Ch 2 Determinants of Interest Rates PDF

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Chapter 2 Determinants of Interest Rates

Interest Rate Fundamentals 

Nominal interest rates: the interest rates actually observed in financial markets o Used to determine fair present value and prices of securities o Two components  Opportunity cost  Adjustments for individual security characteristics

Real Riskless Interest Rates 

Additional purchasing power required to forego current consumption o What causes differences in nominal and real interest rates? o If you wish to earn a 3% real return and prices are expected to increase by 2%, what rate must you charge? o Irving Fisher first postulated that interest rates contain a premium for expected inflation

Loanable Funds Theory   

Loanable funds theory explains interest rates and interest rate movements Views level of interest rates in financial markets as a result of the supply and demand for loanable funds Domestic and foreign households, businesses, and governments all supply and demand loanable funds

Supply and Demand of Loanable Funds

Determinants of Household Savings 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 Determinants of Foreign Funds Invested in the U.S. 1) Relative interest rates and returns on global investments 2) Expected exchange rate changes 3) Safe haven status of U.S. investments 4) Foreign central bank investments in the U.S. Federal Government Demand for Funds 

Federal debt help by the public was $11.9 trillion in 2013 (71% of GDP) and is projected to grow to $21.0 trillion by 2024 (78% of projected 2020 GDP) o Large potential for crowding out and/or dependence on foreign investment

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Total Federal Debt was $16.7 trillion in 2013 and is projected to grow to $27 trillion by 2024

Business Demand for Funds   

Level of interest rates: o When the cost of loanable funds is high business finance internally Expected future profitability vs. risk: o The greater the number of profitable projects available to business Expected economic growth

Factors that Cause Supply and Demand Curves to Shift

Determinants of Interest Rates for Individual Securities    

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Ij* = f(IP,RFR, DRPj, LRPj, SCPj, MPj) Inflation (IP) o IP = [(CPIt+1)-(CPIt)]/(CPIt) x (100/1) Real risk-free interest rate (RFR) and the Fisher effect o RFR = i – Expected (IP) Default risk premium (DRP) o DRP = ijt – iTt  Ijt = interest rate on security j at time t  ITt = interest rate on similar maturity U.S. Treasury security at time t Liquidity risk (LRP) Special provisions (SCP) o Ability to call debt to refund at cheaper interest rate Term to maturity (MP) o All else equal, pay more for 10 year rather than 5 year

Term Structure of Interest Rates: the Yield Curve

Unbiased Expectations Theory - will not be asked to calculate 

Long-term interest rates are geometric averages of current and expected future short-term interest rates o RN = [(1+1R1)(1+E(2r1))…(1+E(Nr1))]1/N – 1 o 1RN = actual N-period rate today o N = term to maturity, N = 1,2,…,4,… o 1R1 = actual current one-year rate today o E(ir1) = expected one-year rates for years, i= 1 to N

Liquidity Premium Theory 

Long-term interest rates are geometric averages of current and expected future short-term interest rates plus liquidity risk premiums that increase with maturity o 1RN = [(1+1R1)(1+E(2r1)+L2)…(1+E(Nr1)+LN)]1/N – 1 o Lt = liquidity premium for period t

o L2 < L3 < …< LN Market Segmentation Theory   

Individual investors and FIs have specfic maturity preferences Interest rates are determined by distinct supply and demand conditions within many maturity segments Investors and borrowers deviate from their preferred maturity segment only when adequately compensated to do so

Implied Forward Rates  

A forward rate (f) is an expected rate on a short-term security that is to be orginated at some point in the future The one-year forward rate for any year N in the future is: f = [(1+1RN)N / (1+1RN-1)N-1] -1

N 1

Time Value of Money and Interest 

The time value of money is based on the notion that a dollar received today is worth more than a dollar received at some future date o Simple interest: interest earned on an investment is not reinvested o Compound interst: interest earned on an investment is reinvested, most common

Present Value of a Lump Sum      

Discount future payments using current interest rates to find the present value (PV) o PV = FVt(1/(1+r)]t = FVt (PVIFr,t) PV = present value of cash flow FVt = future value of cash flow (lump sum) received in t periods r = interest rate per period t = number of years in investment horizon PVIFr,t = present value interst factor of a lump sum

Future Value of a Lump Sum 

The future value (FV) of a lump sum received at the beginning of an investment horizon o FVt = PV(1+r)t = PV(FVIFr,t) o FVIFr,t = future value interest factor of a lump sum

Relation between Interest Rates and Present and Future Values

Present Value of an Annuity 

The present value of a finite series of equal cash flows received on the last day of equal internals throughout the investment horizon

PMT = periodic annuity payment PVIFAr,t = present value interest factor of an annuity Future Value of an Annuity 

The future value of finite series of equal cash flows received on the last day of equal intervals throughout the investment horizon

FVIFAr,t = future value interest of an annuity Effective Annual Return 

Effective or equivalent annual return (EAR) is the return earned or paid over a 12-month period taking compounding into account

EAR = (1+rper period)c – 1 c = the number of compounding periods per year...