or biased expectation theory.

 Pure expectation theory is based on the current data and statistical analysis to project the
behavior of the market in the future.
 Biased expectation theory includes that there are other factors that affect the term structure of
the loans as weel as the interest to be perceived moving forward.
o Liquidity theory states that liquidity premium increases as the maturity lengthens.
o Preferred habitat theory considers the liquidity and the risk premium but disregarding the
consensus of the market on the future interest rates.

Market segmentation theory assumes that the driver of the interest rates are the savings and
investment flows. It is the same with preferred habitat theory however it does not assume that any of
the players are willing to shift sector should opportunity to arise for the asset or liabilities to be retired or
lenders to offer higher rates.

POWERPOINT
1st Slide: Credit Risk and Interest Rate

2nd: Credit Risk

3rd: Interest

4th: Theories related in setting interest rates

5th:

A. Two economic theories that drives the interest rates

6th:

1. loanable funds theory


2. liquidity preference theory

7th:

B. Two economic theories that affect the term structure of interest rate

8th:

1. Expectations Theory
a) Pure expectations theory
b) Biased expectations theory
i. Liquidity Theory
ii. Preferred habitat theory

9th:

2. Market Segmentation Theory

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