Chapter 2: Determinants of Interest Rates

Unbiased expectations Theory

*Current long-term interest rates are geometric averages of current and expected future short short-term interest rates

Compound interest

*Interest earned on an investment is reinvested *Most common

Liquidity Premium theory

*Long term interest rates are geometric averages of current and expected short-term interest rates PLUS liquidity risk premiums that increase with maturity

Nominal Interest Rates can be thought of as the current ___1___ of money

1. "rental price"

Governments ___1___ heavily in the markets for loanable funds

1. Borrow

4 determinants of interest rates for individual securities

1. Default risk premium 2. Liquidity risk 3. Special Provisions 4. Term to maturity

For the factors that affect the supply/demand for loanable funds, Direct = ___1____ Inverse = ____2____

1. Drives up (interest rates) 2. Drives down (interest rates)

Nominal interest rates are used to determine ___1___ and ___2___ of securities

1. Fair present value 2. Prices

5 Determinants of Household savings

1. Interest rates and tax policy 2. Income and wealth 3. Attitudes about saving vs. borrowing 4. Credit availability 5. Job security + belief in soundness of entitlements

4 business demands for funds

1. Level of interest rates 2. Expected future profitability vs. risk 3. Expected economic growth 4. Pecking order theory of fudning

According to the Segmentation Theory, Individual investors and Financial Institutions have specific ___1___ preferences

1. Maturity

Interest rate's impact on (1)demand of funds and (2) impact on Equilibrium Interest Rate

1. Movement along demand curve 2. Direct

Interest rate's impact on (1)supply of funds and (2) impact on Equilibrium Interest Rate

1. Movement along supply curve 2. Direct (Increases)

2 components of Nominal Interest Rates

1. Opportunity cost 2. Adjustments for individual security characteristics

4 Determinants of Foreign Funds invested in the U.S.

1. Relative interest rates and returns on global investments 2. Expected exchange rates 3. Safe haven status of U.S. Investments 4. Foreign central bank investments in the U.S

Economic condition's impact on (1)demand of funds and (2) impact on Equilibrium Interest Rate

1. Shift demand curve 2. Direct

Utility derived from asset purchased with borrowed funds' impact on (1)demand of funds and (2) impact on Equilibrium Interest Rate

1. Shift demand curve 2. Direct

Restrictiveness of nonprice conditions' impact on (1)demand of funds and (2) impact on Equilibrium Interest Rate

1. Shift demand curve 2. Inverse

Near-term spending needs' impact on (1)supply of funds and (2) impact on Equilibrium Interest Rate

1. Shift supply curve 2. Direct

Risk of financial security's impact on (1)supply of funds and (2) impact on Equilibrium Interest Rate

1. Shift supply curve 2. Direct

Economic Conditions' impact on (1)supply of funds and (2) impact on Equilibrium Interest Rate

1. Shift supply curve 2. Inverse

Monetary expansion's impact on (1)supply of funds and (2) impact on Equilibrium Interest Rate

1. Shift supply curve 2. Inverse

Total wealth's impact on (1)supply of funds and (2) impact on Equilibrium Interest Rate

1. Shift supply curve 2. Inverse

The Loanable funds theory categorizes financial market participants - ex. consumers ,businesses ,governments, and foreign participants - as net ___1____ or ___2___ of funds

1. Suppliers 2. Demanders

Real Riskless Interest Rates

Additional purchasing power required to forgo current consumption

Pecking order theory of funding

First internal, then debt, and last equity

Simple interest

Interest earned on an investment that is not reinvested

Default Risk premium (DRP) =

Interest rate on security issued by a non-treasury issuer minus Interest rate on security issued by the U.S treasury

Why are interest rates and tax policy a determinant of household savings

Lower interest rates would lead to re-financing

For the Fisher effect formula, what does RFR mean

Real Risk-free interest rate

According to The Loanable funds theory, foreign participants are

Suppliers of funds

What is the term structure of interest rates?

The Yield Curve

Rule regarding Income and wealth as a determinant of household savings

The greater the wealth or income, the greater the amount saved

Nominal Interest Rates

The interest rates actually observed in financial markets

What is the difference between the real and nominal interest rates

The real interest rate is approximately equal to the nominal interest rate minus the expected rate of inflation RFR = i - Expected(IP)

The time value of money is based on the notion that

a dollar today is worth more than a dollar received in the future

Irving Fisher first postulated that interest rates contain

a premium for expected inflation

Liquidity Risk is the risk that

a sudden surge in liability withdrawals may require an FI to liquidate assets quickly at fire sale prices

Forward rate

an expected rate (quoted today) on a short-term security that is to be originated at some point in the future

According to The Loanable funds theory, Government units are

demanders(borrowers) of funds

According to The Loanable funds theory, businesses are

demanders(borrowers) of funds

Longer bonds are more

expensive

The loanable funds theory views levels of interest rates as resulting from

factors that affect the supply and demand for loanable funds

As interest rate goes up, present value

goes down

As interest rate goes up, future value

goes up

The fair interest rate for a security formula

i* = IP + RFR + DRP + LRP + SCP + MP

Loanable funds theory explains

interest rates and interest rate movements

When the cost of loanable funds is high(i.e interest rates are high), businesses finance

internally

The greater the number of profitable projects available to businesses, the greater demand for

loanable funds

According to The Loanable funds theory, Households are

suppliers of funds

Rule regarding credit availability as a determinant of household savings

the greater the amount of easily obtainable credit, the lower the need to save

According to the Segmentation Theory, Investors and borrowers deviate from their preferred maturity segment only when

they are adequately compensated to do so