CHAPTER 2 STRUCTURE OF INTEREST RATES 3.

Spending needs - If the need for spending for the

different sectors of the economy is high, the supply of
INTRODUCTION TO NOMINAL INTEREST RATE loanable funds is lesser. (INVERSE)
● Funds are transferred from the providers of the funds 4. Economic condition - If the economic growth of one
to the users of funds country is low, supply of loanable funds is low.
● These funds are transferred through the financial (DIRECT)
systems 5. Monetary policy - Policies instituted by the
Financial system - channels the funds to the users for government to support the economy as a whole
their intended users. 6. Foreign investors - foreign investors increase the
● The provider of funds are expecting to receive interest supply of loanable funds in the country by supplying
in exchange for the use of their money. foreign direct investment and other sorts of short-term
Nominal Interest Rates - serves as a guide in investments
establishing the acceptable level of required return for
the different types of financial securities. FACTORS THAT AFFECT DEMAND FOR LOANABLE
● The interest rates charged on borrowed funds are FUNDS
generally classified according to the tenor or maturity
period: Demand for loanable funds - describes the total demand for
- Short-term ( less than one year) excess funds of the users
- Medium-term ( more than one year but less
than five years) The interest rates and demand of loanable funds have an
- Long-term ( more than five years) inverse relationship.

LOANABLE FUNDS THEORY Factors affect the demand of loanable funds:

● This theory identifies consumers, government 1. Interest rate - If the interest rate is high, the quantity
agencies, private and public companies, and foreign of demand for loanable funds is low
investors as the different sectors that determine how 2. Demand for funds - Different economic sectors
the level of interest rate moves. normally demand money for various reasons
● The loanable fund theory assumes that the market for 3. Spending needs - An increase in spending needs of
loanable funds is fully integrated and is characterized the household sector also increases the demand for
by easy access to funds in the market. loanable funds
● It views that there is perfect competition in the market 4. Economic condition - The government sector that
● It is also telling that the lender and the borrower are needs additional funding for government projects will
price-taker because there is only one pure interest also be asking for additional financing by issuing
rate in the market at any time government securities
● It also believed that this happens because the forces 5. Foreign participants - Foreign institutions may also
of competition act so fast that the equilibrium rate of increase the demand for loanable funds to look for
interest is immediately attained funding for their needs even if coming from a foreign
land
FACTORS THAT AFFECT SUPPLY OF LOANABLE FUNDS
EQUILIBRIUM INTEREST RATE
Supply of loanable funds - the providers of funds to the ● FINANCIAL SYSTEM HAS A SURPLUS - The
financial market supplier of funds is willing to lower the interest rate to
a level acceptable to them
Providers of Funds: ● FINANCIAL SYSTEM HAS A DEFICIT - User of
1. Households loanable funds are willing to increase the interest rate
2. Government agencies at a level where the suppliers of funds are willing to
3. Private companies supply
4. Public companies
5. Foreign investors FACTORS THAT CAUSE THE SUPPLY AND DEMAND
CURVES FOR LOANABLE FUNDS TO SHIFT
The interest rates and supply of loanable funds have a
direct relationship. FACTORS THAT CAUSE THE SUPPLY OF LOANABLE
FUNDS TO SHIFT ( other factors held constant )
Factors affect the supply of loanable funds: ● Supply of loanable funds have inverse
1. Level of interest rates - As interest rates increases, relationship to the Equilibrium Interest Rate
the supply of loanable funds also increases (DIRECT)
2. Risks of the securities - Higher risk of financial
Supply of Supply Equilibrium
securities, the lesser the supplier of loanable funds. loanable Curve Interest Rate
(INVERSE) funds
 Cost of Capital ( Cost of Money ) - the amount you are paying
Supply of Increase Right Decreases
funds or receiving for the use of money
Decrease Left Increases Example: interest paid on borrowed capital and dividends paid
on ownership capital
Economic Increase Increase Right Decreases
conditions wealth
FACTORS AFFECTING THE COST OF MONEY
Decrease Decrease Left Increases
1. Production opportunities
wealth ● Refers to the investment opportunities in
productive assets.
Risk* Riskier Decrease Left Increases ● The higher the expected return on the
investment, the more the investor can afford
Less risky Increase Right Decreases
to pay for the interest or cost of money
Spending No Increase Right Decreases
needs immediate 2. Time preference for consumption
spending ● Dependent on the need of the investor to
needs
use his excess money in short-term or
Have Decrease Left Increases long-term period
different ● If all investors need long-term, future returns,
spending then interest rates can go lower
needs
● If the investor needs money in the
Monetary Increase Right Decreases
short-term, the interest rate can go higher
policy 3. Risk
Decrease Left Increases ● Refers to the uncertainty of not achieving
what has been set to attain or to achieve.
*Risk - refers to the uncertainty of fulfillment of the financial instrument ● Risk and interest have direct relationship
when it is due 4. inflation
● Refers to the tendency of price to go up over
FACTORS THAT CAUSE THE DEMAND OF LOANABLE FUNDS TO periods
SHIFT ( other factors held constant ) ● Inflation and interest have direct relationship
● Demand of loanable funds have direct
relationship to the Equilibrium Interest Rate DETERMINANTS OF INTEREST RATES

Demand Deman Equilibrium Factors of Nominal Interest Rate:

for d Curve Interest Rate 1. Real risk-free rate (r*)
loanable 2. Inflation premium (IP)
funds
3. Default risk premium (DRP)
Demand of Increase Right Increase 4. Liquidity premium (LP)
funds 5. Maturity risk premium (MRP)
Decrease Left Decrease 6. Special provision or covenant (SPC)

Economic Increase Increase Right Increase

Nominal Interest Rate (r) = r* + IP + DRP + LP + MRP
conditions wealth

Decrease Decrease Left Decrease Premiums added to Real risk-free rate:

wealth a. Short-term government security
● Also known as treasury bill
Changes in Growing Increase Right Increases
opportunity
● Maturity of 91, 181, 360 days
perceived
business
● r = r* +IP
opportunitie No Decrease Left Decrease b. Long-term government security
s opportunity ● Also known as treasury note and treasury
bond
Change in Budget Increase Right Increase ● Treasury note issued from 1 year to 5 years,
government Deficit Treasury bond issued beyond 5 years
spending ● r = r* +IP + MRP
Budget Decrease Left Decrease
Surplus c. Short-term corporate security
● Short-term securities issued by private
companies
CONCEPT OF THE COST OF MONEY
● r = r* +IP + DRP + LP
● Low level of interest rates helps reduce the costs of
d. Long-term corporate security
capital for businesses which encouraged them to
● Long-term securities issued by private
invest more and hire more people to support their
companies
operations
 ● r = r* +IP + DRP + LP + MRP Liquidity Premium
● Premium added to the real risk-free rate if the
financial security is considered as not liquid
The real risk-free rate of interest plus

IP MRP DRP LP MATURITY RISK PREMIUM

● Charged for the risks associated with the term of the
Short-term security
government / ● Longer maturity, the higher the MRP
security ● Only applied to long-term securities whether
corporate or government security
Long-term
government / / MRP = 0.1% (t-1)
security
TERM STRUCTURE OF INTEREST RATES
● The relationship between interest rates or bond yields
Short-term
corporate / / / between long and short-term interest rates on varying
maturity dates
security
Three Primary Shapes of Term Structure of Interest Rates:
1. Upward Sloping
Long-term
corporate / / / / - happens when long-term interest rates are
higher than short-term interest rates
security - The normal slope of the yield curve and
signals that the economy is about to expand
2. Downward Sloping
REAL RISK-FREE RATE OF INTEREST - Short-term interest rates are higher than
● Rate of interest that exist on a riskless investment in long-term interest rates
the absence of inflation over the expected holding - Also known as inverted yield curve and
period signifies that economy i expected to enter
● r* pronounced as ‘’r-star’’ recession
- Also happens when inflation expected to
INFLATION PREMIUM decline
Inflation 3. Flat
● The erosion of the purchasing power of currency - Reflects that there is a similar borrowing cost
associated with investment between the short and the long-term
● It is the rise in the general level of prices where a unit securities
of currency effectively buys less than it did in prior - Tell something that the market is uncertain
periods about the future direction of the economy

Inflation Premium THEORIES OF TERM STRUCTURE OF INTEREST

● Premium ask by the investors when there is a 1. Expectation Theory
decrease in the purchasing power of the currency - considered that long-term security is
indifferent to short-term security concerning
DEFAULT RISK PREMIUM maturity
● Lender can default on schedules payment on the - Assumes that investors determine the bond
interest or principal prices and interest rates based merely on
● The higher the chances of default, the higher he DRP the expectation for the interest rate
to be added to nominal interest rate charged - Telling us that the long term interest rate is
● Does not apply to government securities simply the weighted average of the current
and the expected future short term interest
Nominal interest rate on corporate security rates
Less: Nominal interest rate on government security
Default Risk Premium

LIQUIDITY PREMIUM
Liquidity
● Refers to the capacity of an asset to be sold 2. Liquidity Preference Theory
immediately - The view that investors are indifferent
between short term and long term securities
 - Under this, the long term security will always
have a higher interest rate than short term
security because of LP
- The longer the maturity, the higher the LP
must be given
3. Market Segmentation Theory
- Interest rates are determined by the
interaction between the aggregate demand
and supply of loanable funds for each
segment
- Each segment is categorized based on its
maturities, whether short term or long term
and the demand and supply of loanable
funds for each segment is the one that
determines the equilibrium interest rate.
- Also assumes that the different economic
sectors are not willing to shift from one
segment to different segment without
consideration of an additional premium in the
form of interest