Chapter 2 Determinants of

Interest rates

Time Value of Money

Supply of Loanable Funds
Demand for Loanable Funds
Equilibrium Interest Rate
Term Structure of Interest Rates
Forecasting Interest Rates
 Interest Rate Fundamentals

•• Nominal
Nominal interest
interest rates
rates -- the
the
interest
interest rate
rate that
that are
are actually
actually
observed
observed inin financial
financial markets
markets
––directly
directly affect
affect the
the value
value (price)
(price) of
of
most
most securities
securities traded
traded in
in the
the market
market
––affect
affect the
the relationship
relationship between
between spotspot
and
and forward
forward FX FX rates
rates
Skövde University, Autumn 2008 2
 Time Value of Money and Interest
Rates
•• Time
Time value
value refers
refers to
to that
that aa dollar
dollar received
received
today
today is
is worth
worth more
more than
than aa dollar
dollar
received
received atat some
some future
future date
date
•• Compound
Compound interest
interest
––interest
interest earned
earned on
on an
an investment
investment is
is
reinvested
reinvested
•• Simple
Simple interest
interest
––interest
interest earned
earned on
on an
an investment
investment is
is not
not
reinvested
reinvested
Skövde University, Autumn 2008 3
 Calculation of Simple Interest

Value
Value == Principal
Principal ++ Interest
Interest (year
(year 1)
1) ++ Interest
Interest (year
(year 2)
2)

Example:
Example:
$1,000
$1,000to
toinvest
investfor
foraaperiod
periodof
oftwo
twoyears
yearsatat12
12percent
percent

Value
Value == $1,000
$1,000 ++ $1,000(.12)
$1,000(.12)++$1,000(.12)
$1,000(.12)

==$1,000
$1,000++$1,000(.12)(2)
$1,000(.12)(2)

== $1,240
$1,240

Skövde University, Autumn 2008 4

 Value of Compound Interest

Value
Value == Principal
Principal ++ Interest
Interest ++ Compounded
Compounded interest
interest

Value
Value == $1,000
$1,000 ++ $1,000(.12)
$1,000(.12) ++ $1,000(.12)
$1,000(.12)++$1,000(.12)(.12)
$1,000(.12)(.12)

== $1,000[1
$1,000[1 + 2(.12) + (.12) ]]
+ 2(.12) + (.12) 22

== $1,000(1.12) 2
$1,000(1.12)2 continuous
continuouscompounding
compounding

== $1,254.4
$1,254.4
Skövde University, Autumn 2008 5
 Present Value of a Lump Sum Payment

•• PV
PV function
function converts
converts future
future cash
cash flows
flows
into
into an
an equivalent
equivalent present
present value
value byby
discounting
discounting future
future cash
cash flows
flows back
back toto
the
the present
present using
using current
current market
market
interest
interest rate
rate
––lump
lump sum
sum payment
payment
––annuity
annuity
•• PV
PV decreases
decreases asas interest
interest rates
rates increase:
increase:
the
the discount
discount rate
rate is
is higher
higher for
for the
the
foreseeable
foreseeable future.
future.
Skövde University, Autumn 2008 6
 Calculating Present Value (PV) of a
Lump Sum payment

PV
PV = FVtt(1/(1 + i)) == FV
= FV (1/(1 + i)) tt
FVt(PVIF )
t(PVIFitit)
where:
where:
PV
PV == present
present value
value
FV
FV == future
future value
value (lump
(lump sum)
sum) received
received inin tt years
years
ii == simple
simple annual
annual interest
interest rate
rate earned
earned
tt == number
number ofof years
years in
in the
the investment
investment horizon
horizon
PVIF
PVIF == present
present value
value interest
interest factor
factor of
of aa lump
lump sum
sum

Skövde University, Autumn 2008 7

Calculating Present Value (PV) of a Lump Sum
with multiple interest payment per year

PV
PV = FVnn(1/(1 + i/m))nm == FV
= FV (1/(1 + i/m)) nm
FVnn(PVIF
(PVIFi/m,nm )
i/m,nm)
where:
where:
PVPV == present
present value
value
FVFV == future
future value
value (lump
(lump sum)sum) received
received in in nn years
years
ii == simple
simple annual
annual interest
interest rate
rate earned
earned
nn ==number
number of of years
years in
in investment
investment horizon
horizon
mm ==number
number of of compounding
compounding periodsperiods inin aayear
year
i/m
i/m == periodic
periodic rate
rate earned
earned on on investments
investments
nm
nm == total
total number
numberof of compounding
compounding periods
periods
PVIF
PVIF == present
present value
value interest
interest factor
factor of
of aa lump
lump sumsum
Skövde University, Autumn 2008 8
 Calculating Present Value of a
Lump Sum
•• You
You are
are offered
offered aa security
security investment
investment that
that
pays
pays $10,000
$10,000 atat the
the end
end of
of 66 years
years in
in exchange
exchange
for
for aa fixed
fixed payment
payment today.
today.

PV
PV==FV
FVnn/(1
/(1 ++ i/m) nm =FV(PVIF
i/m)nm =FV(PVIFi/m,nm )
i/m,nm)

•• 8%
8% interest
interestPV=
PV=$10,000/(1+0,08)
$10,000/(1+0,08)66 == $6,301.70
$6,301.70

•• 12%
12%interest
interest PV=
PV= $10,000/(1+0,12)
$10,000/(1+0,12)66 == $5,066.31
$5,066.31

•• 16%
16%interest
interest PV=
PV= $10,000/(1+0,16)
$10,000/(1+0,16)66 == $4,104.42
$4,104.42
Skövde University, Autumn 2008 9
 Calculation of Present Value (PV) of
an Annuity
nm
nm

= PMT 
PV = PMT ( 1/(1 + i/m)) == PMT(PVIFA
PV ( 1/(1 + i/m)) tt
PMT(PVIFAi/m,nm )
i/m,nm)
t t==11

where:
where:
PV
PV == present
present value
value
PMT
PMT ==periodic
periodic annuity
annuity payment
payment received
received
during
during investment
investment horizon
horizon
i/m
i/m == periodic
periodic rate
rate earned
earned on
on investments
investments

nm
nm == total
total number
number ofof compounding
compounding
Skövde University, Autumn 2008
periods
periods 10
PVIFA = present value interest factor of an annuity
 Calculation of Present Value of an
Annuity
You
Youare
areoffered
offeredaasecurity
securityinvestment
investmentthat
thatpays
pays$10,000
$10,000on
on
the
thelast
lastday
dayofofevery
everyyear
yearfor
forthe
thenext
next66years
yearsin
inexchange
exchange
for
foraafixed
fixedpayment
paymenttoday.
today.
nm
nm

PV ==PMT(1/(1
PV PMT(1/(1 ++ i/m))
i/m))t=PMT(PVIFA )
t
i/m,nm)
=PMT(PVIFAi/m,nm
t=1
t=1

(at
(at8%
8%interest)
interest)PV
PV==$10,000(4.622880)
$10,000(4.622880) == $46,228.80
$46,228.80

IfIfthe
theinvestment
investmentpays
payson
onthe
thelast
lastday
dayof
ofevery
everyquarter
quarterfor
for
the
thenext
nextsix
sixyears
years

(at
(at8%
8%interest)
interest)PV
PV==$10,000(18.913926)
$10,000(18.913926) == $189,139.26
$189,139.26
Skövde University, Autumn 2008 11
 Future Values Equations
FV
FV of
of lump
lump sum
sum equation
equation
FV
FVnn == PV(1
PV(1 ++ i/m)
i/m)nm == PV(FVIF
nm
PV(FVIF i/m, )
nm)
i/m,nm

FV
FV of
of annuity
annuity payment
payment equation
equation
nm-1
nm-1
FV
FVnn == PMT
PMT 
 (1
(1 ++ i/m)
i/m)t == PMT(FVIFA
t
PMT(FVIFAi/m, mn)
i/m,mn
)
t=0
t=0
Note: the last value paid on Annuity pays no interest.
Note: the last value paid on Annuity pays no interest.

Skövde University, Autumn 2008 12

 Relation between Interest Rates
and Present and Future Values

Future
Present Value
Value (FV)
(PV)

Interest Rate
Interest Rate

Skövde University, Autumn 2008 13

 Effective or Equivalent Annual
Return (EAR)

Rate
Rate earned
earned over
over aa 12-month
12-month period
period
taking
taking the
the compounding
compounding of of interest
interest into
into
account.
account.
cc
EAR
EAR = (1 + r) –– 11
= (1 + r)
Where
Where cc == number
number of
of compounding
compounding
periods
periods per
per year
year
Eg.
Eg. A
A 16%
16% annual
annual return
return compounded
compounded
semiannually
semiannually (r=16%/2=8%,
(r=16%/2=8%, c=2) c=2)
EAR= (1 + 0,08)
EAR= (1 + 0,08) 22
-1=16,64%
-1=16,64%
Skövde University, Autumn 2008 14
 Loanable Funds Theory

•• AA theory
theory of
of interest
interest rate
rate determination
determination
that
that views
views equilibrium
equilibrium interest
interest rates
rates in
in
financial
financial markets
markets asas aa result
result of
of the
the
supply
supply and
and demand
demand forfor loanable
loanable funds
funds

Skövde University, Autumn 2008 15

 Supply of Loanable Funds

Demand Supply
Interest
Rate

Quantity of Loanable Funds

Supplied and Demanded
Skövde University, Autumn 2008 16
 Determination of Equilibrium
Interest Rates
D S
Interest
Rate

I H

i E
I L

Q Quantity of Loanable Funds

Supplied and Demanded
Skövde University, Autumn 2008 17
 Effect on Interest rates from a Shift in
the Demand Curve for or Supply curve
of Loanable Funds
Increased supply of loanable funds Increased demand for loanable funds

Interest SS DD*
Rate DD SS
SS* DD

i** E*
i* E E
E* i*
i**

Q* Q** Quantity of Q* Q** Quantity of

Funds Supplied
Funds Demanded

Skövde University, Autumn 2008 18

 Factors Affecting Nominal Interest
Rates

•• Inflation
Inflation
•• Real
Real Interest
Interest Rate
Rate
•• Default
Default Risk
Risk
•• Liquidity
Liquidity Risk
Risk
•• Special
Special Provisions
Provisions
•• Term
Term to to Maturity
Maturity
Skövde University, Autumn 2008 19
 Inflation and Interest Rates: The
Fisher Effect

Real
Real Interest
Interest Rate
Rate (RIR)
(RIR) isis the
the nominal
nominal interest
interest
rate
rate minus
minus expected
expected inflation.
inflation.
the
the interest
interest rate
rate should
should compensate
compensate an an investor
investor
for
for both
both expected
expected inflation
inflation andand the
the opportunity
opportunity
cost
cost of
of foregone
foregone consumption---the
consumption---the Fisher Fisher effect
effect
ii == RIR
RIR ++ Expected(IP)
Expected(IP)
or
or RIR
RIR == ii –– Expected(IP)
Expected(IP)
Example:
Example: 3.49%
3.49% -- 1.60%
1.60% == 1.89%
1.89%
Skövde University, Autumn 2008 20
 Default Risk Premium and Interest
Rates
The
The risk
risk that
that aa security’s
security’s issuer
issuer will
will default
default
on
on that
that security
security by by being
being late
late on
on or
or missing
missing
an
an interest
interest or
or principal
principal payment
payment

DRP
DRPjj == iijtjt -- iiTtTt
ii
TtDenotes
TtDenotesrateratepaid
paid on
ontreasury
treasury bill,
bill, which
whichisis risk
risk free
free
interest
interest rate
rate. .
Example
Example for
for December
December 2003:
2003:
DRP
DRPAaa = 5.66% - 4.01% = 1.65%
Aaa = 5.66% - 4.01% = 1.65%
DRP
DRPBaaBaa
=
= 6.76%
6.76% -- 4.01%
4.01% =
= 2.75%
2.75%
Skövde University, Autumn 2008 21
 Term to Maturity and Interest
Rates: Yield Curve
(a) Upward sloping
Yield to (b) Inverted or downward
Maturity sloping
(c) Flat
(a)

(c)

(b)
Time to Maturity

Skövde University, Autumn 2008 22

 Term Structure of Interest Rates

•• Unbiased
Unbiased Expectations
Expectations Theory
Theory
•• Liquidity
Liquidity Premium
Premium Theory
Theory
•• Market
Market Segmentation
Segmentation Theory
Theory

Skövde University, Autumn 2008 23

 Expectations Theory
• Key Assumption: Bonds of different maturities are
perfect substitutes
• Implication: Re on bonds of different maturities
are equal

• Investment strategies for two-period horizon

1. Buy $1 of one-year bond and when matures buy another
one-year bond
2. Buy $1 of two-year bond and hold it

Skövde University, Autumn 2008 24

 Expectations Theory
• Investment strategies for two-period
horizon
1. Buy $1 of one-year bond and when
matures buy another
one-year bond
2. Buy $1 of two-year bond and hold it

Skövde University, Autumn 2008 25

More generally for n-period bond…
it  it 1  it  2  ...  it  n1
int  (2)
n
• Equation 2 states: Interest rate on long
bond equals the average of short rates
expected to occur over life of long bond

Skövde University, Autumn 2008 26

 Expectations Theory
and Term Structure Facts
• Explains why yield curve has different slopes
1. When short rates are expected to rise in future,
average of future short rates = int is above today's
short rate; therefore yield curve is upward sloping.
2. When short rates expected to stay same in future,
average of future short rates same as today's, and
yield curve is flat.
3. Only when short rates expected to fall will yield
curve be downward sloping.

Skövde University, Autumn 2008 27

 Market Segmentation Theory
• Key Assumption: Bonds of different maturities are
not substitutes at all

• Implication: Markets are completely

segmented; interest rate at each maturity determined
separately

Skövde University, Autumn 2008 28

 Market Segmentation Theory
• Explains fact 3—that yield curve is usually
upward sloping
– People typically prefer short holding periods and thus have
higher demand for short-term bonds, which have higher
prices and lower interest rates than long bonds

• Does not explain fact 1 or fact 2 because its

assumes long-term and short-term rates are
determined independently

Skövde University, Autumn 2008 29

 Liquidity Premium Theory
• Key Assumption: Bonds of different maturities
are substitutes, but are not
perfect substitutes
• Implication: Modifies Expectations
Theory with features of Market
Segmentation Theory

Skövde University, Autumn 2008 30

 Liquidity Premium Theory
• Results in following modification of Pure
Expectations Theory

it  ie
t 1 i e
t2  ...  i e
t   n1
int   nt (3)
 n

Skövde University, Autumn 2008 31

 Liquidity Premium Theory

Figure 5.6 Relationship Between the Liquidity Premium and Pure Expectations Theory
Skövde University, Autumn 2008 32
 Forecasting Interest Rates

Forward
Forward rate rate isis an
an expected
expected or or “implied”
“implied” rate
rate
on
on aa security
security that
that isis to
to be
be originated
originated at
at some
some
point
point inin the
the future
future using
using thethe unbiased
unbiased
expectations
expectations theory
theory
__ __
11R
R22 == [(1
[(1++11RR11)(1
)(1++((22ff11))]
))]1/2 -- 11
1/2

where22ff11 == expected
where expectedone-year
one-yearrate ratefor foryearyear2,
2,or
orthe
theimplied
implied
__ __ forward
forwardone-year one-yearrate
ratefor
fornext
nextyear
year
22ff11=[(1+
=[(1+ 11RR22))2/(1+
/(1+11RR11)]-1
2
)]-1

Skövde University, Autumn 2008 33

Present Value of Cash Flows:
Example

Skövde University, Autumn 2008 34

 U.S. Real and Nominal Interest
Rates

Figure 3-1 Real and Nominal Interest Rates (Three-Month Treasury Bill), 1953–2004
Sample of current rates and indexes
http://www.martincapital.com/charts.htm
Skövde University, Autumn 2008 35
 Yield Curves

Dynamic yield curve that can show the curve

at any time in history Skövde University, Autumn 2008 36
http://stockcharts.com/charts/YieldCurve.html