DETERMINANTS OF INTEREST RATES (Revilla & Sanchez)

A. Time Value of Money and Interest Rates

Interest Rates

 The interest rate is the amount charged on top of the principal by a lender to a
borrower for the use of assets.
 Interest rates apply to most lending or borrowing transactions. The borrowed
money is repaid either in a lump sum by a pre-determined date or in periodic
installments.

As we all know, the money to be repaid is usually more than the borrowed
amount since lenders require compensation for the loss of use of the money
during the loan period. So yung increase doon sa original amount ng loan is
what we called the interest charged.

Time Value of Money

 The time value of money (TVM) is the idea that money available at the present
time is worth more than the same amount in the future due to its potential earning
capacity.

This is because a dollar received today can be invested and it’s value enhanced
by an interest rate or return such that an investor receives more than a dollar in
the future. The concept of Time value of money provides that contractual
agreements to receive cash (or to pay cash) in the future will earn (or incur)
interest due to passage of time.

 This core principle of finance holds that, provided money can earn interest, any
amount of money is worth more the sooner it is received.

Significance of Time Value of Money

In Investment Decision

Small businesses often have limited resources to invest in business operations,

activities and expansion. One of the factors we have to look at is how to invest, is the
time value of money.

In Capital Budgeting Decisions

When a business chooses to invest money in a project, it may be years before that
project begins producing a positive cash flow. The business needs to know whether
those future cash flows are worth the upfront.
Two types of Interest Rates:

Simple Interest- It is the interest that is calculated only on the original amount
(principal), and thus, no compounding of interest takes place.

Compound Interest- It is the interest on a loan or deposit calculated based on both the
initial principal and the accumulated interest from previous periods.

Under simple interest, interest is earned only on the principal while under the compound
interest, interest is earned on both principal and the interest

TERMS RELATED TO TIME VALUE OF MONEY:

Present Value- Is a series of future payment or future value discounted at a rate of

interest up to the current date to reflect the time value of money.

The present value answers the question “How much do I have to deposit today to
receive a a certain amount in the future?

Formula:

Sample Problem

You would like to have $3,000 in 2 years so that you can move into a new apartment
when you graduate. How much must you deposit today if you think you can earn an
interest rate of 7% per year?

Future Value- Is the amount that is calculated by increasing present value or series of
payment at the given rate of interest.

The future value answers the question: “If I deposit 100,000 today in the bank (or in
some other investment), how much will it be worth in the future?

Formula:
Sue now has P125. How much would she have after 8 years if she leaves it invested at
8.5% with annual compounding?

FV = C x [(1+i)^n]

= 125 x [(1+8.5%)^8]

= 240.08

Ordinary Annuity- An ordinary annuity is a series of equal payments made at the end
of consecutive periods over a fixed length of time.

Formulas:

Present Value (Ordinary Annuity)

What is the PV of an ordinary annuity with 10 payments of P2,700 if the appropriate

interest rate is 5.5%?

PV of OA = 2700 x [ 1-(1+5.5%)^-10]
5.5%

= 20,352

Future Value (Ordinary Annuity)

You want to go to Europe 5 years from now, and you can save P3,100 per year,
beginning one year from today. You plan to deposit the funds in a mutual fund that you
think will return 8.5% per year. Under these conditions, how much would you have just
after you make the 5th deposit, 5 years from now?

FV of OA = 3100 x [(1+8.5%)^5 - 1]
8.5%

= 18, 369

Annuity Due - it is an annuity whose payment is due immediately at the beginning of

each period.
Formulas:

Present Value (Annuity Due)

You have a chance to buy an annuity that pays P5,000 at the beginning of each year for
5 years. You could earn 4.5% on your money in other investments with equal risk.
What is the most you should pay for the annuity?

PV of AD = 5000 x [1-(1+4.5%)^-5] x (1+4.5%)

4.5%

= 22,938

Future Value (Annuity Due)

You want to quit your job and return to school for an MBA degree 3 years from now, and
you plan to save P7,000 per year, beginning immediately. You will make 3 deposits in
an account that pays 5.2% interest. Under these assumptions, how much will you have
3 years from today?

FV of AD = 7000 x [(1+5.2%)^3 -1] x (1+5.2%)

5.2%

= 23,261

DIFFERENT PERSPECTIVES AND COMPUTATIONS IN RELATION TO TIME VALUE

OF MONEY

The Rule of 72 (Discovered by Albert Einstein)

The Rule of 72 is a quick, useful formula that is popularly used to estimate the number
of years required to double the invested money at a given annual rate of return.)

the unit does not necessarily have to be invested or loaned money. The Rule of
72 could apply to anything that grows at a compounded rate, such as population,
macroeconomic numbers, charges or loans. (i.e. GDP growth)
Formula: 72 / (periodic interest rate) = number of years to double principal
The Rule of 70 and 69

In some instances, the rule of 72 or the rule of 69 is used. The function is the same as
the rule of 70 but uses the number 72 or 69, respectively, in place of 70 in the
calculations. While the rule of 69 is often considered more accurate when
addressing continuous compounding processes, 72 may be more accurate for less
frequent compounding intervals. Often, the rule of 70 is used because it's easier to
remember.

The Rule of 114 and 144

Rule of 114 can be used to determine how long it will take an investment to triple and
the rule of 144 is used to determine how long will it take for an investment to quadruple.

Formulas:

114 / (periodic interest rate) = number of years to triple principal

144 / (periodic interest rate) = # of years to quadruple principal

The 10, 5, 3 Rule

This is the expected long-term return from equities, bonds and cash. It can be combined
with the rule of 72 so you can see how long it takes for each asset class to
approximately double in value.

Pay Yourself First Rule

Paying yourself first has been called “the golden rule of personal finance.” Before you
do anything else with your paycheck like paying bills, buying groceries, or shopping you
allocate a percentage of it to a specified savings or investment account.

One common mistake is that people wait and only save what’s left and that is paying
yourself last. Basically, paying yourself first means you’re making preparations for your
future finances like emergency fund, retirement fund and much more as a part of your
regular financial routine.

The Emergency Fund Rule

An emergency fund is a separate savings or bank account used to cover or offset the
expense of an unforeseen situation, the rule of thumb is to set aside at least three to six
months’ worth of expenses.

Important Lesson – Investing does not necessarily mean big amount, it can also be
done in small amounts just like what Maam Van told us the last time about the 10 pesos
per day savings that could grow 3,650 in a year then that’s the time na you will lend it sa
bank.
APPLICATION OF INTEREST RATES (TVM)
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Mutual Funds – is a type of financial vehicle made up of a pool of money collected from
many investors to invest in securities like stocks, bonds, money market instruments,
and other assets.
Stock Fund – a type of mutual fund that focuses on the investment of stocks.
Balanced Funds - Balanced funds are mutual funds that invest money across asset
classes, including a mix of low- to medium-risk stocks, bonds, and other securities.
Bond Fund – type of mutual fund that focuses on the investment of bonds.
Money Market Fund – a type of mutual fund that invests in highly liquid, near-term
instruments. These instruments include cash, cash equivalent securities, and high-
credit-rating, debt-based securities with a short-term maturity
Feeder Fund – a feeder fund is a type of investment fund that invests its capital into a
larger master fund similar to an overarching umbrella fund.
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B. Loanable Funds Theory

Loanable Funds Theory

This theory states that the rate of interest is determined by demand for loans
(investments) and supply of loanable funds (savings) in the economy at that level in
which supply and demand are equated.
 ● The supply for loanable funds comes from the people and organizations such as
government and businesses that have decided not to spend some of their money
but instead save it for investment purposes.

The supply of loanable funds represents the behavior of all of the savers in an
economy. The higher interest rate that a saver can earn, the more likely they are
to save money. As such, the supply of loanable funds shows that the quantity of
savings available will increase as the interest rate increases.

● The demand for loanable funds comes from the people who desire to finance
investment through borrowing.

The demand for loanable funds represents the behavior of borrowers and the
quantity of loans demanded. The lower the interest rate, the less expensive it is
to borrow.

The equilibrium in the market for loanable funds is achieved when the quantities of
loans that borrowers want are the same as the quantity of savings that savers provide.
The interest rate adjusts to make these equal.

C. Movements of Interest Rates

The Loanable Funds Market follows the general rule of Demand and Supply:

 The increase in supply (savings) will lower the interest rates if the demand
remains unchanged.

This is so that the lenders can attract more borrowers to invest because of lower
interest rate.. Kasi nga, the lower the interest rate, the less expensive it is to
borrow.

 On the other hand, the increase in demand will also tend to increase the interest
rates if the supply remains unchanged.

so that the number of borrowers will be lessen due to higher interest rates for
borrowings and also , As the interest rate rises, consumers will reduce the
quantity that they borrow. Kasi nga, The market price for interest rates will reach
equilibrium and stabilize where supply of loanable funds equals the demand for
them.
 D. Determinants of Interest Rates for Individual Securities

Inflation Rates

 It is the continual increase in the price level of a basket of goods and services.
 As actual or expected inflation rate increases, interest rate increases.

The intuition behind the positive relationship between interest rates and inflation
rates is that an investor who buys a financial asset demands a higher interest
rate when inflation increases to compensate for the increased cost of forgoing
consumption of real goods and services today and buying these more highly
priced goods and services in the future.

Real Risk-Free Rate

 It is the rate on a security if no inflation is expected over the holding period

If consumers have a high preference to consume and invest today, the real interest rate
is also high because people tend to spend their money for current good rather than in
the future.

The Fisher Effect

The Fisher Effect is an economic theory created by economist Irving Fisher that
describes the relationship between inflation and both real and nominal interest rates.

Formula: i = Expected (IP) + RIR

Default Risk

 This premium reflects the possibility that the issuer will not pay the promised
interest at the stated time.
 As default risk increases, interest rate increases.

 DRP (Default Risk Premiums) = ijt-iTt

Where:

ijt = interest rate on a security issued by an non- Treasury issuer (Issuer j) of

maturity m at time t.

iTt = interest rate on a security issued by the US Treasury of maturity m at time t

Liquidity Risk
  This is the risk that a security cannot be sold at a predictable price with low
transaction costs at short notice.
 Liquidity Risk occurs when an individual investor, business, or financial institution
cannot meet its short-term debt obligations.
 The liquidity premium is added to return on investment (ROI) on securities that
are not liquid.

In the US, liquid markets exist for most government securities and the stocks and some
bonds issued by large corporations. Many bonds, however, do not trade on a regular
basis or on organized exchanges such as the NYSE. As a result, if investors wish to sell
these bonds quickly, they may get a lower price than they could have received if they
had waited to sell the bonds.

Term to Maturity

 It is the length of time a security has until maturity.

 It is term structure of interest rates compares interest rates on securities,
assuming that all characteristics (i,e. default risk, liquidity risk) except maturity
are the same.
 The change in the required interest rates as the maturity of a security changes is
called the maturity premium (MP).

 İJ=f(IP, RIR, DRPJ, LRPJ, SCPJ, MPJ)

Where:
IP= Inflation Premium
RIR= Real Risk-Free Rate
DRPJ= Default Risk Premium in the jth security
LRPJ= Liquidity Risk Premium on the jth security
SCPJ = Special feature premium on the jth security
MPJ = Maturity Premium on the jth security

E. Term Structure of Interest Rates

Unbiased Expectations Theory

• According to this theory, yield curve reflects the market’ s current expectations of
future S-T rates.
 What expectation theory really attempts to do is to predict what short-term
interest rates will be in the future based on current long-term interest rates and
what this theory suggest is that (suppose an investor has a 4-year horizon).. if we
have two investors, one who invests in a single 4-year bond and one who invests
in four consecutive one-year bonds, their return will be equal.. So in other words
according to this theory investors have two choices, they can purchase a current
bond and if they hold it to maturity they can earn the current of spot yield every
year until maturity or they can can purchase a series of one-year bonds .. thing
here is the only rate that is known is the current yield or the spot yield but they
can expect or predict to know what the unknown yields will be in the future..

Liquidity Preference Theory

 It is based on the idea that investors will hold Long-Term maturities only if they
are offered at a premium to compensate for future uncertainty with security’s
value.
 It states that L-T rates are equal to geometric average of current and expected S-
T rates and liquidity risk premium.

Based on the title Liquidity Preference, investors prefer to hold liquid securities or short-
term securities because of its greater marketability and it has lesser price risk (because
of smaller price fluctuations for a given change in interest). Investors prefer to hold this
kind of securities because they can be converted into cash with little risk of a capital
loss.
Market Segmentation Theory

 Individual investors and FIs have specific maturity preferences, and to get them
to hold maturities other than their prefered requires a higher interest rate
(maturity premium).

The segmented markets theory also says that long-term fixed income securities
and short-term fixed income securities are fundamentally different and should not
be put in the same class of assets.

 For example, banks might prefer to hold short-term T-Bonds because of short-
term nature of their deposits. Insurance companies might prefer to hold long-term
T-Bonds because of the long-term nature of their liabilities (such as life insurance
policies)

F. Forecasting Interest Rates

 Upward sloping yield curve suggests that the market expects future S-T interest
rate to increase. So that this theory can be used to forecast interest rates.

For example, if interest rates rise, the value of investment portfolios of FIs and
individuals will fall, resulting in a loss of wealth. Thus, interest rate forecasts are
extremely important for the financial wealth of both FIs and individuals.

 “Forward rate” is the expected or implied rate on a S-T security. The market’s
expectations of forward rates can be derived directly from existing or actual rates
on securities currently traded in the spot market.
1/2
1R2=[(1+ 1R1)(1+ 2f1)] -1

Where: 2f1 = Expected one-year for Year 2, or the implied forward one-year rate for
next year.

2
2f1=[(1+ 1R2) /(1+ 1R1)]-1

Example

The existing (current) one-year, two-year, three-year and four-year zero coupon
Treasury security rates;
1R1= 4.32%,
1R2= 4.31%,
1R3= 4.29%,
1R4= 4.34%

Using the unbiased expectation theory, forward rates on zero coupon T-

Bonds for years 2, 3 and 4 are;

2
2f1=[(1.0431) /(1.0432)1]-1= 4.30%
3 2
3f1=[(1.0429) /(1.0431) ]-1= 4.25%
4 3
4f1=[(1.0434) /(1.0429) ]-1= 4.49%