1. Chapter 8
Interest Rates
© 2011 John Wiley and Sons

2. Supply and Demand for Loanable Funds
Basic Interest Rate Concepts:
Interest Rate: Price that equates the demand for and supply of loanable funds
Role of Financial Markets:
Interest rates are determined by the supply and demand for loanable funds in financial markets

3. Interest Rate Determination in the Financial MarketsB S1 S1 8%
Interest rate (r)
Interest rate (r) 7% D2 D1 D1
Quantity of Loanable Funds
Quantity of Loanable Funds S2 S1 S2 S1 9% 8%
Interest rate (r)
Interest rate (r) D1 D1 D3
Quantity of Loanable Funds
Quantity of Loanable Funds C D

4. Historical Changes in U.S. Interest Rate Levels
Periods of Rising Interest Rates:
(rapid economic expansion after the Civil War)
(pre-war expansion and World War I-related inflation)
(economic boom in late 1920s followed by major depression)
(rapid economic expansion after World War II)

5. Historical Changes in U.S. Interest Rate Levels (continued)
Periods of Falling Interest Rates:
(supply of funds exceeded demand for funds and prices fell)
(rapid growth in supply of funds and falling prices)
(actions taken to fight the depression and finance World War II)
1982-present (generally declining prices and interest rates)

6. Loanable Funds Theory
Loanable Funds Theory Definition: States that interest rates are a function of the supply of and demand for loanable funds
Two Basic Sources of Loanable Funds:
--current savings
--expansion of deposits by depository institutions

7. Factors Affecting the Supply of Loanable Funds
Volume of Savings
Major factor is the level of national income
Expansion of Deposits by Depository Institutions
Amount of short-term credit available depends on lending policies of depository institutions and the Fed
Liquidity Attitude
Refers to how lenders see the future

8. Determinants of Market Interest Rates
Nominal Interest Rate (r): Interest rate that is observed in the marketplace
Basic Equation:
r = RR + IP + DRP
Real Rate of Interest (RR): Interest rate on a risk-free debt instrument when no inflation is expected

9. Determinants of Market Interest Rates (continued)
Basic Equation:
r = RR + IP + DRP
Inflation Premium (IP): Average inflation rate expected over the life of the security
Default Risk Premium (DRP): Compensation for the possibility of the borrower’s failure to pay interest and/or principal when due

10. Determinants of Market Interest Rates (concluded)
Basic Equation Expanded: r = RR + IP + DRP + MRP + LP
Maturity Risk Premium (MRP): Compensation expected by investors due to interest rate risk on debt instruments with longer maturities
Liquidity Premium (LP): Compensation for securities that cannot easily be converted to cash without major price discounts

11. Interest Rate Risk Definition:
Possible price fluctuations in fixed-rate debt instruments associated with changes in market interest rates
Reason: An inverse relationship exists between debt instrument values or prices and nominal interest rates in the marketplace

12. Risk-Free Rate of Interest
Definition:
Interest rate on a debt instrument with no default, maturity, or liquidity risks (Treasury securities are the closest example)
Equation: Risk-Free Rate (rf) = Real Rate (RR) + Inflation Premium (IP)

13. Two Types of U.S. Government Debt Obligations
Marketable Government Securities:
Securities that may be bought and sold through the usual market channels
Nonmarketable Government Securities:
Issues that cannot be transferred between persons or institutions but must be redeemed with the U.S. government

14. Types of U.S. Treasury Debt Obligations
Treasury Bills: Obligations that bear the shortest (up to one year) original maturities
Treasury Notes: Obligations issued with maturities of two to ten years
Treasury Bonds: Obligations issued with maturities usually over five years and up to thirty years

15. Term or Maturity Structure of Interest Rates
Term Structure: Relationship between interest rates or yields and the time to maturity for debt instruments of comparable quality
Yield Curve: Graphic presentation of the term structure of interest rates at a given point in time

16. Term Structure Extremes for U.S. Treasury Securities
Maturity
March 1980
Oct. 2008
6 months
15.0%
0.2%
1 year
14.0%
0.4%
5 years
13.5%
2.3%
10 years
12.8%
3.4%
20 years
12.5%
4.2%
30 years
12.3%

17. Recent Term Structures for U.S. Treasury Securities
Maturity
Oct. 2006
Oct. 2008
6 months
4.9%
0.2%
1 year
5.0%
0.4%
5 years
4.7%
2.3%
10 years
3.4%
20 years
4.2%
30 years

18. Three Term Structure Theories
Expectations Theory: Shape of the yield curve indicates investor expectations about future inflation rates
Liquidity Preference Theory: Investors are willing to accept lower interest rates on short-term debt securities which provide greater liquidity and less interest rate risk

19. Three Term Structure Theories (continued)
Market Segmentation Theory: Interest rates may differ because securities of different maturities are not perfect substitutes for each other

20. Inflation Premiums and Price Movements
Inflation: Occurs when an increase in the price of goods or services is not offset by an increase in quality
Historical Price Movements: Changes in the money supply or in the amount of metal in the money unit have influenced prices since the earliest records of civilization

21. Periods of Inflation in the U. S.
Revolutionary War
War of 1812
Civil War
World War I
World War II
Postwar Period through Early 1982

22. Types of Inflation
Cost-Push Inflation: Occurs when prices are raised to cover rising production costs, such as wages
Demand-Pull Inflation: Occurs during economic expansions when demand for goods and services is greater than supply

23. Types of Inflation (continued)
Speculative Inflation: Caused by the expectation that prices will continue to rise, resulting in increased buying to avoid even higher future prices
Administrative Inflation:
The tendency of prices, aided by union-corporation contracts, to rise during economic expansion and to resist declines during recessions

24. Default Risk Premiums
Default Risk: Risk that a borrower will not pay interest and/or repay the principal on a loan according to the agreed contractual terms
Basic Equation: DRP = r - RR - IP
Basic Equation Expanded: DRP = r - RR - IP - MRP - LP

25. Default Risk Premium Example
Basic Information:
nominal interest rate = 9%; real rate = 3%; inflation premium = 5%; and market risk and liquidity premiums = 0%. What is the default risk premium?
Expanded Equation: DRP = r - RR - IP - MRP - LP DPR = 9% - 3% - 5% - 0% - 0% = 1%

26. Risky Corporate Bonds Investment Grade Bonds: High-Yield Bonds:
Ratings of Baa or higher (Aaa, Aa, or A) that meet financial institution investment standards
High-Yield Bonds:
High-yield or junk bonds that have a substantial probability of default