Chapter Two

Determinants of
Interest Rates

McGraw-Hill /Irwin

Copyright 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

Interest Rate Fundamentals Nominal interest rates - the interest rate actually observed in financial markets
directly affect the value (price) of most securities traded in the market affect the relationship between spot and forward FX rates
McGraw-Hill /Irwin

Copyright 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

Time Value of Money and Interest Rates

Assumes the basic notion that a dollar received today is worth more than a dollar received at some future date Compound interest
interest earned on an investment is reinvested

Simple interest
interest earned on an investment is not reinvested
McGraw-Hill /Irwin

Copyright 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

Calculation of Simple Interest

Value = Principal + Interest
Example: $1,000 to invest for a period of two years at 12 percent
Value = $1,000 + $1,000(.12)(2) = $1,240
McGraw-Hill /Irwin

Copyright 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

Value of Compound Interest

Value = Principal + Interest + Compounded interest

Value = $1,000 + $1,000(12)(2) + $1,000(12)(2) = $1,000[1 + 2(12) + (12)2] = $1,000(1.12)2 = $1,254.40
McGraw-Hill /Irwin

Copyright 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

Present Values
PV function converts cash flows received over a future investment horizon into an equivalent (present) value by discounting future cash flows back to present using current market interest rate lump sum payment
a single cash payment received at the end of some investment horizon

annuity
a series of equal cash payments received at fixed intervals over the investment horizon

PVs decrease as interest rates increase

McGraw-Hill /Irwin

Copyright 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

Calculating Present Value (PV) of a Lump Sum

PV = FVn(1/(1 + i/m))nm = FVn(PVIFi/m,nm)

where: PV = present value FV = future value (lump sum) received in n years i = simple annual interest n = number of years in investment horizon m = number of compounding periods in a year PVIF = present value interest factor of a lump sum
McGraw-Hill /Irwin

Copyright 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

Calculation of Present Value (PV) of an Annuity

PV = PMT (1/(1 + i/m))t = PMT(PVIFA i/m,nm)

t=1

nm

where: PV = present value PMT = periodic annuity payment received during investment i = simple annual interest n = number of years in investment horizon m = number of compounding periods in a year PVIFA = present value interest factor of an annuity
McGraw-Hill /Irwin

Copyright 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

Calculation of Present Value of an Annuity

You are offered a security investment that pays $10,000 on the last day of every quarter for the next 6 years in exchange for a fixed payment today. PV = PMT(PVIFAi/m,nm) at 8% interest - = $10,000(18.913926) = $189,139.26 at 12% interest - = $10,000(16.935542) = $169,355.42 at 16% interest - = $10,000(15.246963) = $152,469.63
McGraw-Hill /Irwin

Copyright 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

Future Values
Translate cash flows received during an investment period to a terminal (future) value at the end of an investment horizon FV increases with both the time horizon and the interest rate

McGraw-Hill /Irwin

Copyright 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

Future Values Equations

FV of lump sum equation
FVn = PV(1 + i/m)nm = PV(FVIF i/m, nm)

FV of annuity payment equation

(nm-1)

FVn = PMT
McGraw-Hill /Irwin

(t = 1)

(1 + i/m)t = PMT(FVIFAi/m, mn)

Copyright 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

Relation between Interest Rates and Present and Future Values

Present Value (PV)

Future Value (FV) Interest Rate Interest Rate

McGraw-Hill /Irwin

Copyright 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

Equivalent Annual Return (EAR) Rate returned over a 12-month period taking the compounding of interest into account
EAR = (1 + i/m)m - 1
At 8% interest - EAR = (1 + .08/4)4 - 1 = 8.24% At 12% interest - EAR = (1 + .12/4)4 - 1 = 12.55%
McGraw-Hill /Irwin

Copyright 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

Discount Yields
Money market instruments (e.g., Treasury bills and commercial paper) that are bought and sold on a discount basis idy = [(Pt - Po)/Pf](360/h)
Where: Pf = Face value Po = Discount price of security
McGraw-Hill /Irwin

Copyright 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

Single Payment Yields

Money market securities (e.g., jumbo CDs, fed funds) that pay interest only once during their lives: at maturity

ibey = ispy(365/360)

McGraw-Hill /Irwin

Copyright 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

Loanable Funds Theory

A theory of interest rate determination that views equilibrium interest rates in financial markets as a result of the supply and demand for loanable funds

McGraw-Hill /Irwin

Copyright 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

Supply of Loanable Funds

Demand
Interest Rate

Supply

Quantity of Loanable Funds Supplied and Demanded

McGraw-Hill /Irwin

Copyright 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

Funds Supplied and Demanded by Various Groups (in billions of dollars)

Funds Supplied

Funds Demanded

Households Business -- nonfinancial Business -- financial Government units Foreign participants

$31,866.4 7,400.0 27,701.9 6,174.8 6,164.8

$ 6,624.4 30,356.2 29,431.1 10,197.9 2,698.3

McGraw-Hill /Irwin

Copyright 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

Determination of Equilibrium Interest Rates

D Interest Rate
IH

i
IL

Quantity of Loanable Funds Supplied and Demanded

McGraw-Hill /Irwin

Copyright 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

Effect on Interest rates from a Shift in the Demand Curve for or Supply curve of Loanable Funds
Increased supply of loanable funds
Interest Rate

Increased demand for loanable funds

DD

DD

SS SS* i**

DD*

SS

E*

i* i**

E E* Q* Q**

E
i*

Quantity of Funds Supplied

Q* Q**

Quantity of Funds Demanded

McGraw-Hill /Irwin

Copyright 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

Factors Affecting Nominal Interest Rates

Inflation
continual increase in price of goods/services

Real Interest Rate

nominal interest rate in the absence of inflation

Default Risk
risk that issuer will fail to make promised payment

(continued)
McGraw-Hill /Irwin

Copyright 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

 Liquidity Risk
risk that a security can not be sold at a predictable price with low transaction cost on short notice

Special Provisions
taxability convertibility callability

Time to Maturity

McGraw-Hill /Irwin

Copyright 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

Inflation and Interest Rates: The Fischer Effect

The interest rate should compensate an investor for both expected inflation and the opportunity cost of foregone consumption (the real rate component) i = Expected (IP) + RIR
Example: 5.08% - 2.70% = 2.38%
McGraw-Hill /Irwin

Copyright 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

Default Risk and Interest Rates

The risk that a securitys issuer will default on that security by being late on or missing an interest or principal payment

DRPj = ijt - iTt

Example: DRPAaa = 7.55% - 6.35% = 1.20% DRPBbb = 8.15% - 6.35% = 1.80%

McGraw-Hill /Irwin

Copyright 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

Tax Effects: The Tax Exemption of Interest on Municipal Bonds

Interest payments on municipal securities are exempt from federal taxes and possibly state and local taxes. Therefore, yields on munis are generally lower than on equivalent taxable bonds such as corporate bonds.

im = ic(1 - ts - tF)
Where: ic = im = ts = tF = Interest rate on a corporate bond Interest rate on a municipal bond State plus local tax rate Federal tax rate

McGraw-Hill /Irwin

Copyright 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

Term to Maturity and Interest Rates: Yield Curve

Yield to Maturity

(a)
(d)

(a) Upward sloping (b) Inverted or downward sloping (c) Humped (d) Flat

(c)
(b)
Time to Maturity
McGraw-Hill /Irwin

Copyright 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

Term Structure of Interest Rates

Unbiased Expectations Theory
at a given point in time, the yield curve reflects the markets current expectations of future short-term rates

Liquidity Premium Theory

investors will only hold long-term maturities if they are offered a premium to compensate for future uncertainty in a securitys value

Market Segmentation Theory

investors have specific maturity preferences and will demand a higher maturity premium
McGraw-Hill /Irwin

Copyright 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

Forecasting Interest Rates

Forward rate is an expected or implied rate on a security that is to be originated at some point in the future using the unbiased expectations theory

_
where

R2 = [(1 + R1)(1 + (f2))]1/2 - 1

f2 = expected one-year rate for year 2, or the implied forward one-year rate for next year
McGraw-Hill /Irwin

Copyright 2001 by The McGraw-Hill Companies, Inc. All rights reserved.