Determinants of Interest Rates

Determinants of Interest
Rates
Our Agenda
Interest Rate Fundamentals
Loanable Funds Theory
Determinants of Interest Rates
Term Structure of Interest Rates
Forecasting Interest Rates
Time Value of Money

Financial Markets | Determinants of Interest Rates | 2
1. Production opportunities. The investment
opportunities in productive (cash-generating) assets.
2. Time preferences for consumption. The preferences of
consumers for current consumption as opposed to
saving for future consumption.
3. Risk. The higher the risk, the higher the required
return.
4. Expected inflation. The higher the expected inflation,
the higher the required return.

What is interest rate?
It is the price the lenders receive, and borrowers pay for
debt capital.
Interest rate varies based on the following:
1. Riskiness of the borrower
2. The use of the funds borrowed
3. The type of collateral used to support the loan
4. Length of time
Nominal interest rates: the interest rates actually
observed in financial markets
► Costs or benefits, depending on whether you are a borrower
or a lender
► Used to determine time value of money (i.e. future versus
present value of securities)
► Two components:
► Opportunity cost
► Adjustments for individual security characteristics

Interest Rate Fundamentals: Real Riskless
Interest Rates
► Additional purchasing power required to forego current
consumption
What causes differences in nominal and real interest
rates?
► If you wish to earn a 3% real return and prices are expected to
increase by 2%, what rate must you charge? The answer is
5% = 3% + 2%.
► Fisher effect postulates that nominal interest rates contain a
premium for expected inflation.

Interest Rate Fundamentals: Annual
Percentage Rate (APR)
► Interest rate when banks lend money to borrowers with an
impression that customers can borrow cheaply
► Calculated on many consumer loans, credit cards and mortgages
► Nominal interest rate quoted by the banks, but is not the actual
interest rate
► Does not include the effects of intra-year compounding
► Standard cost of borrowing, often used by borrowers when
comparing lenders and loan options
► Always lower than effective annual cost (EAR)

Interest Rate Fundamentals: Effective
Annual Interest Rates (EAR)
► Interest rate when banks pay customers who deposit money
allowing them to earn a higher rate
► Applicable to deposit accounts
► The effective return assuming that interest paid is reinvested at
the same rate
► Include the effects of intra-year compounding
► Used when comparing investments with different compounding
periods per year
► Always higher than annual percentage rate (APR)

Interest Rate Fundamentals: Basis Points
Yields are quoted as a percentage with two

decimal places (e.g. 11.82%). With this
quote, the smallest possible change is 0.01%
(i.e. 0.0001). This amount, 1% of 1%, is
called a basis point. When 11.82% rises to
11.94%, we say rate increases by 12 basis
points.
EAR and APR: An example
► A bank offers a 10% APR.
► Monthly rate (i.e. compounding twelve times a year) is
10%/12 = 0.833%
► EAR = (1 + APR/n)n – 1 = (1 + 0.1/12)12 – 1 = (1.00833)12
– 1 = 0.1047
► APR = 10.00%
► EAR = 10.47%

EAR and APR: An example
► $A earns interest at a rate r% per annum. If interest is paid m times a year,
then you will receive m payments with a periodic rate r/m each time. At the
end of the year, you have A(1 + r/m)m.
► Compounding interest on $100 at 4%
Interest payment frequency Sum at the end of one year
Annual $104
Semi-annual $104.04
Monthly $104.0742
Weekly $104.0795
Daily $104.0808

► Loanable funds theory explains real interest rates and their
movements
► Views level of real interest rates as resulting from factors
that affect the supply of and demand for loanable funds
► Supply of loanable funds = demand for bonds
► Demand for loanable funds = supply of bonds
► Categorizes financial market participants – e.g. consumers,
businesses, governments, and foreign participants – as net
suppliers or demanders of funds
Supply of loanable funds describes funds provided to the
financial markets by net suppliers of funds. In general, the
quantity of loanable funds supplied increases as interest
rates rise.
Demand for loanable funds describes the total net

demand for funds by fund users. In general, the quantity
of loanable funds demanded is higher as interest rates
fall.
Households: Largest Suppliers of Loanable
Funds
Their savings are determined by:
1. Interest rates and tax policy
2. Income and wealth: the greater the wealth or income, the
greater the amount saved
3. Attitudes about saving versus borrowing
4. Credit availability: the greater the amount of easily obtainable
consumer credit the lower the need to save
5. Job security and belief in soundness of entitlements

Foreign Investors
Foreign funds supplied are determined by:

1. Relative interest rates and returns on global
investments
2. Expected exchange rate changes
3. Status of investments
4. Foreign central bank investments in other
countries
The Government Sector as suppliers of funds
Governments temporarily generate more cash

inflows than they have initially budgeted to spend
and loans them to the financial market funds until
needed.

Households and the demand for funds
The demand of loanable funds from households

depend on the demand for financing purchases of
homes, durable goods (e.g., car and appliance
loans) and nondurable goods (e.g. insurance loans
and medical loans).

The Government Sector and its demand for
funds
Governments borrow heavily in the markets for

loanable funds.
The government’s demand for funds varies with

the general economic conditions.

Business: Demand for Most Funds
► Level of interest rates:
► When the cost of loanable funds is high (i.e. interest rates are
high), businesses finance internally
► Expected future profitability vs. risk:
► The greater the number of profitable projects available to
businesses, the greater the demand for loanable funds
► Expected economic growth

Equilibrium Interest Rate
The aggregate supply of loanable funds is the sum of the quantity
supplied by households, businesses, governments and foreign agents in
their capacity as suppliers of loanable funds.
Similarly, the aggregate demand for loanable funds is the sum of the
quantity demanded by the separate demanding sectors.
Therefore, the aggregate quantity of loanable funds supplied is

positively related to to interest rates. On the other hand, the aggregate
of loanable funds demanded is inversely related to interest rates.

Supply and Demand for Loanable Funds
Demand (Ld) = Supply (Bs) Supply (Ls) = Demand (Bd)

Interest
Rate (i)
Loanable Funds L($)

Quantity of Bonds B(Q)
Factors that Affect the Supply of and Demand for
Loanable Funds for a Financial Security
The factors below affect the supply for loanable funds:

Supply of funds. Factors that cause the supply curve of loanable funds to shift, at any
given interest rate, include the wealth of fund suppliers, the risk of financial security,
the near-term spending needs, monetary policy objectives and economic conditions.
1. Wealth. As the total wealth of financial market participants increases, the absolute
dollar available for investment increases. Thus, the supply curve shifts downward
and to the right.
2. Risk. As the risk of financial security decreases, it becomes more attractive to the
suppliers of funds. Conversely, as the risk of financial securities increases, it
becomes less attractive to the suppliers of funds .

The factors below affect the supply for loanable funds:

3. Near-term spending needs. When financial market participants have few near-term needs,
the absolute amount available for investment increases
4. Monetary Expansion. The Central Bank implements monetary policies to alter the funds
currently available in the market, growth in the money supply and thus the rate of economic
expansion of a country.
5. Economic Conditions. As the underlying economic conditions (e.g., the inflation rate,
unemployment rate, unemployment rate, economic growth) improve in a country relative to
others, it increases the flow of funds to that country.

Effect on Interest Rates from a Shift in the
Supply Curve for Loanable Funds

Demand for Funds. Factors that cause the demand curve for the loanable funds to shift
include the utility derived from assets purchased with borrowed funds, restrictiveness of
nonprice conditions on borrowings, and economic conditions:
1. Utility Derived from Assets Purchased with Borrowed Funds. As the utility derived from an
asset purchased from borrowed funds increases, the willingness of market participants to
borrow increases and the absolute amount increases.
2. Restrictiveness of Nonprice Conditions on Borrowed Funds. As the non-price restrictions on
put on borrowers as conditions for borrowing (e.g., fees, collaterals or required restrictions
for the use of money) decreases, the willingness of market participants to borrow increases
and the absolute amount increases.
3. Economic Conditions. When the domestic economy experiences a period of growth, market
participants are willing to borrow more heavily.

Effect on Interest Rates from a Shift in the
Demand Curve for Loanable Funds

Factors that Affect the Supply of and
Demand for Loanable Funds for a Financial
Security

ij* = f(IP, RFR, DRPj, LRPj, SCPj, MPj)

► First two factors are common to all financial securities
(i.e. risk-free interest rate), while the others can be
unique to each individual security

►

►

The real risk-free rate is the interest rate that would exist on a
risk-free security if no inflation was expected over a holding period.
From the Fisher Effect formula, it can be inferred that the risk-free
rate formula is as follows:

Risk-Free Rate: An Example
►

►

Default Risk Premium: An Example
►

A highly liquid asset can be sold at a predictable price with
low transaction costs and thus can be converted into its
full market value at short notice. If the asset is illiquid,
investors add liquidity risk premium (LRP) to the interest
rate to reflect the relative liquidity of the asset.

Special covenants are stipulations specifically

written provisions in the contract for an underlying
security. Some of these special provisions pertain
to the security’s taxability, convertibility and
callability. These provisions will affect the interest
rates demanded.

Term to maturity and interest rates are related as shown
by the yield curve or the term structure of interest rates.
The change in required interest rates as maturity changes
is called the maturity risk premium.
• Maturity risk premium is the difference between the required
yield on long and short-term securities of the same
characteristic other than maturity.
• The value of the maturity risk premium can be positive,
negative or zero.

Term Structure of Interest Rates
Unbiased Expectations Theory
► The unbiased expectations theory contends that
the shape of the yield curve depends on
investors’ expectations about future interest
rates. This theory is indifferent when it comes to
maturity.
► If interest rates are expected to increase, L-T
rates will be higher than S-T rates, and
vice-versa. Thus, the yield curve can slope up,
down, or even bow.

Assumes that the maturity risk
premium for Treasury securities is
zero.
Assumptions
Long-term rates are an average of
of Unbiased current and future short-term rates.
Expectations
If the pure expectations theory is
correct, you can use the yield curve to
“back out” expected future interest
rates.

Pure Expectations Theory Formula

An Example: Observed Treasury Rates and
Pure Expectations
Maturity Yield
1 year 6.0%
2 years 6.2
3 years 6.4
4 years 6.5
5 years 6.5
If the pure expectations theory holds, what does the market expect will be the
interest rate on one-year securities, one year from now? Three-year securities,
two years from now?

One-Year Forward Rate
6.0% x%
0 1 2
6.2%
(1.062)2 = (1.060) (1 + X)
1.12784/1.060 = (1 + X)
6.4004% = X
► The pure expectations theory says that one-year securities will
yield 6.4004%, one year from now.
► Notice, if an arithmetic average is used, the answer is still very
close. Solve: 6.2% = (6.0% + X)/2, and the result will be 6.4%.

Three-Year Security, Two Years
from Now 6.2% x%
0 1 2 3 4
5
6.5%
(1.065)5 = (1.062)2 (1 + X)3

1.37009/1.12784 = (1 + X)3
6.7005% = X
• The pure expectations theory says that

three-year securities will yield 6.7005%, two years
from now.
Unbiased Expectation Theory: Another Example

Unbiased Expectation Theory:
A Yield Curve

Key assumption: bonds of different maturities
are substitutes, but are not perfect substitutes
Liquidity Implication: modifies pure expectations theory

with features of market segmentation theory
Preference Investors prefer short rather than long bonds →

Theory must be paid a risk (liquidity) premium, LRPN,
to hold long-term bonds
Results in following modification: long-term

interest rates will be averages of the expected
short-term rates plus a positive term premium
Liquidity Preference Theory Formula

Liquidity Preference Formula: An Example
Suppose that the current one-year rate (one-year spot rate) and expected
one-year T-bond rates over the following three years (i.e., years 2, 3, and 4,
respectively) are as follows:
R = 1.94%, E(2r1) = 3.00%, E(3r1) = 3.74%, E(4r1) = 4.10%

1 1
In addition, investors charge a liquidity premium on longer-term

securities such that:
L2 = 0.10%, L3 = 0.20%, L4 = 0.30%

Liquidity Preference Formula: An Example

Unbiased Expectation Theory:
A Yield Curve

Pure Unbiased Theory vs. Liquidity Premium
Theory

Market Segmentation
Theory
► Key assumption: bonds of different maturities are not
substitutes at all
► Implication: markets are completely segmented.
Interest rate at each maturity determined separately
► People typically prefer short holding periods and thus
have higher demand for short-term bonds, which
have higher price and lower interest rates than long
bonds
► Explains fact 3 that yield curve is usually upward
sloping
► This theory does not explain fact 1 or fact 2 because it
assumes long and short rates are determined
independently
Market Segmentation Yield Curve
► The supply and demand for securities at a particular maturity determine the yield
for that maturity.
Dl
Sl
yield
Sm Dm
Ss DS
Years to maturity
Forecasting Interest Rates: Forward Rates
A forward rate is an expected or implied rate on a short-term security that is originated at
some point in the future.

Forecasting Interest Rates: An Example
For example, on June 4, 2013, the existing or current (spot) one-year,
two-year, three-year, and four-year zero-coupon Treasury security rates
were as follows:
R = 0.156%,
1 1
R = 0.305%,
1 2
R = 0.499%,
1 3
R = 0.753%
1 4
Using the unbiased expectations theory, one-year forward rates on

zero-coupon Treasury bonds for years 2, 3, and 4 as of June 4, 2013,
were:
f = [(1.00305)2/(1.00156)] - 1 = 0.454%
2 1
f = [(1.00499)3/(1.00305)2] - 1 = 0.888%
3 1
f = [(1.00753)4/(1.00499)3] - 1 = 1.519%
4 1
Time Value of Money
► Time value of money is the basic notion that a dollar received today is worth more
than a dollar received at some future date.
► The time value of money concept can be used to convert cash flows earned over an
investment horizon into a value at the end of the investment horizon: the investment’s
future value (FV ).
► The time value of money concept can be also used to convert the value of future cash
flows into their current or present values (PV).
► Two forms of time value of money calculations are commonly used in finance for
security valuation purposes: the value of a lump sum and the value of annuity
payments.

Time Value of Money: Lump Sum Valuation
A lump sum payment is a single cash payment received at
the beginning or end of some investment horizon.
► Present Value of a Lump Sum. The present value
function converts cash flows received over a future
investment horizon into an equivalent (present) value
as if they were received at the beginning of the current
investment horizon. This is done by discounting future
cash flows back to the present using the current market
interest rate.
Present value (PV) of a lump sum received at the end of
the investment horizon, or future value (FV ):

Time Value of Money: Present Value of a Lump
Sum - An Example

Future Value of a Lump Sum. The future value of a lump sum
equation translates a cash flow received at the beginning of an
investment period to a terminal (future) value at the end of an
investment horizon.
Future value (FV ) of a lump sum received at the beginning of the
investment horizon is computed as follows:

Time Value of Money: Future Value of a
Lump Sum - An Example

Time Value of Money: Annuity Valuation
Present Value of an Annuity. The present value of an annuity equation converts a finite series of
constant (or equal) cash flows received on the last day of equal intervals throughout the investment
horizon into an equivalent (present) value as if they were received at the beginning of the investment
horizon. The time value of money equation used to calculate this value is represented as follows:
Present value (PV ) of an annuity stream (PMT ) received in the future:

Time Value of Money: Present Value of an
Annuity – An Example

Time Value of Money: Annuity Valuation
Future Value of an Annuity. The future value of an annuity equation converts a series of
equal cash flows received at equal intervals throughout the investment horizon into an
equivalent future amount at the end of the investment horizon. The equation used to
calculate this value is represented as follows:
Future value (FV) of an annuity payment stream received over an investment horizon:

Time Value of Money: Future Value of an
Annuity – An Example

Determinants of Interest Rates

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Determinants of Interest

Interest Rate Fundamentals

Loanable Funds Theory

Determinants of Interest Rates

Term Structure of Interest Rates

Forecasting Interest Rates

Time Value of Money

Financial Markets | Determinants of Interest Rates | 3

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Yields are quoted as a percentage with two

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Demand for loanable funds describes the total net

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Foreign funds supplied are determined by:

Governments temporarily generate more cash

Financial Markets | Determinants of Interest Rates | 16

The demand of loanable funds from households

Financial Markets | Determinants of Interest Rates | 17

Governments borrow heavily in the markets for

The government’s demand for funds varies with

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Therefore, the aggregate quantity of loanable funds supplied is

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Demand (Ld) = Supply (Bs) Supply (Ls) = Demand (Bd)

Loanable Funds L($)

The factors below affect the supply for loanable funds:

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The factors below affect the supply for loanable funds:

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ij* = f(IP, RFR, DRPj, LRPj, SCPj, MPj)

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Special covenants are stipulations specifically

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(1.065)5 = (1.062)2 (1 + X)3

• The pure expectations theory says that

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