CHAPTERS TWO & THREE

The Level & Structure of Interest

Rates
FIN 331
Financial Markets & Institutions
W.P Carey School of Business
Arizona State University
Art Budolfson, CEBS, CFA

Interest rates
An interest rate is the price paid by a
borrower to a lender.
The amount borrowed is referred to as
the principal of a loan and the price
paid by the borrower is referred to as
interest, usually expressed as an
annualized percentage of principal.
The level of interest rate paid is
generally determined by supply and
demand in the marketplace.

Fishers Law
Its the real rate of interest
that we should care about,
not the nominal rate of
interest.
The nominal rate is the
observable market rate; the
interest rate we see quoted.
Because of inflation,
however, the real rate of
interest is different from the
nominal rate.

Loanable funds theory

The Loanable Funds Theory suggests
that the market interest rate is
determined by the factors that control
supply of and demand for loanable
funds.
Can be used to explain:
Movements in the general level of
interest rates in a particular country
Why interest rates among debt
securities of a given country vary.
4

Loanable funds theory cont

Household demand for loanable funds

Households demand loanable funds
to finance housing expenditures as
well as the purchase of automobiles
and household items.
Inverse relationship between the
interest rate and the quantity of
loanable funds demanded.
5

Loanable funds theory cont

Business demand for loanable funds

Shifts in the Demand for Loanable funds

Depends on number of business projects to be

implemented. More demand at lower interest rates.
n

CFt
NPV INV
t
t 1 (1 k )
NPV net present va lue of project
INV initial investment
CFt cash flow in period t
k required rate of return on project
6

Loanable funds theory cont

Government Demand for Loanable Funds

Governments demand loanable funds
when planned expenditures are not
covered by incoming revenues.
Government demand is said to be
interest inelastic: insensitive to interest
rates. Expenditures and tax policies are
independent of the level of interest rates.

Loanable funds theory cont

Foreign demand for loanable funds

A countrys demand for foreign funds depends
on the interest rate differential between the
two.
The greater the differential, the greater the
demand for foreign funds.
The quantity of U.S. loanable funds demanded
by foreign governments will be inversely
related to U.S. interest rates.)

Aggregate demand for loanable funds

The sum of the quantities demanded by the

separate sectors at any given interest rate.
8

Determination of the aggregate demand curve for

loanable funds

Loanable funds theory cont

Supply of Loanable Funds

Households are largest supplier, but some
supplied by government units.
More supply at higher interest rates.
Supply by buying securities.
Effects of the Fed - By affecting the supply of
loanable funds, the Feds monetary policy affects
interest rates.
Aggregate supply of funds Is the combination of
all sector supply schedules along with the supply
of funds provided by the Feds monetary policy.
10

Aggregate Supply Curve for Loanable Funds

11

Loanable funds theory cont

Equilibrium Interest Rate Algebraic Presentation
Aggregate Demand for funds (DA)

DA = Dh + Db + Dg + Dm + Df
Dh = household demand for loanable funds
Db = business demand for loanable funds
Dg = federal government demand for loanable funds
Dm = municipal government demand for loanable funds
Df = foreign demand for loanable funds

Aggregate Supply of funds (SA)

SA = Sh + Sb + Sg + Sm + Sf
Sh = household supply for loanable funds
Sb = business supply for loanable funds
Sg = federal government supply for loanable funds
Sm = municipal government supply for loanable funds
Sf = foreign supply for loanable funds
12

Loanable funds theory: Interest rate equilibrium

13

Factors that impact interest rates

Impact of economic growth on interest rates
Puts upward pressure on interest rates by shifting
demand for loanable funds outward.

Impact of inflation on interest rates

Puts upward pressure on interest rates by shifting
supply of funds inward and demand for funds
outward.

Impact of Monetary Policy on Interest Rates

When the Fed reduces (increases) the money
supply, it reduces (increases) the supply of loanable
funds, putting upward (downward) pressure on
interest rates.
14

Factors that impact interest rates cont

Impact of foreign fund flows on interest rates
Interest rate for a certain currency is determined
by the demand for funds in that currency and
the supply of funds available in that currency.

Impact of budget deficits on interest rates

Crowding-out effect: Given a certain amount of
loanable funds supplied to the market, excessive
government demand for funds tends to crowd
out the private demand for funds.

15

Bond rate determinants

It might be helpful to think of the
yield of a bond as a combination of a:
Base interest rate, plus
Risk premiums for:

Credit risk.
Term to maturity.
Tax status of interest.
Liquidity.
Embedded options.

Credit risk
Credit risk, also known as default risk, refers to
the likelihood that the issuer may not be able to
make timely principal or interest payments.
Rating agencies offer opinions regarding this risk.
Moodys: Aaa (top rating); S & P: AAA; Fitch: AAA.

Dodd-Frank established an Office of Credit Ratings

within the S.E.C. to regulate the rating agencies.
Differences in yield due to credit ratings are called
credit spreads.

Term to maturity
The difference in yield between maturity
sectors is called a maturity spread or yield
curve spread.
U.S. Treasury yields are most commonly
used for this purpose, although any credit
rating may be used.
Example of how spreads are quoted: If a two
year Treasury yields 2.34% and a five year
Treasury yields 3.02%, they would be said to
be trading at a 68 basis point maturity spread.

Tax treatment
Unless exempted under federal tax
code, interest income from bonds is
taxable at the federal level. State and
local income taxes may apply as well.
Municipal bonds are securities issued
by state and local governments and
their authority. The vast majority pay
interest that is exempt from income
taxes.

Liquidity
The greater the expected liquidity of
a bond, the lower the required yield
(the higher the price).
The type and size of issues can affect
their liquidity.
Bonds trade primarily over-thecounter, where significant differences
in liquidity among issues can exist.

Embedded options
Call provision: Most common option embedded in
bonds. Allows issuer to retire the debt, partially or
in full, before the scheduled maturity date, at
designated dates and prices. (benefits issuer)
Put provision: Less common. Allows the bondholder
to sell bond back to the issuer at designated dates
and prices. (benefits bondholder)
Convertible provision: Grants the bondholder the
right to exchange the bond for a specific number of
shares of common stock. (may benefit both issuer &
bondholder)
And many others.

Actual yield differentials in money market

securities
Yields on commercial paper and
negotiable CDs are only slightly
higher than T-bill rates to
compensate for lower liquidity and
higher default risk.
Market forces cause the yields on all
securities to move in the same
direction.
22

Actual yield differentials in capital market

securities
Municipal bonds have the lowest
before-tax yield but their after-tax
yields are typically higher than
Treasury bonds.
Treasury bonds have the lowest yield
because of their low default risk and
high liquidity.

23

The yield curve

The yield curve is the relationship between
yield and maturity for bonds of the same
credit quality but different maturities.
Yield curve shapes
Normal (upward sloping or positively sloped).
Inverted (downward sloping).
Flat.
Humped.

Academics refer to the yield curve as the

term structure of interest rates.

Uses of the term structure

Forecasting Interest Rates - The shape of the yield
curve can be used to assess the general expectations of
investors and borrowers about future interest rates.
Forecasting Recessions - Some analysts believe that
flat or inverted yield curves indicate a recession in the
near future.
Making Investment Decisions - If the yield curve is
upward sloping, some investors may attempt to benefit
from the higher yields on longer-term securities even
though they have funds to invest for only a short period
of time.
Making Decisions about Financing - Firms can
estimate the rates to be paid on bonds with different
maturities. This may enable them to determine the
maturity of the bonds they issue
25

Shape of the yield curve

Normal
Flat

Inverted

Do you know what shape we have

now?

Yield Curves at Various Points in Time

Determinants of yield curve shape

Pure expectations theory

Liquidity theory
Market segmentation theory
Preferred habitat theory
All of the theories have some validity.
None of the theories fully explain the
shape of the yield curve.

Pure expectations theory

Yields on different maturities are based on
expectations of future short-term rates.
Yield curve might be normal, inverted, flat
or humped under this theory.
One common interpretation
Normal yield curve implies interest rates are
headed up.
Inverted yield curve implies interest rates are
headed down.
Does this make sense?

Liquidity theory
Yields on different maturities are based on
expected future rates plus a liquidity premium
that increases with maturity.
Yield curve would be normal or perhaps flat
under this theory.
One common interpretation
Long-term yields should be higher than short-term
yields because investors will not invest unless they
are compensated for locking up their money.
Does this make sense?

Market segmentation theory

Yields at different maturities are based
on supply and demand at each maturity.
Yield curve might be normal, inverted,
humped or flat under this theory.
Issuers and buyers of bonds have
maturity preferences and will not shift
to another maturity because each
maturity is a separate market.
Does this make sense?

Preferred habitat theory

Yields at different maturities are based on
supply and demand at each maturity.
Yield curve might be normal, inverted,
humped or flat under this theory.
Issuers and buyers of bonds will shift to other
maturities if yields are attractive enough.
Sometimes combined with market
segmentation theory and called biased
expectations theory.
Does this make sense?

Risks of a changing yield

curve

The changing shape and level of

the yield curve presents
substantial risks for the bond
investor.

Price risk: the risk that the price

of a bond will go down if the level
of interest rates in the economy
go up.
Reinvestment risk: the risk that
interest rates may be lower when
a bond matures and the
proceeds need to be reinvested;
or when coupons are received
and need to be reinvested.

The dynamic yield curve

www.stockcharts.com