350 CH2

term structure of interest rates

A comparison of market yields on securities, assuming all characteristics except maturity are the same.

Annuity

A series of equal cash flows received at fixed intervals over the investment horizon

Lump Sum Payment

A single cash flow occurs at the beginning and end of the investment horizon with no other cash flows exchanged.

Loanable Funds Theory

A theory of interest rate determination that views equilibrium interest rates in financial markets as a result of the supply of and demand for loanable funds. One model that is commonly used to explain interest rates and interest rate movements is the loanable funds theory . The loanable funds theory views the level of interest rates as resulting from factors that affect the supply of and demand for loanable funds. It categorizes financial market participants—consumers, businesses, governments, and foreign participants—as net suppliers or demanders of funds.

Forward Rate

An expected rate (quoted today) on a security that originates at some point in the future

Market Segmentation Theory

Assumes that investors do not consider securities with different maturities as perfect substitutes. Rather, individual investors and FIs have preferred investment horizons (habitats) dictated by the nature of the liabilities they hold. Thus, interest rates are determined by distinct supply and demand conditions within a particular maturity segment (e.g., the short end and long end of the bond market).

Unbiased Expectations Theory

At any given point in time, the yield curve reflects the market's current expectations of future short term rates . According to the unbiased expectations theory, the return for holding a 4-year bond to maturity should equal the expected return for investing in four successive 1-year bonds (as long as the market is in equilibrium).

Demand for Loanable Funds

The demand for loanable funds is a term used to describe the total net demand for funds by fund users. In general, the quantity of loanable funds demanded is higher as interest rates fall.

Nominal Interest Rates

The interest rates actually observed in financial markets. These nominal interest rates (or just interest rates) directly affect the value (price) of most securities traded in the money and capital markets, both at home and abroad. Changes in interest rates influence the performance and decision making for individual investors, businesses, and governmental units alike.

Supply of Loanable Funds

The supply of loanable funds is a term commonly used to describe funds provided to the financial markets by net suppliers of funds. In general, the quantity of loanable funds supplied increases as interest rates rise.

Term to Maturity

length of time a security has until maturity

Liquidity Premium Theory

long-term rates are equal to geometric averages of current and expected short-term rates, plus liquidity risk premiums that increase with the security's maturity. Longer maturities on securities mean greater market and liquidity risk. So, investors will hold long-term maturities only when they are offered at a premium to compensate for future uncertainty in the security's value. The liquidity premium increases as maturity increases.

Real Risk-Free Rate

nominal risk-free rate that would exist on a security if no inflation were expected.

Special Provisions

provisions (e.g., taxability, convertibility, and callability) that impact the security holder beneficially or adversely and as such are reflected in the interest rates on securities that contain such provisions.

Liquidity Risk

risk that a security cannot be sold at a predictable price with low transaction costs at short notice.

Default Risk

risk that a security issuer will default on the security by missing an interest or principal payment.

Inflation

the continual increase in the price level of a basket of goods and services.