Fisher Interest Rate Theory (1)

7/29/2019 Fisher Interest Rate Theory (1)

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UNIT : 2

THE LEVEL AND

STRUCTURE OFINTEREST RATES


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Interest Rates

An interest rateis the price paid by aborrower to a lender for the use of

resources that will be used during sometime period then returned.

Real rate

Risk-free rateShort-term rate

3/2/2013 2Ms.Sadhna Gaur


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Theories of Interest Rates

Fishers Classical Approach

Loanable Funds TheoryKeynes Liquidity Preference Theory



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Fishers Classical

Approach

Supply of Savings

Marginal rate of time preference

IncomeReward for saving

Demand for Borrowed Resources

Marginal productivity of capitalRate of interest

Equilibrium Rate of Interest



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Fishers Law

Nominal Rate of Interest (i)

Real Rate of Interest (r)

Premium for Expected Inflation (p)

Fishers Law

(1 + i) = (1 + r)(1 + p)

or

i = r + p3/2/2013 5Ms.Sadhna Gaur


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The Loanable Funds

Theory

Demand for and Supply of Funds byFirms, Governments, and Households

Changes in the money supplyGovernment deficits

Changes in preferences by households

New investment opportunities for firmsEquilibrium Rate of Interest



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The Liquidity Preference

Theory

Demand for Money Balances

Transactions demand

Precautionary demandSpeculative demand

Supply of Money

Equilibrium Rate of Interest



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Changes in the Demand for

Money and Interest Rates

Liquidity EffectIf increasing, causes the interest rate to rise.

Income EffectIf increasing, causes the interest rate to rise.

Price Expectations EffectIf increasing, causes the interest rate to rise.

Net Effect:The interest rate may rise, fall, or remain unchanged

depending on the net effect of changes in desiredliquidity, income, and price expectations.



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Features of a Bond

Time to Maturity

Principal or Par Value

Coupon Interest

Yield-to-Maturity (YTM)If YTM = coupon rate, market price = par value

If YTM > coupon rate, market price < par valueIf YTM < coupon rate, market price > par value



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Determinants of the

Structure of Interest Rates

The Base Interest Rate

Risk PremiumsAre Determined By:

Issuer TypeCredit risk

Term to maturity

Embedded options

Taxability of interest

Liquidity



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Types of Issuers

Treasury Market Sector

Corporate Market Sector

Utilities

Industrials

Finance

Banks

Intermarket and intramarket Sector



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Default or Credit Risk

Rating Companies

Moodys, S&P, Fitch

Credit RatingsInvestment grade

Non-investment grade

Credit Spread



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Term to Maturity

The volatility of a bonds price isinfluenced by its maturity.

The longer the maturity of a bond, thegreater its price sensitivity to a change inmarket yields.

Maturity spread or yield curve spread



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Embedded Options

Call optionbenefits issuer

increases required return on Treasuries

Conversion optionbenefits bondholder

reduces required return on bonds

Prepayment optionBenefits issuerIncreases required return on mortgage-backed

securities



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Tax Treatment

Yield on taxable bond

After-tax yield = Pretax yield x (1 - Marginal tax rate)

Equivalent taxable yield

Taxable yield = Tax-exempt yield/(1 - Marginal tax

rate)



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Liquidity

The greater the expected liquidity ofasecurity issue, the lower the required

yield.The size of the issue is an important

factor that affects its liquidity.


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Fisher Interest Rate Theory (1)