REVIEW: The Determinants of Interest Rates

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REVIEW The Determinants of Interest Rates

• FINC 4320
• Fall 2004

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Objectives

• This material should serve as a review
  fundamental information from FINC 3340 on the
  determinants of interest rates
• Loanable funds theory
• Real interest rates and inflation
• Variation in rates across securities
• Term to maturity
• Default risk
• Liquidity (marketability) risk
• Tax effects
• Optionality and convertibility

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The Loanable Funds Theory

• Supply of and Demand for Loanable Funds
• The demand for loanable funds represents the
  behavior of borrowers and thus the supply of all
  debt instruments.
• The supply of loanable funds represents the
  behavior of lenders and thus the demand for
  owning debt instruments.
• Any change in the risk-free rate represents a
  movement along DF and SF.

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The Loanable Funds Theory
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Inflation and Interest Rates

• Loanable Funds Theory gets us to the risk-free
  real interest rate, but we observe nominal rates
• The first adjustment to the rate for any
  security, before other risks or features are
  considered, is an adjustment for expected
  inflation
• The Fisher relation decomposes the nominal market
  interest rate (i) into
• an expected real interest rate component (r),
• an expected inflation premium (pe)
• i r pe (r x pe)
• The cross product term r x pe is often ignored,
  hence the nominal rate is composed of the real
  rate of interest plus expected inflation
• i r pe

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Market interest rates and annual inflation rates
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Interest Rates and the Business Cycle
Expansion Increasing Consumer Spending,
Inventory Accumulation, and Rising Loan Demand
Federal Reserve Begins to Slow Money
Growth. Peak Monetary restraint, High Loan
Demand, Little Liquidity. Contraction Falling
Consumer Spending, Inventory Contraction, Falling
Loan Demand Federal Reserve Accelerates Money
Growth. Trough Monetary Ease, Limited Loan
Demand, Excess Liquidity.
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Why do interest rates differ between securities?

• After adjusting the real rate of interest for
  purchasing power protection with a premium for
  expected inflation, investors also alter yields
  due to variations in
• Term to maturity
• Default risk
• Liquidity (marketability) risk
• Tax effects
• Optionality and convertibility

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Yields and Term to Maturity

• The yield curve plots the relationship between
  the yield on a security and its term to maturity.
• Recall, there are three common theories of the
  term structure of interest rates
• the pure expectations theory (PET),
• the liquidity premium theory, and
• the market segmentation theory.

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Yields and Term to Maturity
Treasury Yield Curve, August 31, 2004
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Default risk

• A default risk premium is the difference between
  the yield on a risk security and a comparable
  Treasury security
• The risk premium will always be positive since
  risky securities offer higher yields than
  comparable Treasury securities.

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Marketability and Liquidity

• Liquidity Effects
• Liquidity refers to the speed and ease with which
  an asset can be converted to cash and to the
  certainty of the price received.
• Marketability refers to the speed and ease with
  which an asset can be sold and converted to cash.
• Liquidity Premiums
• Highly liquid assets carry the lowest rates, low
  liquidity securities typically pay a liquidity
  premium.

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Income tax effects

• For investors, the key measure is a securitys
  after-tax return.
• Most municipals pay interest that is exempt from
  federal income taxes, so it is appropriate to
  look at the tax-equivalent municipal yield, or
  the pretax yield that a taxable security would
  offer to provide the same after-tax yield
  available on the municipal
• tax-equivalent municipal yield im / (1-t).

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Special features or options

• Some bonds have call or put options.
• Some bonds are issued which can be converted into
  the common stock of the company.