Determinants of Interest Rates and Time Value of Money

Vocabulary flashcards covering loanable funds, interest rate determinants, term structure theories, and time-value of money equations from the transcript.

Loanable Funds Theory

A theory that explains the level of interest rates in financial markets as the result of the supply and demand for loanable funds.

$$i^*$$

The equilibrium interest rate in the loanable funds market, located at the intersection of the supply and demand curves.

$$Q^*$$

The equilibrium quantity of loanable funds in the loanable funds market.

Supply Curve for Loanable Funds

An upward-sloping curve indicating that as interest rates increase, suppliers receive a greater return and increase the quantity of funds supplied.

Demand Curve for Loanable Funds

A downward-sloping curve indicating that lower interest rates lower the cost of external financing and increase the number of positive net present value projects.

Equilibrium Nominal Interest Rate Formula

The formula $i_j^* = RFR + IP + DRP_j + LRP_j + SCP_j + MP_j$ representing the required rate of return on an individual security $j$.

Real Risk-Free Rate ($RFR$)

The interest rate free of risk and inflation adjustments, expressed approximately as $RFR = i - \text{Expected Inflation}$ and exactly as $1 + RFR = \frac{1 + i}{1 + \text{Expected Inflation}}$.

Inflation Premium ($IP$)

A premium compensating investors for loss of purchasing power, calculated using CPI as $IP = \frac{CPI_{t+1} - CPI_t}{CPI_t} \times 100$.

Default Risk Premium ($DRP$)

A premium compensating investors for the possibility that a borrower fails to make payments, calculated as $DRP_j = i_{jt} - i_{Tt}$ using a U.S. Treasury security of similar maturity.

Liquidity Risk Premium ($LRP$)

A premium compensating investors for liquidity risk, which increases when a security becomes harder to buy or sell quickly without affecting its price.

Special Provisions Premium ($SCP$)

A premium that adjusts a security's required interest rate based on features such as taxability, convertibility, and callability.

Term-to-Maturity Premium ($MP$)

The difference between interest rates on long-term and short-term securities while holding all other factors constant.

Term Structure of Interest Rates

The relationship between interest rates and the maturity of securities, graphically depicted by the yield curve.

Unbiased Expectations Theory ($UET$)

A term-structure theory asserting that long-term interest rates are geometric averages of current and expected future short-term interest rates, assuming no investor maturity preference.

Forward Rate

An expected interest rate on a security originating at a specific future date, such as $_2f_1$ representing the expected 1-year rate starting at the end of Year 1.

Liquidity Premium Theory

A term-structure theory stating that long-term rates are geometric averages of current and expected short-term rates plus liquidity premiums that increase with maturity ($L_2 < L_3 < \cdots < L_N$).

Market Segmentation Theory

A term-structure theory proposing that financial market participants have distinct maturity preferences, causing interest rates in separate maturity segments to be determined by individual supply and demand conditions.

Discounting

The process of determining the present value of a future cash flow using $PV = \frac{FV_t}{(1 + r)^t}$.

Compounding

The process of determining the future value of a present cash flow using $FV_t = PV(1 + r)^t$.

Annuity

A finite series of equal cash flows occurring at regular, equal intervals.

Ordinary Annuity

An annuity where cash flow payments occur at the end of each period, evaluated using END mode on a financial calculator.

Annuity Due

An annuity where cash flow payments occur at the beginning of each period, evaluated using BGN mode on a financial calculator.

Deferred Annuity

An annuity whose cash flow series begins at a future date rather than immediately or after one single period.

Annual Percentage Rate ($APR$)

An annualized interest rate calculated as $APR = r_{\text{period}} \times c$, which ignores intra-year compounding.

Effective Annual Return ($EAR$)

The total annual return earned including interest compounding, calculated as $EAR = (1 + r_{\text{period}})^c - 1$.