Institutions Ch 2 (Done)

Nominal interest rates

are the interest rates actually observed in financial markets

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

• Changes in interest rates influence the performance and decision making for individual investors, businesses, and governmental units

Changes in interest rates impact security values

FIs (Financial Institutions) 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

Loanable funds theory

views equilibrium interest rates in financial markets as a result of the supply of and demand for loanable funds

Loanable funds theory views equilibrium interest rates in financial markets as a result of the supply of and demand for loanable funds

Categorizes financial market participants – consumers, businesses, governments, and foreign participants – as net suppliers or demanders of funds

“Supply of loanable funds”

describes funds provided to the financial markets by net suppliers of funds

• Generally, the quantity of loanable funds supplied increases as interest rates rise

Generally, the quantity of loanable funds supplied increases as interest rates rise

• Household sector (consumer sector) is one of the largest suppliers of loanable funds in the U.S. ($84.66t in 2019)

• Business sector often has excess cash that it can invest for short periods of time ($28.06t for nonfinancial and $98.47t for financial business in 2019)

• Governments may supply loanable funds ($5.66t in 2019)

• Foreign investors view U.S. markets as alternatives to their domestic financial markets ($27.20t in 2019)

Supply of and Demand for Loanable Funds

“Demand for loanable funds”

describes the total net demand for funds by fund users

• In general, the quantity of loanable funds demanded is higher as interest rates fall

In general, the quantity of loanable funds demanded is higher as interest rates fall

• Household demand reflects financing purchases of homes, durable goods, and nondurable goods ($16.05t in 2019)

• Businesses demand funds to finance investments in long-term assets and for short-term working capital needs ($66.46t for nonfinancial and $111.87t for financial in 2019)

• Governments also borrow heavily ($28.86t in 2019)

• Foreign participants, mostly from the business sector, borrow in U.S. financial markets ($20.81t in 2019)

Factors that cause the supply curve of loanable funds to shift, at any given interest rate:

1. As wealth of fund suppliers increases (decreases), the supply of loanable funds increases (decreases)

2. As risk of the financial security increases (decreases), the supply of loanable funds decreases (increases) 

3. As near-term spending needs increase (decrease), the supply of loanable funds increases (decreases)

4. When monetary policy objectives allow the economy to expand (restrict expansion), the supply of loanable funds increases (decreases)

5. As economic conditions improve in a domestic (foreign) country, the supply of funds increases (decreases)

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

Factors that cause the demand curve for loanable funds to shift include the following:

1. As the utility derived from an asset purchased with borrowed funds increases (decreases), the demand for loanable funds increases (decreases)

2. As the restrictiveness of nonprice conditions on borrowed funds decreases (increases), the demand for loanable funds increases (decreases)

   • Nonprice conditions may include fees, collateral, or requirements or restrictions on the use of funds (i.e., restrictive covenants)

3. When domestic economic conditions result in a period of growth (stagnation), the demand for funds increases (decreases)

Inflation

is the continual increase in the price level of a basket of goods and services

• The higher the level of actual or expected inflation, the higher will be the level of interest rates 

• In the U.S., inflation is measured using indexes 

  • Consumer price index (CPI) 

  • Producer price index (PPI) 

Annual inflation rate using the CPI index between years t and t+1 would be equal to:

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

• The higher society’s preference to consume today, the higher the real risk-free rate (RFR)

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

• The Fisher effect is often written as the following:

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

• 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 

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) 

Liquidity risk

is the risk that a security can be sold at a predictable price with low transaction costs on short notice

Liquidity risk is the risk that a security can be sold at a predictable price with low transaction costs on short notice

• 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 

• If a security is illiquid, investors add a liquidity risk premium (LRP) to the interest rate on the security that reflects its relative liquidity 

  • LRP might also be thought of as an “illiquidity” premium 

• 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 

Special provisions or covenants that may be written into the contract underlying a security also affect the interest rates on different securities 

• 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 

• In general, special provisions that provide benefits to the security holder (e.g., tax-free status and convertibility) are associated with lower interest rates 

The term structure of interest rates

is a comparison of market yields on securities, assuming all characteristics except maturity are the same

• Change in required interest rates as the maturity of a security changes is called the maturity premium (MP)

  • The MP can be positive, negative, or zero 

The following general equation can be used to determine the factors that functionally impact the fair interest rate (ij*) on an individual (jth) financial security: 

Term Structure of Interest Rates

• 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

• 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

Unbiased expectations theory

at any given point in time, the yield curve reflects the market's current expectations of future short-term rates. According to the unbiased expectations theory, the return for holding a four-year bond to maturity should equal the expected return for investing in four successive one-year bonds (as long as the market is in equilibrium).

Liquidity premium theory

long-term rates are equal to geometric averages of current and expected short-term rates, plus liquidity risk premiums that increase with the security's maturity. Longer maturities on securities mean greater market and liquidity risk. So, investors will hold long-term maturities only when they are offered at a premium to compensate for future uncertainty in the security's value. The liquidity premium increases as maturity increases.

Market segmentation theory

assumes that investors do not consider securities with different maturities as perfect substitutes. Rather, individual investors and FIs have preferred investment horizons (habitats) dictated by the nature of the liabilities they hold. Thus, interest rates are determined by distinct supply and demand conditions within a particular maturity segment (e.g., the short end and long end of the bond market).

Unbiased Expectations Theory

At a given point in time, the yield curve reflects the market’s current expectations of future short-term rates

Liquidity Premium Theory

• A weakness of the unbiased expectations theory is that it assumes that investors are risk neutral

• 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

Market Segmentation Theory

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 

• Individual 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)

Market Segmentation and Determination of the Slope of the Yield Curve

Time Value of Money

Time value of money is the basic notion that a dollar received today is worth more than a dollar received at some future date 

Two forms of time value of money calculations are commonly used in finance for security valuation purposes:

1. Value of a lump sum 

   • A lump sum payment is a single cash payment received at the beginning or end of some investment horizon

2. Value of annuity payments 

   • Annuity payments are a series of equal cash flows received at fixed intervals over the entire investment horizon

Value of a lump sum 

A lump sum payment is a single cash payment received at the beginning or end of some investment horizon

Value of annuity payments

Annuity payments are a series of equal cash flows received at fixed intervals over the entire investment horizon

Present Value of a Lump Sum

Future Value of a Lump Sump

Present Value of an Annuity

Future Value of an Annuity