ADMN 4720 Chapter 2

Chapter 2: Determinants of Interest Rates

Chapter Outline

• Interest rate fundamentals

• Loanable Funds Theory

• Movement of Interest Rates Over Time

• Determinants of interest rates for individual securities

• Term structure of interest rates

• Forecasting interest rates

• Time value of money and interest rates

Interest Rate Fundamentals

• Nominal interest rates: the rates observed in financial markets

  • Directly affect the value (price) of most securities in the money and capital markets

  • Changes in interest rates influence performance and decision-making for investors, businesses, and governments

Key U.S. Interest Rates (1972-2022)

• Overview of interest rate trends over time including:

  • Federal Funds Rate

  • 3-Month T-Bill

  • Moody's AAA Bond Yield

  • 30-Year Fixed Rate Mortgage Average

Loanable Funds Theory

• Explains interest rates and movements in interest rates

• Level of interest rates is determined by the supply and demand for loanable funds

  • Participants include consumers, businesses, governments, and foreign entities as net suppliers or demanders

Supply of Loanable Funds

• Describes funds provided to financial markets by net suppliers

  • Generally increases as interest rates rise

  • Key suppliers:

    • Household sector: $84.66 trillion (2019)

    • Business sector: $28.06 trillion (nonfinancial), $98.47 trillion (financial)

    • Governments: $5.66 trillion

    • Foreign investors: $27.20 trillion

Demand for Loanable Funds

• Describes total net demand for funds by users

  • Quantity demanded generally increases as interest rates fall

  • Key demanders include:

    • Households: $16.05 trillion (2019)

    • Businesses: $66.46 trillion (nonfinancial), $111.87 trillion (financial)

    • Governments: $28.86 trillion

    • Foreign participants: $20.81 trillion

Factors Affecting Supply and Demand for Loanable Funds

Supply Factors

1. Increased wealth of suppliers raises supply

2. Higher risk diminishes supply

3. Near-term spending needs decrease supply

4. Expansionary monetary policy increases supply

5. Improved economic conditions increase supply

Demand Factors

1. Higher utility from assets increases demand

2. Less restrictiveness of borrowing conditions increases demand

3. Economic growth increases demand

Determinants of Interest Rates for Individual Securities

Inflation

• Defined as continual price level increases

• Higher actual or expected inflation leads to higher interest rates

• Measured by:

  • Consumer Price Index (CPI)

  • Producer Price Index (PPI)

Real Risk-Free Rate

• Interest rate existing without inflation expectations

• Higher consumer preference for current consumption raises this rate

• Relationship with nominal rates captured by the Fisher effect:

  • Real risk-free rate (RFR) = nominal interest rate (i) - expected inflation (E(IP))

Default Risk

• Risk that an issuer will fail to meet payment obligations

• Higher default risk necessitates higher interest rates to compensate investors

• Default or credit risk premium (DRPj) is calculated against Treasury securities

Liquidity Risk

• Risk of selling a security at a predictable price

• Illiquid securities incur a liquidity risk premium (LRP) added to interest rates

Special Provisions/Covenants

• Special features affect interest rates such as:

  • Taxability

  • Convertibility

  • Callability

• Provisions providing benefits reduce interest rates

Determinants of Household Savings

1. Influence of interest rates and tax policies

2. Higher income and wealth lead to greater savings

3. Saving attitudes versus borrowing preferences

4. Availability of easy consumer credit reduces savings needs

5. Job security affects savings behavior

Determinants of Foreign Investments in U.S.

1. Relative interest rates and returns

2. Expected exchange rate changes

3. U.S. investments as a safe haven

4. Foreign central bank investments

Federal Government Demand for Funds

• Governments heavily rely on loanable funds

• Significant U.S. national debt and borrowing requirements

Business Demand for Funds

• Level of interest rates influences financing decisions

• Expected profitability and economic growth drive demand

Effect on Interest Rates from Supply and Demand Shifts

• Changes in supply or demand curves can alter equilibrium interest rates

  • Increase in supply leads to lower rates

  • Increase in demand leads to higher rates

Yield Curve and Interest Rate Theories

Unbiased Expectations Theory

• Long-term rates as geometric averages of expected future short-term rates

Liquidity Premium Theory

• Long-term rates include liquidity risk premiums

Market Segmentation Theory

• Interest rates shaped by unique supply and demand within maturity segments

Time Value of Money and Interest Rates

• Present value (PV) vs. future value (FV) concepts

  • PV calculated using interest rates

  • FV based on compounding returns

Future Value and Present Value Calculations

1. Present Value Formula:

   • PV = FVt / (1 + r)^t

2. Future Value Formula:

   • FVt = PV(1 + r)^t

Future Value of an Annuity

• Series of equal cash flows treated with annuity calculations

Financial Calculator Settings

• Important input/output settings for financial calculations

  • Number of compounding periods

  • Calculation of PV, PMT, FV based on inputs.