Determinants of IR

Adopted from “Financial Markets and Institutions” – Saunders & Cornett

For TCHE401/TCH401E Classes in FTU only, no further distribution/reproduction allowed.
Interest rate:
The price of borrowing/lending
Income for one side, cost for another side
Nominal interest rates: the interest rates actually observed in
financial markets.
Used to determine fair present value and prices of securities.
Two components:
Opportunity cost.
Adjustments for individual security characteristics.

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Additional purchasing power required to forego current
consumption.
What causes differences in nominal and real interest rates?
If you wish to earn a 3% real return and prices are expected to increase by
2%, what rate must you charge?
Irving Fisher first postulated that interest rates contain a premium for
expected inflation.
Fisher equation iR ≈ iN - π

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Loanable funds theory explains interest rates and interest rate
movements
Views level of interest rates as resulting from factors that affect the
supply of and demand for loanable funds
Categorizes financial market participants – e.g., consumers,
businesses, governments, and foreign participants – as net
suppliers or demanders of funds

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Access the long description slide. 2-5
1-6
 VN and US lending rates
18

16

14

12

10

0
1990 2000 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
[YR1990] [YR2000] [YR2011] [YR2012] [YR2013] [YR2014] [YR2015] [YR2016] [YR2017] [YR2018] [YR2019] [YR2020]

Lending interest rate (%) FR.INR.LEND Vietnam VNM

Lending interest rate (%) FR.INR.LEND United States USA

Data from database: World Development Indicators

Last Updated: 07/30/2021

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TABLE 2–1 Funds Supplied and Demanded by Various Groups (in trillions of dollars)

Net Funds Supplied

Funds Supplied Funds (Funds Supplied—
Demanded Funds Demanded)

Households $70.33 $14.51 $55.82

Business—nonfinancial 23.20 55.85 −32.65
Business—financial 85.91 96.90 −10.99
Government units 5.22 23.19 −17.97
Foreign participants 23.03 17.24 5.79

Source: Federal Reserve Board website, “Financial Accounts of the United States,” May 2016. www.federalreserve.gov

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Interest rates (+) and tax policy (-).
Income and wealth (+)
Attitudes about saving versus borrowing.
Credit availability (-)
Job security and belief in soundness of entitlements (-).

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Relative interest rates and returns on global investments.
Expected exchange rate changes.
Safe haven status of U.S. investments.
Foreign central bank investments in the U.S.

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Governments borrow heavily in the markets for loanable funds.
$23.19 trillion in 2016.
United States.
National debt was $19.21 trillion in 2016.
National debt (and interest payments on the national debt) have to be financed in
large part by additional borrowing.

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Level of interest rates:
When the cost of loanable funds is high (i.e., interest rates are high),
businesses finance internally.
Expected future profitability vs. risk:
The greater the number of profitable projects available to businesses, the
greater the demand for loanable funds.
Expected economic growth.

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Figure 2–4 The Effect on Interest Rates from a Shift in the
Supply Curve of or Demand Curve for Loanable Funds
(a) Increase in the supply of loanable funds

Access the long description slide.

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(b) Increase in the demand for loanable funds

Access the long description slide.

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TABLE 2–2 Factors That Affect the Supply of and Demand for
Loanable Funds for a Financial Security

Panel A: The supply of funds

Factor Impact on Supply of Funds Impact on Equilibrium Interest

Rate*
Interest rate Movement along the supply curve Direct

Total wealth Shift supply curve Inverse

Risk of financial security Shift supply curve Direct

Near-term spending needs Shift supply curve Direct

Monetary expansion Shift supply curve Inverse

Economic conditions Shift supply curve Inverse

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 Panel B: The demand for funds

Factor Impact on Demand for Funds Impact on Equilibrium Interest Rate

Interest rate Movement along the demand curve Direct

Utility derived from asset purchased Shift demand curve Direct

with borrowed funds
Restrictiveness of nonprice conditions Shift demand curve Inverse

Economic conditions Shift demand curve Direct

*A “direct” impact on equilibrium interest rates means that as the “factor” increases
(decreases) the equilibrium interest rate increases (decreases). An “inverse” impact means
that as the factor increases (decreases) the equilibrium interest rate decreases (increases).

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ij* = f(IP, RFR, DRPj, LRPj, SCPj, MPj)

Inflation (IP).
(𝐶𝑃𝐼𝑡+1 − 𝐶𝑃𝐼𝑡 )
IP = × 100
𝐶𝑃𝐼𝑡

Real risk-free interest rate (RFR) and the Fisher effect.

RFR = i − Expected (IP)

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Default risk premium (DRP).
DRPj = ijt − iTt

ijt = interest rate on security issued by a non-Treasury issuer (issuer j) of maturity

m at time t
iTt = interest rate on security issued by the U.S. Treasury of maturity m at time t

Liquidity risk (LRP).

Special provisions (SCP).
Term to maturity (MP).

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 Figure 2–6 Default Risk Premium on Corporate Bonds

Source: Federal Reserve Board website, May 2016. www.federalreserve.gov

Access the long description slide.

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

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Current long-term interest rates (1RN) are geometric averages of
current and expected future, E(Nr1), short-term interest rates.

1
1𝑅𝑁 = [(1+ 1R1 )(1 + 𝐸( 2𝑟1 )). . . (1 + 𝐸( 𝑁𝑟1 ))] 𝑁 −1

1RN = actual N-period rate today

N = term to maturity, N = 1, 2, …, 4, …
1R1 = actual current one-year rate today
E(ir1) = expected one-year rates for years, i = 1 to N

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Long-term interest rates are geometric averages of current and
expected future short-term interest rates plus liquidity risk
premiums that increase with maturity.
1
1𝑅𝑁 = [(1 +1 𝑅1 )(1+𝐸(2 𝑟1 ) + 𝐿2 ). . . (1 + 𝐸( 𝑁𝑟1 )+) + 𝐿𝑁 )]𝑁 −1

Lt = liquidity premium for period t

L2 < L3 < …LN

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Figure 2–9 Yield Curve under the Unbiased Expectations
Theory (UET) versus the Liquidity Premium Theory (LPT)

Access the long description slide.

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Individual investors and FIs have specific maturity preferences.
Interest rates are determined by distinct supply and demand
conditions within many maturity segments.
Investors and borrowers deviate from their preferred maturity
segment only when adequately compensated to do so.

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A forward rate (f) is an expected rate on a short-term security that
is to be originated at some point in the future.
The one-year forward rate for any year, N years into the future is:

(1 +1 𝑅𝑁 )𝑁
𝑁𝑓1 = 𝑁−1 −1
(1 +1 𝑅𝑁−1 )

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The time value of money is based on the notion that a dollar
received today is worth more than a dollar received at some future
date.
Simple interest: interest earned on an investment is not reinvested.
Compound interest: interest earned on an investment is reinvested, most
common.

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Discount future payments using current interest rates to find the
present value (P V)

PV = FVt I(1 + r)t

P V = present value of cash flow

FVn = future value of cash flow (lump sum) received in t periods
r = interest rate earned per period on investment
t = number of compounding periods in investment horizon

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The future value (F V) of a lump sum received at the beginning of
the investment horizon

FVt = PV(1 + r)t

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Access the long description slide.
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The present value of a finite series of equal cash flows received on
the last day of equal intervals throughout the investment horizon.

𝑡 𝑗
1
𝑃𝑉 = 𝑃𝑀𝑇 ෍
(1 + 𝑟)
𝑗=1

1
1− 𝑡
1+𝑟
𝑃𝑉 = 𝑃𝑀𝑇 ×
𝑟

PMT = periodic annuity payment

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The future value of a series of equal cash flows received at equal
intervals throughout the investment horizon.

𝑡−1

𝐹𝑉𝑡 = 𝑃𝑀𝑇 ෍(1 + 𝑟)𝑗

𝑗=0

(1 + 𝑟)𝑡 − 1
𝐹𝑉𝑡 = 𝑃𝑀𝑇 ×
𝑟

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