Chapter 2: Determinants of Interest Rates
Value of a lump sum
A lump sum payment is a single cash payment received at the beginning or end of some investment horizon
Foreign participants, mostly from the
Business sector, borrow in U.S. financial markets
Who are the net fund demanders?
Corporations, business units
If a security is illiquid, investors add a
Liquidity risk premium (LRP) to the interest rate on the security that reflects its relative liquidity
The MP can be
Positive, negative, or zero
"Supply of loanable funds" describes funds
Provided to the financial markets by net suppliers of funds
Business sector often has excess cash that it can invest for short periods of time
TRUE
Foreign investors view U.S. markets as alternatives to their domestic financial markets
TRUE
Governments may supply loanable funds
TRUE
Household sector is one of the largest suppliers of loanable funds in the US in 2019.
TRUE
Inflation is
The continual increase in the price level of a basket of goods and services
Generally, the quantity of loanable funds supplied increases
as interest rates rise
As risk of the financial security increases (decreases), the supply of loanable funds
decreases (increases)
Governments also borrow
heavily
1s near-term spending needs increase (decrease), the supply of loanable funds
increases (decreases)
In the U.S., inflation is measured using
indexes Consumer price index (CPI) Producer price index (PPI)
lIndividual investors and FIs have preferred investment horizons (habitats) dictated by
the nature of the liabilities they hold (i.e., investors have complete risk aversion for securities outside their maturity preferences)
The higher the level of actual or expected inflation, the higher
will be the level of interest rates
Explanations for the shape of the yield curve fall predominately into three theories:
1.Unbiased expectations theory 2.Liquidity premium theory 3.Market segmentation theory
Two forms of time value of money calculations are commonly used in finance for security valuation purposes:
1.Value of a lump sum 2.Value of annuity payments
Generally, the quantity of loanable funds supplied decreases as interest rates increases.
FALSE
If supply of loanable funds increases with constant demand, interest rate decreases.
TRUE
In general, special provisions tat provide benefits to the security holder are associated with lower interest rates.
TRUE
In general, the quantity of loanable funds demand increases as interest rates fall.
TRUE
Relationship between a security's interest rate and its remaining term to maturity (i.e., the term structure of interest rates) can
Take a number of different shapes
A real risk-free rate is
The interest rate that would exist on a risk-free security if no inflation were expected over the holding period of a security
Change in required interest rates as the maturity of a security changes is called
The maturity premium (MP)
Changes in interest rates influence
The performance and decision making for individual investors, businesses, and governmental units
According to the unbiased expectations theory:
The return for holding 4 year bond to matuirty should equal the expected return for investing in four successive one year bond (as long as the market is in equilibrium)
The higher the default risk, the
Higher the interest rate that will be demanded by the buyer of the security to compensate him or her for this default (or credit) risk exposure
A weakness of both the unbiased expectations and liquidity premium theories is that
They assume that investors have no preference when it comes to different maturities and the risks associated with them.
A weakness of the unbiased expectations theory is that it
assumes that investors are risk neutral
Unbiased Expectations Theory
at any given point in time, the yield curve reflects the market's current expectations of future short-term rates The return for holding 4 year bond to matuirty should equal the expected return for investing in four successive one year bond (as long as the market is in equilibrium)
Difference between a quoted interest rate on a security (security j) and a Treasury security with similar maturity, liquidity, tax, and other features (such as callability or convertibility) is called a
default or credit risk premium (DRPj)
The term structure of interest rates is
A comparison of market yields on securities, assuming all characteristics except maturity are the same
A highly liquid asset is one that can be sold at
A predictable price with low transaction costs, and thus can be converted into its full market value at short notice
Loanable funds theory
Views equilibrium interest rates in financial markets as a result of the supply of and demand for loanable funds
lThe following general equation can be used to determine the factors that functionally impact the fair interest rate (ij*) on an individual (jth) financial security:
i* = IP + RFR + DRP + LRP + SCP + MRP RFR = Real risk-free rate DRPj = Default risk premium on the jth security LRPj = Liquidity risk premium on the jth security SCPj = Special feature premium on the jth security MPj = Maturity premium on the jth security
As economic conditions improve in a domestic (foreign) country, the supply of funds
increases (decreases)
As the utility derived from an asset purchased with borrowed funds increases (decreases), the demand for loanable funds
increases (decreases)
As wealth of fund suppliers increases (decreases), the supply of loanable funds
increases (decreases)
When monetary policy objectives allow the economy to expand (restrict expansion), the supply of loanable funds
increases (decreases)
Relationship among the real risk-free rate (RFR), the expected rate of inflation [E(IP)], and the nominal interest rate (i) is referred to as
The Fisher effect
Time value of money is
The basic notion that a dollar received today is worth more than a dollar received at some future date
The higher society's preference to consume today
The higher the real risk-free rate (RFR)
Liquidity risk is
The risk that a security can be sold at a predictable price with low transaction costs on short notice
Default risk is
The risk that a security issuer will fail to make its promised interest and principal payments to the buyer of a security
"Demand for loanable funds" describes
The total net demand for funds by fund users
lLRP might also be thought of as
An "illiquidity" premium
Liquidity premium theory is
An extension of the unbiased expectations theory Based on the idea that investors will hold long-term maturities only if they are offered at a premium to compensate for future uncertainty in a security's value, which increases with an asset's maturity (1+1RN)^N= (1+1R1)*(1+E(2r1)+L2)*(1+E(3r1)+L3)*........(1+E(Nr1)+LN)
Value of annuity payments
Annuity payments are a series of equal cash flows received at fixed intervals over the entire investment horizon
Nominal interest rates
Are the interest rates actually observed in financial markets Directly affect the value (price) of most securities traded in the money and capital markets
lIn general, special provisions that provide benefits to the security holder (e.g., tax-free status and convertibility) are
Associated with lower interest rates
Categorizes financial market participants
Consumers, businesses, governments, and foreign participants - as net suppliers or demanders of funds
Changes in interest rates impact security values
FIs spend much time and effort trying to identify factors that determine the level of interest rates at any moment in time, as well as what causes interest rate movements over time
Some of these provisions include the security's taxability, convertibility, and callability
For investors, interest payments on municipal securities are free of federal, state, and local taxes A convertible (special) feature of a security offers the holder the opportunity to exchange one security for another type of the issuer's securities at a preset price
The quantity of loanable funds demanded is
Higher as interest rates fall
An investor requires a 3 percent increase in purchasing power in order to induce her to lend. She expects inflation to be 2 percent next year. The nominal rate she must charge is about
I=RFR+IP 3%+2% = 5%
As the restrictiveness of nonprice conditions on borrowed funds decreases (increases), the demand for loanable funds
Increases (decreases)
When domestic economic conditions result in a period of growth (stagnation), the demand for funds
Increases (decreases)
Market segmentation theory argues that
Individual investors and FIs have specific maturity preferences, and to get them to hold securities with maturities other than their most preferred requires a higher interest rate (maturity premium) Does not consider securities with different maturities as perfect substitutes
LRP may also exist if
Investors dislike long-term securities because their prices (present values) are more sensitive to interest rate changes than short-term securities
Businesses demand funds to finance investments in
Long-term assets and for short-term working capital needs
Special provisions or covenants that may be
Written into the contract underlying a security also affect the interest rates on different securities