Determinants of Interest Rates

1
Determinants of Interest Rates
LOANABLE FUNDS THEORY
TERM STRUCTURE OF RATES
RATES FOR INDIVIDUAL SECURITIES
RATES OVER TIME
Supply
Demand borrowers, issuers of securities,
deficit spending unit Supply lenders,
financial investors, buyers of securities,
surplus spending unit Slope of demand/supply
curves related to elasticity or sensitivity of
interest rates
Demand
Shifts
2
Supply of Loanable Funds

• Quantity supplied directly related to interest
  rates
• Households are major suppliers of loanable funds
• Businesses and governments may invest (loan)
  funds temporarily
• Foreign sector a net supplier of funds in last
  twenty years
• Federal Reserves monetary policy impacts supply
  of loanable funds
• Sector cash receipts in period greater than
  outlayslender

3
Demand for Loanable Funds

• Quantity demanded inversely related to interest
  rates
• Household demand (mortgages, cars, appliances,..)
• Business demand (working capital, profitable
  investments Net present value NPV0,..)
• Governments (temporary imbalances, budget
  deficits, general economic conditions,)
• Foreign demand (differential interest rates,)

4
Equilibrium Interest Rate

• Aggregate Demand
• DA Dh Db Dg Df
• Aggregate Supply
• SA Sh Sb Sg Sf
• In equilibrium, DA SA

5
Shifts in the Supply and Demand

• Supply
• Wealth
• Risk
• Near-term spending needs
• Monetary expansion
• Economic conditions
• Demand
• Utility derived from asset purchases with
  borrowed funds
• Restrictiveness on nonprice conditions on
  borrowed funds
• Economic conditions

6
Movement of Interest Rates Over Time

• Key interest rates 1970 -1999
• Interpret the patterns
• www.stls.frb.org/fred/index.html

7
Rates for Individual Securities i

• i IP RIR DRP LRP MP SCP
• Inflation premium (IP)
• Real interest rates (RIR)
• Default risk premium (DRP)
• Liquidity risk premium (LRP)
• Maturity premium (MP)
• Special covenant premium (SCP)

8
Rates for Individual Securities i

• Fisher effect Inflation and Real Interest rates
• RIR I Expected IR
• http//www.bls.gov/cpi/
• Default risk DRP i i(gov)
• ..www.moodys.com and www.standardpoors.com
• Liquidity risk ability to sell at predictable
  price with low transaction cots
• Maturity risk
• In general, rates rise with maturity. (Upward
  sloping yield curve)
• Special provisions
• Call premium
• Conversion premium
• Tax exemption of municipal bonds

9
Yield Curves at Various Points in Time
17
16
15
February 17, 1982
14
13
January 2, 1985
12
1
1
10
Annualized Treasury Security Yields
9
August 2, 1989
8
October 22, 1996
7
October 15, 2000
6
5
September 18, 2001
4
3
2
0
5
10
15
20
25
30
Number of Years to Maturity
10
Term Structure of Interest Rates

• The relationship between maturity and yield.
• The Yield Curve is the plot of current interest
  yields versus time to maturity.
• Unbiased expectation theory
• Forward rate calculations
• Forward rate Expected short rates
• Different maturities are perfect substitutes
• Liquidity premium theory
• Market segmentation theory

11
Upward and Downward Sloping Yield Curve

• Upward
• Expected higher interest rate levels
• Expansive monetary policy
• Expanding economy
• Downward
• Expected lower interest rate levels
• Tight monetary policy
• Recession soon?

12
Uses of The Term Structure

• Forecast interest rates
• The market provides a consensus forecast of
  expected future interest rates
• Expectations theory dominates the shape of the
  yield curve
• Forecast recessions
• Flat or inverted yield curves have been a good
  predictor of recessions.
• Investment and financing decisions
• Lenders/borrowers attempt to time
  investment/financing based on expectations shown
  by the yield curve
• Riding the yield curve
• Timing of bond issuance

13
Treasury Debt Management

• U.S. Treasury attempts to finance federal debt at
  the lowest overall cost
• Treasury uses a mixture of Bills, Notes, and
  Bonds to finance periodic deficits and refinance
  outstanding securities
• Treasury focuses on short-term issuance, phasing
  out 30-year bonds
• Treasury 10-year bond now the standard issue
• Leave the long-term issuance to private issuers