Determination of Interest Rates

1
Determination of Interest Rates

• Interest rates are created and used by the
  financial markets.
• They are embodiments of knowledge and
  expectations.

2
Definition of Interest Rate

• Interest rate is the price paid to borrow debt
  capital or in other words it is the cost of
  Money. To understand it better we can also say
  that interest rates transforms money-today into
  money-tomorrow it is the rate at which it grows
  when invested. There are 4 main factors that
  affect interest rates.

3
Factors Affecting Interest Rates

• There are 4 main factors that affect interest
  rates
• Production Opportunities
• The return (or yield) available within an economy
  from investments in productive (cash-generating)
  assets.
• Time Preference for Consumption
• The preference of consumers for current
  consumption as opposed to saving for future
  consumption.
• Risk
• The chance that an investment will not provide
  the expected return.
• Inflation (The tendency of prices to increase
  over time)

4
Interest Rate Formula
r r DRP LP MRP IP

• Where
• r Nominal (quoted) Interest Rate
• Real Risk Free Rate of Interest, reflects
  production opportunities and time preference for
  consumption
• DRP Default Risk Premium. This premium
  reflects the possibility (chances) that the
  issuer will not
• pay interest or principle at the
  stated time and in the stated amount.
• LP Liquidity Premium. The premium charged to
  compensate the fact that some securities cannot
  be
• converted to cash on a short notice at
  a reasonable price. LP is relatively high on
  securities issued by
• small firms.
• MRP Maturity Risk Premium. A premium, which
  reflects interest rate risk or in other words, a
  premium
• charged to compensate the risk
  stemming from probability of adverse movements in
  the interest
• rates that might cause capital
  losses.
• IP Inflation Premium. A premium equal to
  expected inflation that investors add to the
  real-risk-free rate
• of return.

5
Role of the Interest Rates

• Role of the Interest Rate
• A measure to price the funds (or valuation of the
  securities)
• A factor to bring supply of and demand for funds
  in balance.

6
Risk Free Rate

• Risk free rate (krf) is a rate of return on risk
  free (free from default risk) very liquid
  investment. The interest rates on short term
  government bonds are commonly used to measure
  this rate.

7
Fisher Effect
(1 krf) (1 r) (1 IP)
or a shorter version of it as
krf r IP

• Fisher Effect suggests that the rate of increase
  in actual purchasing power (r) can be obtained
  after adjusting nominal rates for inflation.

8
Technical Aspect of Interest Rate

• Simple Interest Rate
• Interest rate is said to be simple if interest
  is paid only on the principle money (or initial
  investment).
• 2. Compound Interest Rate
• Interest rate is said to be compound if
  interest is paid not only on the initial
  investment, but also on any interest re-invested
  in the previous period.
• 3. Real vs. Nominal Interest Rate
• 4. After- vs. Before-Tax Interest Rate

9
Understanding of Interest Rates

• Interest rate movements affect value of
  securities, and therefore affect the performance
  of all types of companies. It is critical for
  managers to understand why interest rates change,
  how their movements affect performance and how to
  manage according to anticipated interest rate
  movements.

10
The Loanable Funds Theory

• The loanable funds theory is commonly used to
  explain interest rate movements. LF theory
  suggests that the market interest rates are
  determined by the factors that control the
  control the supply of and demand for the loanable
  funds

11
Interest Rates Loanable Funds
12
Loanable Funds Approach
r f (SSLF, DDLF)

• Interest Rate is a function of
• Supply of Loanable Funds ( SSLF) and
• Demand for Loanable Funds ( DDLF).

13
Supply of LF
SSLF SSH SSB SSG SSF

• SSLF Supply of Loanable Funds
• SSH Household Supply of loanable Funds
• SSB Business Supply of Loanable Funds
• SSG Government Supply of Loabale Funds
• SSF Foregn Supply of Loanable Funds (foreign
  lending)
• Savings of domestic economic units SSH SSB
  SG

14
Demand for LF
DDLF DDH DDB DDG DDF

• DDLF Demand for Loanable Funds
• DDH Household Demand for loanable Funds
• DDB Business Demand for Loanable Funds
• DDG Government Demand for Loabale Funds
• DDF Foregn Demand for Loanable Funds

15
Impacts on Supply of LF

• Impacts on Supply of LF
• Households via savings attitude, propensity
  to save (differs from country to country)
• Foreign Parties via foreign savings
• Central Bank via Reserve requirement
  
  Policy

16
Impacts on Demand for LF

• Households as income increases YH? ? Ability to
  barrow? ?DDLF-H?
• Businesses (short term/long term) as r?
  Expected Cash Flow of a project increases? ? NPV?
  ? more projects get accepted ?DDLF-B ?
• Government (cover expenditures) !interest
  inelastic! ?BD? ? DDLF-G?
• Foreign Parties (benefit from interest rate
  differentials)

17
Key Issues

• Economic Growth g ? ? DDLF? ? r?
• Impact of inflation Inf ? ? Fischer Effect ?
  r?
•  Impact of budget deficit DDLF-G ? ? r?
•  Impact of foreign interest rates r foreign ?
  ? DDLF-F? ? r?
•  Impact of Money Supply SSM? ? SSLF? ? r?
• SSM? ? Inf? ? r?

18
Forecasting Interest Rates

• Economic Models
• T-Bond and T-Notes Future Contracts

19
Main Point - 1

• Interest rates can be considered both as
• Price of funds determined by supply of and demand
  for loanable funds,
• Toll that brings demand and supply of funds into
  equilibrium.

20
Main Point - 2

• Observed nominal interest rates in different
  financial markets are manifestations of a unique
  unobservable real interest rate which
  interconnects all financial markets.

21
Summary

• A required rate represents a single price for all
  the characteristics of a financial asset.
• While interest rates are set by market
  conditions, ones decision to accept or reject a
  particular rate affects the market.

22
Relationships between Interest Rates and Security
Prices

• Interest rate is the common element to all
  security prices.

23
Two Faces of Financial Assets

• Borrowing and lending money
• Selling and buying securities

24
Valuation of Financial Assets

• Bonds
• Stocks
• Futures
• Options
• The price of any security is a function of
  several factors. The required rate is the
  fundamental element in price determination.

25
Summary

• On the basis of the price of all securities, we
  can find the required rate.
• Parallel relationships between factors can be
  observed in the different aspects of a security.