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REVIEW: The Determinants of

Interest Rates

FINC 4320

Fall 2004

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Objectives

This material should serve asa review

fundamentalinformation 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

SF(lenders)Supply of loanable funds

DF(borrowers)

Demand for loanable funds

Loanable Funds $

Risk

freerate%

if

QL

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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 adjustmentfor expected inflation

The Fisher relation decomposes the nominal marketinterest 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 expectedinflation:

i = r + pe

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Market interest rates and annual inflation rates

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

14.00%

16.00%

18.00%

Jan-58 Jan-62 Jan-66 Jan-70 Jan-74 Jan-78 Jan-82 Jan-86 Jan-90 Jan-94 Jan-98 Jan-02

Annual Inflation Rate (CPI)1-Year Treasury Bill Rate

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terestRatesandthe

Business

Cycle

Time

Int

erestRates(P

ercent)

ExpansionContraction Expansion

Long-Term Rat

Short-Term RatesPeak

Trough

Expansion: Increasing Consumer Spending, Inventory Accumulation, andRising 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 thereal rate of interest for purchasing

power protection with a premium for expectedinflation, 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

Theyield curve plots the relationship between theyield on a security and its term to maturity.

Recall, there are three common theories of the term

structure of interest rates:

1. the pure expectations theory (PET),

2. the liquidity premium theory, and

3. the market segmentation theory.

Theory of the Term StructurePure expectations Liquidity premium Pure market segmentation

|||

Perfect substitutability of maturites No substitutability of maturities

Assumption about maturities

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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 comparableTreasury securities.

0.90

0.75

0.60

0.45

0.30

0.15

0

-0.151996 1997 1998 1999 2000 2001 2002

Aaa corporate bond yields

minus 10-year Treasury

Baa corporate bond yield

minus 10-year Treasury

Long-Term Interest Rate Spreads

Percent

Year

A. Yield Spreads on Aaa-rated and Baa-rated Corporate Bonds

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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 andto 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 yieldthat 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 orputoptions.

Some bonds are issued which can be convertedinto

the common stock of the company.