PV

interest rate

FV

interest rate

Chapter 2 - Determinants of Interest RatesNominal Interest Rates – the interest rates actually observed in financial markets

- Directly affect the value (price) of most securities traded in the money and capital marketsTime Value of Money – the basic notion that a dollar received today is worth more than a dollar received at some future date.

- Consume now than later because of the effect of interest rates- Specifically assumes that any interest or other return earned on a dollar invested today over any given period of

time is immediately reinvested (compounded)Compound Interest – interest earned on an investment is reinvested

FV = P ( 1 + i )n

Simple Interest – interest earned on an investment is not reinvested

FV = P (1 + i)Lump Sum Payment – a single cash flow occurs at the beginning and end of the investment horizon with no other cash flows exchanged

FV = P [1 - (1 + r)n ] / r PV = P (1 + r)-n

Annuity payments – a series of equal cash flows received (constant payment) at fixed intervals over the investment horizon

FV = R (1 + r)

INCREASE in INT. RATE FV / PV Periods increase

FV increase Increasing rate increases

PV decrease Decreasing rate

Effective Annual Return (EAR) / Equivalent Annual Return- the return earned or paid over a 12-month period taking any within-year compounding interest into account

EAR = (1 + j/w)n – 1

What causes movement on interest rates?Loanable Funds Theory

- a theory of interest rate determination that views equilibrium interest rates in financial markets as a result of the supply and demand for loanable funds

Supply of Loanable Funds- commonly used to describe funds provided to the financial markets by net suppliers of funds- quantity supplied increases as the interest rates increase- household sector - the largest supplier of loanable funds

o supply when they have excess income or want to reallocate their asset portfolio holdingso the greater the perceived risk of securities investments, the less households are willing to invest

Factors Impact on Supply Impact on Equilibrium IRinterest rate inc movement along the supply curve directtotal wealth dec shift supply curve inverserisk of financial security dec shift supply curve directnear-term spending needs dec shift supply curve directmonetary expansion inc shift supply curve inverseeconomic conditions inc shift supply curve inverse

(direct) as factor increase, EIR increase . (inverse) as factor decrease, EIR increase

Demand of Loanable Funds- describe the total net demand for funds by fund users- quantity demanded is higher as interest falls- the better the overall economic conditions, the greater demand

Factors Impact on Demand Impact on Equilibrium IRInterest rate Movement along demand curve directUtility derived from asset purchased wd borrowed funds shift demand curve directRestrictiveness of nonprice conditions shift demand curve inverseEconomic conditions shift demand curve direct

Equilibrium Interest Rate Aggregate supply of loanable funds – the sum of quantity supplied by the separate fund sectors (household, businesses, governments, foreign agents) Aggregate demand of loanable funds – the sum of quantity demanded by the demanding sectors

Factors that causes supply and demand curves to shiftSupply of Funds

Wealth Risk Near-Term Spending Needs Monetary Expansion Economic Conditions

Demand of Funds Utility Derived from Assets Purchased with Borrowed Funds

Restrictiveness on Nonprice Conditions on Borrowed Funds Economic Conditions

Factors Affecting Nominal Interest Rates

Inflation (IP) – the continual increase in the price of a basket of goods and services the higher level of actual or expected inflations, the higher the level of interest rates will be

Real Interest Rate (RIR) – nominal interest rate that would exist on a security if no inflation were expected the percentage change in the buying power of a dollar Fisher Effect – nominal interest rates observed in financial markets must compensate investors for (1) any

reduced purchasing power on funds lent due to inflationary price changes and (2) an additional premium above the expected rate of inflation for forgoing present consumption

RIR = I – Expected (IP) i = RIR + Expected (IP) + [RIR x Expected (IP)]Default Risk (DRP)– risk that a security issuer will default on the security by missing an interest or principal paymentLiquidity Risk (LRP)– risk that a security cannot be sold at a predictable price with low transaction cost at short notice

illiquid – investors add liquidity risk premium (LRP) to the interest rate on the security Special Provisions or Covenants (SCP) – provisions (taxability, convertibility, callability) that impact the security holder beneficially or adversely and as such are reflected in the interest rates on securities that contain such provisionsTime to Maturity (MP) – length of time a security has until maturity

term of structure of interest rates (yield curve) – compares the interest rates on securities, assuming that all characteristics except maturity are the same

maturity premium – the change in required interest rates as the maturity of a security changeso the difference between required yield on long- and short-term securities

ij = f (IP, RIR, DRP, LRP, SCP, MP) fair interest rateReal Interest Rate – the interest rate that would exist on a security if no inflation were expected over the holding period of a security

- the percentage change in the buying power of a dollar

Term Structure of Interest RatesUnbiased Expectations Theory

Liquidity Premium Theory

Market Segmentation Theory