Determinants of Interest Rates

Introduction

• Interest rates are central to actuarial calculations and finance.
• This study note explores what interest rates represent, how they arise, and the factors affecting their value.

Background

What is Interest?

• Interest represents compensation for deferring consumption or the cost of borrowing money to consume immediately.
• A person's decision to save or spend depends on the incentives provided by interest rates.
• Supply and demand for money dictate the equilibrium interest rates:
  • Supply Curve: Represents the number of lenders willing to lend for different interest rates.
  • Demand Curve: Represents the number of borrowers willing to borrow at different rates.

Quotation Bases for Interest Rates

• Different methods exist for quoting interest rates, affecting comparisons across products and markets.
• U.S. Treasury Bills: Quoted rates differ from effective rates calculated using compound interest. For example:
  • Quoted rate formula: 360*(Dollar amount of interest)/(Days to maturity * Maturity value of T-bill).
  • Canadian Treasury Bills follow a different convention.
  • Effective Interest Rates: Measure true growth better than quoted rates.

Understanding the Components of the Interest Rate

Interest Rates in a World of No Inflation or Default Risk

• Assumes stable prices and guaranteed loan repayments.
• Loans for different terms show differing interest rates due to market segmentation.
• Yield Curves: Illustrate how interest rates vary over different terms.

Interest Rates in a World with Inflation

• Inflation affects both lenders' required rates and borrowers' repayment abilities.
• The equilibrium repayment amount adjusts for expected inflation.
• The rate can be decomposed to adjust for time value of money, inflation rates, and compensation for default risk.

Retail Savings and Lending Interest Rates

Banks as Intermediaries

• Banks function as intermediaries between borrowers and savers, managing deposits and loans.
• Overhead costs and competition influence the rates offered on savings and loans.

Savings Interest Rates

• Determined by:
  • Overhead costs of banks.
  • Demand for loans in specific regions.
  • Strategies of banks to attract deposits.

Lending Interest Rates

• Include secured loans (backed by collateral), unsecured loans (higher risk), and guaranteed loans (assured by third parties).
• Interest rates reflect borrower creditworthiness, prevailing economic conditions, and potential defaults.

Bonds Issued by Governments and Corporations

Types of Bonds

• Bonds include zero-coupon bonds, Treasury securities, municipal bonds, and corporate bonds.
• Each type has unique characteristics and yields based on credit risk and market conditions.

U.S. Treasury Securities

• Highly regarded as safe investments; include T-bills (short-term) and T-notes/bonds (longer maturity).

Role of Central Banks

• Central banks stabilize the financial system, manage payment operations, and serve as lenders of last resort.
• They influence interest rates through monetary policy, affecting economic activity levels.
• The Federal Reserve System sets the federal funds rate, influencing borrowing costs across the economy.

Conclusion

• Understanding the determinants of interest rates is critical for actuarial science and financial decision-making.
• Monetary policy and market conditions create a dynamic landscape for interest rates.