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