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Part 1: Determination of Interest Rates

Chapter Outline

¤Overview of Interest rates

¤Loanable funds theory
¤Economic forces that affect interest rates
¤Forecasting interest rates

Overview of Interest rates

¤What does interest mean?

¤ Interest is the price demanded by the lender from the
borrower for the use of borrowed money
¤ a fee paid by the borrower to the lender on borrowed cash as
a compensation for forgoing the opportunity of earning
income from other investments that could have been made
with the loaned cash.
¤ "opportunity cost’ or "rent of money" – from the lenders’

1. Overview of Interest rates

¤Why do lenders charge interest rates on loans?

o Compensation for inflation
o Compensation for default risk – the chance that the
borrower will not pay back the loan
o Compensation for the opportunity cost of waiting
to spend your money
Overview of Interest rates

¤ Interest rate? the rate at which interest (or ‘opportunity

cost’) accumulates over a period of time.
¤ The longer the period for which money is borrowed, the larger is
the interest (or the opportunity cost).
¤ The amount lent is called the principal.
¤ Interest rate is typically expressed as percentage of the principal
and in annualized terms.
¤ From a borrower’s perspective: interest rate is the cost of capital -
the cost that a borrower has to incur to have access to funds.

¤ Question: How to measure interest rate?

Present value
¤A dollar paid to you one year from now is less
valuable than a dollar paid to you today
o A dollar deposited today can earn interest and
become $1 x (1+i) one year from today.

Discounting the Future
Let i = .10
In one year $100 X (1+ 0.10) = $110
In two years $110 X (1 + 0.10) = $121
or 100 X (1 + 0.10) 2
In three years $121 X (1 + 0.10) = $133
or 100 X (1 + 0.10)3
In n years
$100 X (1 + i ) n
Simple Present Value
PV = today's (present) value
CF = future cash flow (payment)
i = the interest rate
PV = n
(1 + i)

Time Line
Cannot directly compare payments scheduled in different points in the
time line

$100 $100 $100 $100

Year 0 1 2 n

PV 100 100/(1+i) 100/(1+i)2 100/(1+i)n

Four Types of Credit Market
¤Simple Loan
¤Fixed Payment Loan
¤Coupon Bond
¤Discount Bond

Yield to Maturity

¤The interest rate that equates the present value of cash

flow payments received from a debt instrument with
its value today

Simple Loan
PV = amount borrowed = $100
CF = cash flow in one year = $110
n = number of years = 1
$100 =
(1 + i )1
(1 + i ) $100 = $110
(1 + i ) =
i = 0.10 = 10%
For simple loans, the simple interest rate equals the
yield to maturity
Fixed Payment Loan

The same cash flow payment every period throughout

the life of the loan
LV = loan value
FP = fixed yearly payment
n = number of years until maturity
LV = + 2
+ 3
+ ...+
1 + i (1 + i ) (1 + i ) (1 + i ) n

Coupon Bond

Using the same strategy used for the fixed-payment loan:

P = price of coupon bond
C = yearly coupon payment
F = face value of the bond
n = years to maturity date
P= + 2
+ 3
+. . . + +
1+i (1+i ) (1+i ) (1+i ) (1+i ) n

Coupon Bond

¤A coupon bond is identified by three pieces of

o First is the corporation or government agency that issues the
o Second is the maturity date of the bond
o Third is the bond’s coupon rate, the dollar amount of the
yearly coupon payment expressed as a percentage of the
face value of the bond.

Table 1 Yields to Maturity on a 10%-Coupon-Rate
Bond Maturing in Ten Years
(Face Value = $1,000)

¤ When the coupon bond is priced at its face value, the yield to maturity
equals the coupon rate

¤ The price of a coupon bond and the yield to maturity are negatively

¤ The yield to maturity is greater than the coupon rate when the bond
price is below its face value
Consol or Perpetuity

¤ A bond with no maturity date that does not repay principal but
pays fixed coupon payments forever

P = C / ic
Pc = price of the consol
C = yearly interest payment
ic = yield to maturity of the consol

can rewrite above equation as this : ic = C / Pc

For coupon bonds, this equation gives the current yield, an easy to
calculate approximation to the yield to maturity

Discount Bond
For any one year discount bond
F = Face value of the discount bond
P = current price of the discount bond
The yield to maturity equals the increase
in price over the year divided by the initial price.
As with a coupon bond, the yield to maturity is
negatively related to the current bond price.

Rate of Return
The payments to the owner plus the change in value
expressed as a fraction of the purchase price
C P - Pt
RET = + t +1
Pt Pt
RET = return from holding the bond from time t to time t + 1
Pt = price of bond at time t
Pt +1 = price of the bond at time t + 1
C = coupon payment
= current yield = ic
Pt +1 - Pt
= rate of capital gain = g
Rate of Return and Interest Rates

¤The return equals the yield to maturity only if the

holding period equals the time to maturity
¤A rise in interest rates is associated with a fall in bond
prices, resulting in a capital loss if time to maturity is
longer than the holding period
¤The more distant a bond s maturity, the greater the
size of the percentage price change associated with an
interest-rate change
Rate of Return and Interest Rates (cont d)

¤The more distant a bond s maturity, the lower the rate

of return the occurs as a result of an increase in the
interest rate
¤Even if a bond has a substantial initial interest rate, its
return can be negative if interest rates rise

Interest-Rate Risk

¤Prices and returns for long-term bonds are more

volatile than those for shorter-term bonds
¤There is no interest-rate risk for any bond whose time
to maturity matches the holding period

Real and Nominal Interest Rates

¤Nominal interest rate makes no allowance

for inflation
¤Real interest rate is adjusted for changes in price level
so it more accurately reflects the cost of borrowing
¤Ex ante real interest rate is adjusted for expected
changes in the price level
¤Ex post real interest rate is adjusted for actual changes
in the price level

¤ Would a dollar tomorrow be worth more to you today when the
interest rate is 20% or when it is 10%?

¤ 2. You have just won $20 million in the state lottery, which
promises to pay you $1 million (tax free) every year for the
next 20 years. Have you really won $20 million?

¤ 3. If the interest rate is 10%, what is the present value of a

security that pays you $1,100 next year, $1,210 the year after,
and $1,331 the year after that?

¤ 4. If the security in Problem 3 sold for $3,500, is the yield to
maturity greater or less than 10%? Why?

¤ 5. Write down the formula that is used to calculate the yield to

maturity on a 20-year 10% coupon bond with $1,000 face
value that sells for $2,000.

¤ 6. What is the yield to maturity on a $1,000-face-value

discount bond maturing in one year that sells for $800?

¤ 7. What is the yield to maturity on a simple loan for $1 million
that requires a repayment of $2 million in five years’ time?

¤ 8. To pay for college, you have just taken out a $1,000

government loan that makes you pay $126 per year for 25
years. However, you don’t have to start making these payments
until you graduate from college two years from now. Why is
the yield to maturity necessar- ily less than 12%, the yield to
maturity on a normal $1,000 fixed-payment loan in which you
pay $126 per year for 25 years?

2. Loanable Funds Theory

¤Loanable funds theory suggests that the market

interest rate is determined by the factors that affect the
supply of and demand for loanable funds
¤ Can be used to explain movements in the general level of
interest rates of a particular country
¤ Can be used to explain why interest rates among debt
securities of a given country vary

Loanable Funds Theory
(cont d)
¤ Business demand for loanable funds
o Businesses demand loanable funds to invest in fixed assets
and short-term assets
o Businesses evaluate projects using net present value (NPV):
NPV = -INV +
t =1 (1
+ k ) t

ü Projects with a positive NPV are accepted

o There is an inverse relationship between interest rates and
business demand for loanable funds

Loanable Funds Theory (cont d)

¤Government demand for loanable funds

o Governments demand funds when planned
expenditures are not covered by incoming revenues
ü Municipalities issue municipal bonds
ü The federal government issues Treasury securities and
federal agency securities
o Government demand for loanable funds is interest-

Loanable Funds Theory (cont d)

¤Aggregate demand for loanable funds

o The sum of the quantities demanded by the separate sectors
at any given interest rate is the aggregate demand for
loanable funds

Loanable Funds Theory (cont d)

Dh Db

Household Demand Business Demand

Loanable Funds Theory (cont d)

Dg Dm

Federal Government Demand Municipal Government Demand

Loanable Funds Theory (cont d)


Foreign Demand

Loanable Funds Theory (cont d)


Aggregate Demand

Loanable Funds Theory (cont d)

¤Supply of loanable funds

o Funds are provided to financial markets by
ü Households (net suppliers of funds)
ü Government units and businesses (net borrowers of funds)
o Suppliers of loanable funds supply more funds at higher
interest rates

Loanable Funds Theory (cont d)

¤Supply of loanable funds (cont d)

¤ Foreign households, governments, and corporations supply
funds by purchasing Treasury securities
¤ Foreign households have a high savings rate
¤ The supply is influenced by monetary policy implemented
by the Federal Reserve System
¤ The Fed controls the amount of reserves held by depository
¤ The supply curve can shift in response to economic
¤ Households would save more funds during a strong economy

Loanable Funds Theory (cont d)

Aggregate Supply

Loanable Funds Theory
(cont d)

¤Equilibrium interest rate - algebraic

o The aggregate demand can be written as

DA = Dh + Db + Dg + Dm + Df

o The aggregate supply can be written as

SA = Sh + Sb + Sg + Sm + S f

Loanable Funds Theory (cont d)


Equilibrium Interest Rate - Graphic

3. Economic Forces That Affect Interest
¤Economic growth
o Shifts the demand schedule outward (to the right)
o There is no obvious impact on the supply schedule
ü Supply could increase if income increases as a result of the
o The combined effect is an increase in the equilibrium
interest rate

Loanable Funds Theory (cont d)



Impact of Economic Expansion

Economic Forces That Affect Interest Rates
(cont d)
o Shifts the supply schedule inward (to the left)
ü Households increase consumption now if inflation is
expected to increase
o Shifts the demand schedule outward (to the right)
ü Households and businesses borrow more to purchase
products before prices rise

Loanable Funds Theory (cont d)



Impact of Expected Increase in Inflation

Economic Forces That Affect Interest Rates
(cont d)
¤Fisher effect
o Nominal interest payments compensate savers for:
ü Reduced purchasing power
ü A premium for forgoing present consumption
o The relationship between interest rates and expected
inflation is often referred to as the Fisher effect

Economic Forces That Affect Interest
Rates (cont d)

¤Fisher effect (cont d)

¤ Fisher effect equation:

i = E (INF ) + i R

¤ The difference between the nominal interest rate and

the expected inflation rate is the real interest rate:

i R = i - E (INF )

Economic Forces That Affect Interest Rates
(cont d)
¤Money supply
o If the Fed increases the money supply, the supply of
loanable funds increases
ü If inflationary expectations are affected, the
demand for loanable funds may also increase
o If the Fed reduces the money supply, the supply of
loanable funds decreases
o During 2001, the Fed increased the growth of the
money supply several times
Economic Forces That Affect Interest Rates
(cont d)
¤Money supply (cont d)
o September 11
ü Firms cut back on expansion plans
ü Households cut back on borrowing plans
ü The demand of loanable funds declined
o The weak economy in 2001–2002
ü Reduced demand for loanable funds
ü The Fed increased the money supply growth
ü Interest rates reached very low levels

Economic Forces That Affect Interest Rates
(cont d)
¤ Budget deficit
¤ A high deficit means a high demand for loanable funds by the
¤ Shifts the demand schedule outward (to the right)
¤ Interest rates increase
¤ The government may be willing to pay whatever is necessary to borrow
funds, but the private sector may not
¤ Crowding-out effect
¤ The supply schedule may shift outward if the government creates more
jobs by spending more funds than it collects from the public

Economic Forces That Affect Interest Rates
(cont d)
¤Foreign flows of funds
¤ The interest rate for a currency is determined by the demand
for and supply of that currency
¤ Impacted by the economic forces that affect the equilibrium interest
rate in a given country, such as:
¤ Economic growth
¤ Inflation
¤ Shifts in the flows of funds between countries cause
adjustments in the supply of funds available in each country

Economic Forces That Affect Interest
Rates (cont d)
¤ Explaining the variation in interest rates over time
¤ Late 1970s: high interest rates as a result of strong economy and
inflationary expectations
¤ Early 1980s: recession led to a decline in interest rates
¤ Late 1980s: interest rates increased in response to a strong economy
¤ Early 1990s: interest rates declined as a result of a weak economy
¤ 1994: interest rates increased as economic growth increased
¤ Drifted lower for next several years despite strong economic growth,
partly due to the U.S. budget surplus

4. Forecasting Interest Rates

¤It is difficult to predict the precise change in the

interest rate due to a particular event
o Being able to assess the direction of supply or demand
schedule shifts can help in understanding why rates changed

Forecasting Interest Rates
(cont d)
¤To forecast future interest rates, the net
demand for funds (ND) should be

ND = DA - SA
= Dh + Db + Dg + Dm + Df ]
- [Sh + Sb + Sg + Sm +S ]

Forecasting Interest Rates (cont d)

¤A positive disequilibrium in ND will be

corrected by an increase in interest rates
¤A negative disequilibrium in ND will be
corrected by a decrease in interest rates