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