Chapter 8

Structure of Interest Rates

Chapter Outcomes

Describe how interest rates change

in response to shifts in the supply
and demand for loanable funds
Identify major historical movements
in interest rates in the United States
Describe what is meant by the
loanable funds theory of interest
rates
2

Chapter Outcomes (Continued)

Identify the major determinants of

market interest rates
Describe the types of marketable
securities issued by the U.S.
Treasury
Describe the ownership of Treasury
securities and the maturity
distribution of the federal debt
3

Chapter Outcomes (Continued)

Explain what is meant by the term or

maturity structure of interest rates
Identify and briefly describe the three
theories used to explain the term
structure of interest rates
Identify broad historical price level
changes in the U. S. and other
economies and discuss their causes
4

Chapter Outcomes (Concluded)

Describe the various types of

inflation and their causes
Discuss the effect of default risk
premiums on the level of long-term
interest rates

Basic Interest Rate Concepts

INTEREST RATE:
Price that equates the demand for
and supply of loanable funds
ROLE OF FINANCIAL MARKETS:
Interest rates are determined by the
supply and demand for loanable
funds in financial markets
6

Historical Changes in U.S. Interest

Rate Levels: Periods of Rising
Interest Rates

1864-1873 (rapid economic expansion

after the Civil War)
1905-1920 (pre-war expansion and World
War I-related inflation)
1927-1933 (economic boom in late 1920s
followed by major depression)
1946-early 1980s (rapid economic
expansion after World War II)
7

Historical Changes in U.S. Interest

Rate Levels: Periods of Falling
Interest Rates

1873-1905 (supply of funds exceeded

demand for funds and prices fell)
1920-1927 (rapid growth in supply of
funds and falling prices)
1933-1946 (actions taken to fight the
depression and finance World War II)
Since early 1980s (generally declining
prices and interest rates)
8

Loanable Funds Theory

DEFINITION:
States that interest rates are a function
of the supply of and demand for
loanable funds
SOURCES OF LOANABLE FUNDS:
--current savings
--expansion of deposits by depository
institutions

Interest Rate Determination in the

Financial Markets
B
S1

Interest rate (r)

Interest rate (r)

7%
D1

S1
8%
D1

Quantity of Loanable Funds

S1

9%

D1
Quantity of Loanable Funds

Quantity of Loanable Funds

Interest rate (r)

Interest rate (r)

S2

D2

S2

S1

8%

D3 D1
Quantity of Loanable Funds

10

Factors Affecting the Supply of

Loanable Funds

Volume of Savings
Expansion of Deposits by Depository
Institutions
Liquidity Attitudes

11

Determinants of Market
Interest Rates

NOMINAL INTEREST RATE (R):

Interest rate that is observed in the
marketplace
BASIC EQUATION:
r = RR + IP + DRP
REAL RATE OF INTEREST (RR):
Interest rate on a risk-free debt
instrument when no inflation is
expected

12

Determinants of Market
Interest Rates (Continued)

BASIC EQUATION:
r = RR + IP + DRP
INFLATION PREMIUM (IP):
Average inflation rate expected
over the life of the security
DEFAULT RISK PREMIUM (DRP):
Compensation for the possibility of
the borrowers failure to pay interest
and/or principal when due
13

Determinants of Market
Interest Rates (Concluded)

BASIC EQUATION EXPANDED:

r = RR + IP + DRP + MRP + LP
MATURITY RISK PREMIUM (MRP):
Compensation expected by investors
due to interest rate risk on debt
instruments with longer maturities
LIQUIDITY PREMIUM (LP):
Compensation for securities that cannot
easily be converted to cash without
major price discounts
14

Interest Rate Risk

DEFINITION:
Possible price fluctuations in fixedrate debt instruments associated
with changes in market interest rates
REASON:
An inverse relationship exists
between debt instrument values or
prices and nominal interest rates in
the marketplace

15

Risk-Free Rate of Interest

DEFINITION:
Interest rate on a debt instrument
with no default, maturity, or liquidity
risks (Treasury securities are the
closest example)
EQUATION:
Risk-Free Rate = Real Rate (RR) +
Inflation Premium (IP)

16

Two Types of U.S. Government

Debt Obligations

MARKETABLE GOVERNMENT
SECURITIES: Securities that may be
bought and sold through the usual
market channels
NONMARKETABLE GOVERNMENT
SECURITIES: Issues that cannot be
transferred between persons or
institutions but must be redeemed
with the U.S. government
17

Types of U.S. Treasury Debt

Obligations

TREASURY BILLS:
Obligations that bear the shortest
(up to one year) original maturities
TREASURY NOTES:
Obligations issued for maturities of
one to ten years
TREASURY BONDS:
Obligations of any maturity but usually
over five years
18

Term or Maturity Structure of

Interest Rates

TERM STRUCTURE:
Relationship between interest rates or
yields and the time to maturity for debt
instruments of comparable quality
YIELD CURVE:
Graphic presentation of the term
structure of interest rates at a given
point in time
19

Three Term Structure Theories

EXPECTATIONS THEORY:
Shape of the yield curve indicates
investor expectations about future
inflation rates
LIQUIDITY PREFERENCE THEORY:
Investors are willing to accept lower
interest rates on short-term debt
securities which provide greater
liquidity and less interest rate risk
20

Three Term Structure Theories

(Continued)

MARKET SEGMENTATION THEORY:

Interest rates may differ because
securities of different maturities are
not perfect substitutes for each other

21

Inflation Premiums and Price

Movements

INFLATION:
Occurs when an increase in the price
of goods or services is not offset by
an increase in quality
HISTORICAL PRICE MOVEMENTS:
Changes in the money supply or in
the amount of metal in the money
unit have influenced prices since the
earliest records of civilization
22

Periods of Inflation in the U. S.

Revolutionary War
War of 1812
Civil War
World War I
World War II
Postwar Period through Early 1980s
23

Types of Inflation

COST-PUSH INFLATION:
Occurs when prices are raised to
cover rising production costs, such
as wages
DEMAND-PULL INFLATION:
Occurs during economic expansions
when demand for goods and services
is greater than supply
24

Types of Inflation (Continued)

SPECULATIVE INFLATION:
Caused by the expectation that
prices will continue to rise, resulting
in increased buying to avoid even
higher future prices
ADMINISTRATIVE INFLATION:
The tendency of prices, aided by
union-corporation contracts, to rise
during economic expansion and to
resist declines during recessions
25

Default Risk Premiums

DEFAULT RISK:
Risk that a borrower will not pay
interest and/or repay the principal on
a loan according to the agreed
contractual terms
BASIC EQUATION:
DPR = r - RR - IP
BASIC EQUATION EXPANDED:
DPR = r - RR - IP - MRP - LP
26

Default Risk Premium Example

BASIC INFORMATION: nominal

interest rate = 9%; real rate = 3%;
inflation premium = 5%; and market
risk and liquidity premiums = 0%.
What is the default risk premium?
EXPANDED EQUATION:
DRP = r - RR - IP - MRP - LP
DPR = 9% - 3% - 5% - 0% - 0% = 1%
27