Chapter Two

Determinants of
Interest Rates

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Interest Rate Fundamentals Nominal interest rates - the interest rate actually observed in financial markets
directly affect the value (price) of most securities traded in the market affect the relationship between spot and forward FX rates
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Time Value of Money and Interest Rates

Assumes the basic notion that a dollar received today is worth more than a dollar received at some future date Compound interest
interest earned on an investment is reinvested

Simple interest
interest earned on an investment is not reinvested
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Calculation of Simple Interest

Value = Principal + Interest (year 1) + Interest (year 2)

Example: $1,000 to invest for a period of two years at 12 percent Value = $1,000 + $1,000(.12) + $1,000(.12)

= $1,000 + $1,000(.12)(2)
= $1,240
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Value of Compound Interest

Value = Principal + Interest + Compounded interest
0 Invest $ 1,000 1 Receive interest $ 1,000 x .12= $120 2 Receive interest= $ 1,000 x .12= $120 + $120 x .12= 14.4 = $134.40

Value of investment= $1,000+$120

Value of investment= $1000+ $120 +$134.4= $1,254.40

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Present Value of a Lump Sum

PV function converts cash flows received over a future investment horizon into an equivalent (present) value by discounting future cash flows back to present using current market interest rate
lump sum payment~ single cash payment received at the beginning or end of some investment horizon. Annuity~ a series of equal cash flows received at fixed intervals over the entire investment horizon.

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Present Value of a Lump Sum

TODAY Yr. 6

? $10,000 HOW MUCH ARE YOU GOING TO INVEST TODAY (YEAR 0) TO BE ABLE TO GET $10,000 AT YEAR 6?

PVs decrease as interest rates increase

As interest rates increase, fewer funds need to be invested at the beginning of an investment horizon to receive a stated amount at the end of the investment horizon.
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Calculating Present Value (PV) of a Lump Sum PV = FVn(1/(1 + i/m))nm = FVn(PVIFi/m,nm)

where: PV = present value FV = future value (lump sum) received in n years i = simple annual interest rate earned n = number of years in investment horizon m = number of compounding periods in a year i/m = periodic rate earned on investments nm = total number of compounding periods PVIF = present value interest factor of a lump sum
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Calculating Present Value of a Lump Sum

You are offered a security investment that pays $10,000 at the end of 6 years in exchange for a fixed payment today.

PV = FVn(1/(1 + i/m))nm at 8% interest - = $10,000(0.630170) = $6,301.70

at 12% interest - = $10,000(0.506631) = $5,066.31

at 16% interest - = $10,000(0.410442) = $4,104.42
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Present Value (PV) of an Annuity

TODAY 1 2 3 4

? $10,000 $10,000 $10,000 $10,000 HOW MUCH WILL YOU INVEST TODAY TO BE ABLE TO RECEIVE $10,000 AT END/AT THE BEGINNING OF EVERY YEAR? PV ANNUITY LAST DAY OF EVERY YEAR FIRST DAY OF EVERY YEAR
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Calculation of Present Value (PV) of an Annuity

PV = PMT (1/(1 + i/m))t = PMT(PVIFA i/m,nm)

t=1

nm

where: PV = present value PMT = periodic annuity payment received during investment horizon i/m = periodic rate earned on investments nm = total number of compounding periods PVIFA = present value interest factor of an annuity
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Calculation of Present Value (PV) of an Annuity (LAST DAY)

PV= PMT(PVIFA i/m,nm)

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Calculation of Present Value of an Annuity (LAST DAY)

You are offered a security investment that pays $10,000 on the last day of every year for the next 6 years in exchange for a fixed payment today. PV = PMT(PVIFAi/m,nm) at 8% interest - = $10,000(4.622880) = $46,228.80 If the investment pays on the last day of every quarter for the next six years (2%, 24) at 8% interest - = $10,000(18.913926) = $189,139.26
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Calculation of Present Value of an Annuity (FIRST DAY)

If the investment pays on the FIRST day of every quarter for the next six years (2%, 24) PV = PMT(PVIFAi/m,nm)(1 + i/m)
at 8% interest - = $10,000(18.913926)(1.02) = $10,000(19.29220452)= $192,922.04

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Future Values

Translate cash flows received during an investment period to a terminal (future) value at the end of an investment horizon
HOW MUCH WILL YOUR INVESTMENT TODAY/ EVERY YEAR BE WORTH IN THE FUTURE?
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Future Values
FV increases with both the time horizon and the interest rate
As interest rates increase, a stated amount of funds invested at the beginning of an investment horizon accumulates to a larger amount at the end of the investment horizon.

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LUMP SUM ANNUITY LAST DAY FIRST DAY

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Future Value of a Lump Sum

TODAY $10,000 Year 6 ?

HOW MUCH WILL YOUR $10,000 INVESTMENT TODAY BE WORTH AT THE END OF THE 6TH YEAR? FVn = PV(1 + i/m)nm = PV(FVIF i/m, nm)

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Calculation of Future Value of a Lump Sum

You invest $10,000 today in exchange for a fixed payment at the end of six years FVn = PV(1 + i/m)nm = PV(FVIF i/m, nm)
at 8% interest = $10,000(1.586874) = $15,868.74 at 12% interest = $10,000(1.973823) = $19,738.23 at 16% interest = $10,000(2.436396) = $24,363.96 at 16% interest compounded semiannually (8%,12) = $10,000(2.518170) = $25,181.70
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Future Value of an Annuity (LAST&FIRST DAY)

TODAY
$10,000

1
$10,000

2
$10,000

3
$10,000

4
?

HOW MUCH WILL YOUR YEARLY CASH INVESTMENT BE WORTH AT THE END OF THE FOURTH YEAR?
(nm-1)

FVn = PMT
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(t = 0)

(1 + i/m)t = PMT(FVIFAi/m, mn)

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Future Value of an Annuity (LAST DAY)

FVn = PMT

(1 + i/m)t = PMT(FVIFAi/m, mn)

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Calculation of the Future Value of an Annuity

You invest $10,000 on the last day of every year for the next six years,
at 8% interest = $10,000(7.335929) = $73,359.29

If the investment pays you $10,000 on the last day of every quarter for the next six years,
FV = $10,000(30.421862) = $304,218.62

If the annuity is paid on the first day of each quarter, FV= PMT(FVIFAi/m, mn)(1+ i/m)
FV = $10,000(30.421862)(1.02)= $10,000(31.030300) = $310,303.00 McGraw-Hill/Irwin
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Relation between Interest Rates and Present and Future Values

Present Value (PV)
As interest rates increase, a stated amount of funds invested at the beginning of an investment horizon accumulates to a larger amount at the end of the investment horizon. Future Value (FV)

Interest Rate

As interest rates increase, fewer funds need to be invested at the beginning of an investment horizon to receive a stated amount at the end of the investment horizon.
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Interest Rate

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Effective or Equivalent Annual Return (EAR)

Rate earned over a 12 month period taking the compounding of interest into account.

EAR = (1 + r) c 1

Where c = number of compounding periods per year

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Loanable Funds Theory

A theory of interest rate determination that views equilibrium interest rates in financial markets as a result of the supply and demand for loanable funds

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Supply of Loanable Funds

Demand
Interest Rate

Supply

Quantity of Loanable Funds Supplied and Demanded

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Funds Supplied and Demanded by Various Groups (in billions of dollars)

Funds Supplied Funds Demanded

Net

Households Business - nonfinancial Business - financial Government units Foreign participants

$34,860.7 12,679.2 31,547.9 12,574.5 8,426.7

$15,197.4 30,779.2 45061.3 6,695.2 2,355.9

$19,663.3 -12,100.0 -13,513.4 5,879.3 6,070.8

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Determination of Equilibrium Interest Rates

D Interest Rate
IH

i
IL

Quantity of Loanable Funds Supplied and Demanded

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Effect on Interest rates from a Shift in the Demand Curve for or Supply curve of Loanable Funds
Increased supply of loanable funds
Interest Rate

Increased demand for loanable funds

DD

DD

SS SS* i**

DD*

SS

E*

i* i**

E E* Q* Q**

E
i*

Q* Q** Quantity of Quantity of Funds Supplied Funds Demanded More funds are supplied as interest rates increase The quantity of loanable funds demanded is higher as interest falls (the cost of borrowing (the reward for supplying funds is higher). funds is lower).
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Factors Affecting Nominal Interest Rates

Inflation-the continual increase in price level Real Interest Rate- interest rate that would exist on a default free security if no inflation were expected. Default Risk-risk that security issuer will default Liquidity Risk- risk that a security can be sold at a predictable price with low transaction costs on short notice Special Provisions-additional terms written in the contract. Term to Maturity-the change in required interest rates as the maturity of a security changes.

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Inflation and Interest Rates: The Fisher Effect

The interest rate should compensate an investor for both (1) expected inflation and (2) the opportunity cost of foregone consumption (the real rate component) HIGH RISK, HIGH RETURNS i = RIR + Expected(IP) RIR = i Expected(IP)
Example: 3.49%2-30 - 1.60% = The McGraw-Hill Companies, All Rights Reserved 2007, 1.89%

or
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Default Risk and Interest Rates

The risk that a securitys issuer will default on that security by being late on or missing an interest or principal payment
DRPj = ijt - iTt
Ijt= non-Treasury issuer iTt= Treasury issuer

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Term Structure of Interest Rates

Unbiased Expectations Theory- at a given point in time the yield curve reflects the markets current expectations of future short-term rates. e.g. 4-year bond vs 4 successive 1-year bond Liquidity Premium Theory- investors will hold long-term maturities only if they are offered at a premium to compensate for future uncertainty in a securities value, which increases with an assets maturity. Market Segmentation Theory-individual investors and FIs have specific maturity preferences, and to get them to hold securities with maturities other than their preferred requires a higher interest rate. (BANK vs INSURANCE COMPANY)
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Forecasting Interest Rates

Forward rate is an expected or implied rate on a security that is to be originated at some point in the future using the unbiased expectations theory

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END
Next meeting: Examples and illustrations/ quiz bowl

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