Chapter Two

Determination of
Interest Rates
2-1

2009, The McGraw-Hill Companies, All Rights

Interest Rate Fundamentals

Nominal
Nominal interest
interest rates:
rates: the
the interest
interest rates
rates
actually
actually observed
observed in
in financial
financial markets
markets
affect
affect the
the values
values (prices)
(prices) of
ofsecurities
securities traded
traded in
in
money
money and
and capital
capital markets
markets
affect
affect the
the relationships
relationships between
between spot
spot and
and
forward
forward FX
FX rates
rates

2-2

2009, The McGraw-Hill Companies, All Rights

Time Value of Money and Interest Rates

The
The time
time value
value of
of money
money isis based
based on
on the
the
notion
notion that
that aa dollar
dollar received
received today
today isis
worth
worth more
more than
than aa dollar
dollar received
received at
at
some
some future
future date
date
Simple
Simple interest:
interest: interest
interest earned
earned on
on an
an

investment
investment isis not
not reinvested
reinvested
Compound
Compound interest:
interest: interest
interest earned
earned on
on an
an
investment
investment isis reinvested
reinvested
2-3

2009, The McGraw-Hill Companies, All Rights

Present Value of a Lump Sum

Discount
Discount future
futurepayments
payments using
using current
current
interest
interest rates
rates to
to find
find the
the present
present value
value (PV)
(PV)
t t = FV (PVIF )
PV
+
r)]
PV == FV
FVt[1/(1
[1/(1
+
r)]
= FVt t(PVIFr,tr,t)
t
PV
PV==present
presentvalue
valueof
ofcash
cashflow
flow
FV
FVt t==future
futurevalue
valueof
ofcash
cashflow
flow(lump
(lumpsum)
sum)received
receivedin
intt
periods
periods
rr==interest
interestrate
rateper
perperiod
period
tt==number
numberof
ofyears
yearsin
ininvestment
investmenthorizon
horizon
PVIF
PVIFr,tr,t==present
presentvalue
valueinterest
interestfactor
factorof
ofaalump
lumpsum
sum
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2009, The McGraw-Hill Companies, All Rights

Future Value of a Lump Sum

The
The future
future value
value (FV)
(FV) of
of aa lump
lump sum
sum
received
received at
at the
the beginning
beginning of
of an
an
investment
investment horizon
horizon
FV
FVtt == PV
PV(1
(1 ++ r)
r)t t == PV(FVIF
PV(FVIFr,tr,t))
FVIF
FVIFr,tr,t == future
future value
value interest
interest factor
factor of
ofaalump
lump
sum
sum

2-5

2009, The McGraw-Hill Companies, All Rights

Relation between Interest Rates and

Present and Future Values
Present
Value
(PV)

Future
Value
(FV)
Interest Rate
Interest Rate
2-6

2009, The McGraw-Hill Companies, All Rights

Present Value of an Annuity

The
The present
present value
value of
of aa finite
finite series
series of
of equal
equal
cash
cash flows
flows received
received on
on the
the last
last day
dayof
of equal
equal
intervals
intervals throughout
throughout the
the investment
investment horizon
horizon
t

PV PMT [1 /(1 r )] j PMT ( PVIFAr ,t )

j 1

PMT
PMT==periodic
periodicannuity
annuitypayment
payment
PVIFA
PVIFAr,tr,t==present
presentvalue
valueinterest
interestfactor
factorof
ofan
anannuity
annuity

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2009, The McGraw-Hill Companies, All Rights

Future Value of an Annuity

The
The future
futurevalue
value of
of aa finite
finite series
series of
of equal
equal cash
cash
flows
flows received
received on
on the
the last
lastday
day of
of equal
equal intervals
intervals
throughout
throughoutthe
theinvestment
investment horizon
horizon
t 1

FVt PMT (1 r ) j PMT ( FVIFAr ,t )

j 0

FVIFA
FVIFAr,tr,t==future
futurevalue
valueinterest
interestfactor
factorof
ofan
anannuity
annuity

2-8

2009, The McGraw-Hill Companies, All Rights

Effective Annual Return

Effective
Effective or
or equivalent
equivalent annual
annual return
return
(EAR)
(EAR) isis the
the return
return earned
earned or
or paid
paid over
over aa
12-month
12-month period
period taking
taking compounding
compounding
into
into account
account
EAR
EAR == (1
(1 ++ r)
r)cc 11
cc==the
thenumber
numberof
ofcompounding
compoundingperiods
periodsper
peryear
year

2-9

2009, The McGraw-Hill Companies, All Rights

Financial Calculators
Setting
Setting up
up aa financial
financial calculator
calculator

Number
Numberof
ofdigits
digitsshown
shownafter
afterdecimal
decimalpoint
point
Number
Numberof
ofcompounding
compoundingperiods
periodsper
peryear
year

Key
Keyinputs/outputs
inputs/outputs (solve
(solvefor
forone
oneof
of five)
five)
NN==number
numberof
ofcompounding
compoundingperiods
periods
I/Y
I/Y==annual
annualinterest
interestrate
rate
PV
PV==present
presentvalue
value(i.e.,
(i.e.,current
currentprice)
price)
PMT
PMT==aaconstant
constantpayment
paymentevery
everyperiod
period
FV
FV==future
futurevalue
value(i.e.,
(i.e.,future
futureprice)
price)
2-10

2009, The McGraw-Hill Companies, All Rights

Loanable Funds Theory

Loanable
Loanable funds
funds theory
theory explains
explains interest
interest rates
rates
and
and interest
interest rate
rate movements
movements
Views
Views level
level of
of interest
interest rates
rates in
in financial
financial
markets
markets as
as aa result
result of
of the
the supply
supply and
and demand
demand
for
forloanable
loanable funds
funds
Domestic
Domestic and
and foreign
foreign households,
households, businesses,
businesses,
and
and governments
governments all
all supply
supply and
and demand
demand
loanable
loanable funds
funds
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2009, The McGraw-Hill Companies, All Rights

Supply and Demand of Loanable Funds

Interest
Rate

Demand

Supply

Quantity of Loanable Funds

Supplied and Demanded
2-12

2009, The McGraw-Hill Companies, All Rights

Shifts in Supply and Demand Curves

change Equilibrium Interest Rates
Increased supply of loanable funds
Interest
Rate

Interest
Rate

SS

DD

Increased demand for loanable funds

SS*

DD

DD*

i**
i*

i*

E*

i**
Q* Q**

Quantity of
Funds Supplied

2-13

SS

E*
E

Q* Q**

Quantity of
Funds Demanded

2009, The McGraw-Hill Companies, All Rights

Determinants of Interest Rates

for Individual Securities

iij*j* == f(IP,
f(IP,RIR,
RIR, DRP
DRPj,j, LRP
LRPj,j, SCP
SCPj,j, MP
MPj)j)
Inflation
Inflation (IP)
(IP)
IP
) (CPI )]/(CPI ) x (100/1)
IP== [(CPI
[(CPIt+1
t+1) (CPIt t)]/(CPIt t) x (100/1)

Real
Real Interest
Interest Rate
Rate (RIR)
(RIR) and
and the
the Fisher
Fisher
effect
effect
RIR
RIR == ii Expected
Expected (IP)
(IP)

2-14

2009, The McGraw-Hill Companies, All Rights

Determinants of Interest Rates

for Individual Securities (contd)
Default
Default Risk
Risk Premium
Premium (DRP)
(DRP)
DRP
DRPj j ==iijtjt iiTtTt
iijtjt==interest
interestrate
rateon
onsecurity
securityjjatattime
timett
iiTtTt==interest
interestrate
rateon
onsimilar
similarmaturity
maturityU.S.
U.S.Treasury
Treasury
security
securityatattime
timett

Liquidity
Liquidity Risk
Risk (LRP)
(LRP)
Special
Special Provisions
Provisions (SCP)
(SCP)
Term
Term to
to Maturity
Maturity (MP)
(MP)
2-15

2009, The McGraw-Hill Companies, All Rights

Term Structure of Interest Rates:

the Yield Curve
(a) Upward sloping
(b) Inverted or downward
sloping
(c) Flat

Yield to
Maturity

(a)
(c)

(b)
Time to Maturity

2-16

2009, The McGraw-Hill Companies, All Rights

Unbiased Expectations Theory

Long-term
Long-term interest
interest rates
rates are
aregeometric
geometric
averages
averages of
of current
current and
and expected
expected future
futureshortshortterm
term interest
interest rates
rates

RN [(11 R1 )(1 E ( 2 r1 ))...(1 E ( N r1 ))]

1/ N

RR ==actual
actualN-period
N-periodrate
ratetoday
today
NN==term
termto
tomaturity,
maturity,NN==1,1,2,2,,
,4,4,

11R
R11==actual
actualcurrent
currentone-year
one-yearrate
ratetoday
today
11 NN

E(
E(irir11))==expected
expectedone-year
one-yearrates
ratesfor
foryears,
years,ii==11to
toNN
2-17

2009, The McGraw-Hill Companies, All Rights

Liquidity Premium Theory

Long-term
Long-term interest
interest rates
rates are
aregeometric
geometric
averages
averages of
of current
current and
and expected
expected future
futureshortshortterm
term interest
interest rates
ratesplus
plus liquidity
liquidityrisk
riskpremiums
premiums
that
that increase
increase with
with maturity
maturity
1/ N
R

[(
1

R
)(
1

E
(
r
)

L
)...(
1

E
(
r
)

L
)]
1
1
N
1 1
2 1
2
N 1
N

LLt t==liquidity
liquiditypremium
premiumfor
forperiod
periodtt
LL22<<LL33<<<L
<LNN

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2009, The McGraw-Hill Companies, All Rights

Market Segmentation Theory

Individual
Individual investors
investors and
and FIs
FIs have
havespecific
specific
maturity
maturity preferences
preferences
Interest
Interest rates
rates are
aredetermined
determined by
by distinct
distinct supply
supply
and
and demand
demand conditions
conditions within
withinmany
manymaturity
maturity
segments
segments
Investors
Investors and
and borrowers
borrowers deviate
deviate from
from their
their
preferred
preferred maturity
maturity segment
segment only
only when
when
adequately
adequately compensated
compensated to
to do
do so
so
2-19

2009, The McGraw-Hill Companies, All Rights

Implied Forward Rates

A
Aforward
forward rate
rate (f)
(f) isis an
an expected
expected rate
rate on
on aa
short-term
short-term security
security that
that isis to
to be
be originated
originated at
at
some
some point
point in
in the
the future
future
The
The one-year
one-yearforward
forward rate
rate for
forany
any year
yearN
N in
in the
the
future
futureis:
is:
N

f1 [(11 RN ) N /(11 RN 1 ) N 1 ] 1

2-20

2009, The McGraw-Hill Companies, All Rights