Chapter 3 : Interest Rates in the

Financial System

Chapter Objectives
 To understand the different types of interest rate theories
 To examine the inter-relation between interest rates, inflation
and security price
 Identifying the factors that affect in the determination of
interest rate
 Definition of Interest Rate

 Interest rate: is the price paid to borrow debt capital

or in other words it is the cost of Money.
 Interest rate: is a rate of return paid by a borrower of
funds to a lender of them, or a price paid by a
borrower for a service, the right to make use of funds
for a specified period.
 CONT’D
 To understand it better we can also say that
interest rates transform money-today into
money-tomorrow; it is the rate at which it
grows when invested.
 Interest is compensation to the lender for
forgoing other useful investments that could
have been made with the loaned asset.
 Role of the Interest Rate in the economy
1. It facilitates the flow of current savings in to
investment that promote economic growth.
2. It allocate the available supply of credit to those
investment projects with higher returns
3. Adjustment of interest rates can bring the supply of
money in to balance with demand
4. It is an important tool of government policy through
their influence on the volume of saving and
investments
Theory and Structure of Interest Rate

 Interest rate structure: is the relationships

between the various rates of interest in an economy
on financial instruments of different lengths (terms)
or of different degrees of risk.
 The term structure of interest rates describes the
relationship between long- and short-term rates.
 Cont’d
Thus, it is important to understand:
1. how long- and short-term rates relate
to each other and
2. what causes shifts in their relative
positions.
 Determinants of Interest Rates For Individual Securities

1. Inflation: the first factor to affect interest rate is the

actual or expected inflation rate in the economy.
 The higher the level of actual or expected inflation, the
higher will be the level of interest.
 The intuition behind the +ve r/ship b/n interest and
inflation rate is that an investor who buys a financial
asset must earn a higher interest rate when inflation
increase to compensate the forgone consumption.
 Cont’d
2. Real interest rates: is the interest rate that
would exist on a security if no inflation were
expected over the holding period of a security.
 It measures society’s relative time preference
for consuming today rather than tomorrow.
 The higher society’s preference to consume
today, the higher the real interest rate will be.
 Cont’d
Fisher Effect
 The Fisher effect states that nominal rates
equal real rates plus a premium for
expected inflation. This relationship is the
basis for the term structure.
 The Fisher Effect relates nominal and real interest rates. The
approximate Fisher effect is given as
i = RIR + Expected (IP)
where i = nominal interest rate, RIR = real interest rate and
Expected (IP) = expected inflation.
 Cont’d
The actual Fisher Effect is given as
(1+i) = (1+RIR)*(1+Expected(IP))

3. Default or Credit Risk

Default risk premiums (DRPs) are increases in required yield
needed to offset the possibility the borrower will not repay
the promised interest and principle in full or as scheduled.
 Cont’d
4. Liquidity Risk: Liquidity risk premiums are
increases in required or promised yields
designed to offset the risk of not being able to
sell the asset in timely fashion at fair value.
 Cont’d
• If a security is illiquid , investors add a liquidity risk premium
(LRP) to the interest rate on the security.

5. Special Provisions of Numerous

Covenants:
special provision or covenants that may
be written in to the contracts underlying
the issuance of a security also affects the
interest rates on d/t securities.
 Cont’d
 Some of these special provision includes the
securities taxability, convertibility, and
callability.
• Eg. For investors, interest rate payment on a
security are free of tax , thus the interest
rate demanded by bond holder is smaller
than a comparable taxable bond.
 Cont’d
• Convertibility: Exchange one security to an
other.
 The convertible security holders requires a lower
interest rate than a comparable nonconvertible
security holders (all else equal).
 In general, special provision that provides benefit to
the security holders (eg. Tax free& convertibility),
are associated with lower interest rate, and special
provision that provide benefit to the security issuers
(eg. callablity), associated higher interest rate.
 6. Term to Maturity

 There is r/ship b/n interest rate and the term to maturity of a

security.
 This r/ship is often called the term structure of interest rate or
yield curve.
 The security have more interest rate risk the longer the
maturity of the bond. Therefore, a maturity risk premium (MRP),
which is higher the longer the years to maturity, must be
included in the required interest rate.
 Cont’d
Summary
Nominal interest rate(NIR) = f(Riskless real rate,
Expected inflation, Default risk premium, Liquidity risk
premium, Special covenant premium, Maturity risk
premium)
 Brain storming questions
1.Define interest rate?
2.Describe term- structure interest rate?
3.Write the economic role of interest rate?
4.What are the determinants of interest rates
for individual securities?
 Interest Rate Theories
1. Loanable Funds Theory

•Loanable funds: are funds borrowed and lent in an

economy during a specified period of time – the

flow of money from surplus to deficit units in the

economy.
 Cont’d
 The loanable funds theory was formulated by the
Swedish economist Knut Wicksell in the 1900s.
According to him, the level of interest rates is
determined by the supply and demand of loanable
funds available in an economy’s .
 This theory suggests that investment and savings in
the economy determine the level of long-term
interest rates.
 Cont’d
 Short-term interest rates, however, are determined by an
economy’s financial and monetary conditions.
 According to the loanable funds theory for the economy as a
whole:
 Demand for loanable funds = net investment + net
additions to liquid reserves
 Supply of loanable funds = net savings + increase in the money supply
 Cont’d
So, this theory of interest rate determination views the
level of interest rate in the financial market as resulting
from factors that affects the supply and demand of
loanable funds.
 The supply of loanable funds is a term describes
funds provided to the financial market by the net
suppliers of the fund.
 The demand of loanable funds describe the total net
demand for funds by fund users.
 Supply of loanable funds
• In general, the quantity of loanable
funds supplied increase as interest
rates rise. So, other factors held
constant, more funds are supplied as
interest rates increase (the rewards for
supplying funds is higher).
Supply of and demand for loanable funds
 Demand for loanable funds
• In general, the quantity of loanable funds
demanded is higher as interest rates fall. So,
other factors held constant, more funds are
demanded as interest rates decrease (the
cost of borrowing funds is lower). See the
above figure.
 Equilibrium interest rate
 The aggregate supply of loanable funds is the
sum of the quantity supplied by the separate
fund supplying sector (Eg. Households,
business, gov’t, foreign agents).
 The aggregate demand for loanable funds is
the sum of the quantity demanded by the
separate fund demanding sectors.
 Cont’d
• To sum up, the aggregate quantity of funds
supplied is positively related to interest rates,
while the aggregate quantity of funds
demanded in inversely related to interest
rates.
• Look at the following figure
Cont’d
 Factors affect in SS & DD LF shift
 Supply of funds
 Wealth
 Risk
 Near-term spending needs
 Monetary expansion
 Economic conditions
 1. Wealth
 As the total wealthy of financial mkt
participants(households, business, etc.) increase ,
the absolute birr amount available for investment
increase.
 Accordingly, at every interest rate, the supply of
loanable funds increase, or the supply curve shifts
down and to the right and viceversal.
Figure
Cont’d
 2. Risk
 As the risk of a financial security decrease (Eg. The
profitability that the issuer of the security will default
on promised repayment of the funds borrowed), it
becomes more attractive to suppliers of funds.
 At every interest rate, the supply of loanable funds
increase, or the supply curve shifts down to the
right, from SS to SS’’ in the above fig. and vice
versal.
 3. Near- Term Spending Needs
 When financial mkt participants have few near term
spending needs, the absolute birr amount of funds
available to invest increases.
 At every interest rate, the supply of loanable funds
increase, or the supply curve shifts down to the right
and vice versal.
 4. Monetary Expansion
 When monetary policy objectives are to allow
the economy to expand, the federal reserve
increases the supply of funds available in the
financial mkt.
 At every interest rate, the supply of loanable
funds increase, the supply curves shifts down
to the right and vice versal. See the above fig.
 5. Economic Conditions
 As the underlying economic conditions
(inflation rate, unemployment rate, economic growth)
improve in a country relative to other countries, the
flow of funds to that country increase.
 This reflects the lower risk that the country , in the
guise of its governments, will default on its obligation
to replay funds borrowed.
 Demand for loanable funds
• Factors affects it are:
 Utility derived from asset purchased with
borrowed funds
 Restrictions on non price conditions on
borrowed funds
 Economic conditions
 Brain storming questions
1.Describe the loanable fund theory?
2.What are the factors influencing the supply of
loanable funds in an economy?
3.What are the factors influencing the demand
of loanable funds in an economy
 2.Liquidity Preference Theory
 J. M. Keynes has proposed (back in 1936) a simple
model, which explains how interest rates are
determined based on the preferences of households to
hold money balances rather than spending or
investing those funds.
 Cont’d
 Liquidity preference is preference for
holding financial wealth in the form of short-
term, highly liquid assets rather than long-
term illiquid assets, based principally on the
fear that long-term assets will lose capital
value over time.
 The Liquidity
Cont’d
Preference Theory, also known as the
Liquidity Premium.
 The Liquidity Preference Theory asserts that long-
term interest rates not only reflect investors’
assumptions about future interest rates but also
include a premium for holding long-term bonds
(investors prefer short term bonds to long term
bonds), called the term premium or the liquidity
premium.
 cont’d
 This theory claims that long-term interest rate should be
higher than short-term interest rate for the following
reasons:
1. Savers have to be compensated for giving up cash (i.e. liquidity).

2. Long-term bonds are more sensitive to interest rate

changes than short-term bonds. Hence, the return for a
longer-term bond needs to be higher than a shorter-term
bond.
 Cont’d
 As a result, investors (or savers) need a positive
liquidity (or term) premium to induce them to give
up their money for a period of time.
 The longer the period of time they have to give up
their money, the larger the term premium.
 Yield Curve
 It Shows the relationships between the interest rates
payable on bonds with different lengths of time to
maturity. That is, it shows the term structure of
interest rates.
 Yield curves continually move all the time that the
markets are open, reflecting the market's reaction to
news. A further "stylized fact" is that yield curves
tend to move in parallel (i.e., the yield curve shifts
up and down as interest rate levels rise and fall).
 Cont’d
The yield curve can be of any of the following four shapes:
1.Normal yield curve: The short-term yield is lower than the long-
term yield. In other words, it is cheaper to borrow short-term than it
is to borrow long-term.
 Cont’d
2.Inverted yield curve: The short-term yield is higher than the long-
term yield. In other words, it is more expensive to borrow short-term
than it is to borrow long-term.
 Cont’d
3.Flat yield curve: The short-term yield is the same as the long-term
yield. In other words, the short-term cost of borrowing is the same as
the long-term cost of borrowing.
 Cont’d
4. Humped yield curve: The intermediate yield is higher than
both the short-term and long-term yields. In other words, it is cheaper
to borrow short-term or long-term than it is to borrow intermediate-
term.
Theories of term structure of interest rates

• There are several major economic theories that

explain the observed shapes of the yield curve:
 Classical theory
 Unbiased or pure Expectations theory
 Liquidity premium theory
 Market segmentation theory
 Preferred habitat theory
• 1.Classical Theory of Interest
 The Classical theory of interest defines the rate of interest
as the element that equates savings and investment. In other
words interest rate determine by two factors:
1. The supply of saving , divided mainly from households and
business or governments
2. The demand for investment capital coming from the business

sector .
 Cont’d
•Saving can be:
 Saving by Households
 Saving by business firm
 Saving by Government
 Cont’d
•Proponents of the classical theory of interest have different ways of
looking at the theory and they may be explained as under:
 Marshall: According to Marshall the interest rate is the price paid for the
use of capital. This rate of interest is determined by the equilibrium
formed by the interaction of the aggregate demand for capital;
and its forthcoming supply.
 Taussig: According to Taussig, the interest rate is determined at the level
where the marginal productivity of capital equals the marginal
installment of saving.
 2. Pure Expectations Theory
 The pure expectations theory assumes that investors
are indifferent between investing for a long period on
the one hand and investing for a shorter period with a
view to reinvesting the principal plus interest on the
other hand.
• For example an investor would have no preference
between making a 12-month deposit and making a
6-month deposit with a view to reinvesting the
proceeds for a further six months so long as the
expected interest receipts are the same.
• The theory suggested that , in the absence of new
information, the optimal forecast of next periods
interest rate would probably be equal to the current
periods interest rate until new information causes
market participants to revise their expectation.
If future one year rate are expected to raise each successive year
in to the future, then the yield curve will slope upwards.

Fig. yield curve

 Cont’d
There are a few assumptions that are important to the pure
expectation theory. It is assumed that there is no transaction
cost and investors form similar expectations regarding future
interest rate.
The main assumption behind this theory is that investors do
not prefer bonds of one maturity to bonds of another
maturity (as long as they can maximize their holding period
returns).
 3. Liquidity Premium Theory
 Some investors may prefer to own shorter rather than
longer term securities because a shorter maturity
represents greater liquidity.
 In such case they will be willing to hold long term
securities only if compensated with a premium for
the lower degree of liquidity.
 Cont’d
 It is an extension of unbiased expectation
theory.
 It is based on the idea that investors will hold
long-term maturity only if they are offered at a
premium to compensate for future uncertainty
in security value, which increases the asset
maturity.
 Thus, investors must be offered liquidity
premium if they hold long maturity life.
 Cont’d
 This theory states that long term rates are equal to
geometric average of current and expected short-
term rates( like unbiased exp. theory), plus
liquidity premium that increase the maturity life of
a securities.
 According to this theory, an upward sloping yield
curve may reflect investors expectation that future
short-term rates will be falt, but b/c liquidity
premium increase with maturity, the yield curve
will nevertheless be upward sloping.
Yield curve of UEC & LPH
Cont’d
 4. Market Segmentation Theory

 According to the market segmentation theory, interest rates for

different maturities are determined independently of one another.
 The underlining assumption is that all financial assets are not
perfectly substitutes in mind of investors.
 The interest rate for short maturities is determined by the supply
of and demand for short-term funds. Long-term interest rates are
those that equate the sums that investors wish to lend long term

with the amounts that borrowers are seeking on a long-term basis.

 Cont’d
 This argued that individual investors and Financial
institutions have specific maturity preference and to
get them to hold securities with maturities other
than their most prefer requires a higher interest rate
(maturity premium).
• Eg. Banks my prefer to hold short term securities b/c
short term nature of deposit liabilities while
insurance companies may prefer long term since
the nature of liabilities are long term.
 Market segmentation and
determination of the slope of yield
curve
Cont’d
 Cont’d
• According to market segmentation theory,
investors and borrowers do not consider
their short-term investments or borrowings
as substitutes for long-term ones. This lack
of substitutability keeps interest rates of
differing maturities independent of one
another.
 5. The preferred
 Preferred habitat theory is a variation on the market
habitat
segmentation theory.
theory
 The preferred habitat theory allows for some
substitutability between maturities.
 However the preferred habitat theory views that
interest premiums are needed to entice investors from
their preferred maturities to other maturities.
 Interest rates and security price
 Interest rate movements affect value of
securities, and therefore affect the
performance of all types of companies.
 It is critical for managers to understand why
interest rates change, how their movements
affect performance and how to manage
according to anticipated interest rate
movements.
 Various Interest Rate Measures

 Coupon Rate
 Required Rate of Return
 Expected Rate of Return
 Required Versus Expected Rates of Return
 Realized Rate of Return
 An Inverse Relationship

 When new bonds are issued, they typically carry

coupon rates at or close to the prevailing market
interest rate.
 Interest rates and bond prices have what's called
an "inverse relationship" – meaning, when one goes
up, the other goes down .
 Cont’d
 Investors constantly compare the returns on
their current investments to what they could
get elsewhere in the market.
 As market interest rates change, a bond's
coupon rate – which, remember, is fixed –
becomes more or less attractive to investors,
who are therefore willing to pay more or less
for the bond itself.
 Interest rates and inflation
 Interest and rate
inflation are key to
investing decisions, since they have a
direct impact on the investment yield.
 When prices rise, the same unit of a
currency is able to buy less.
 A sustained deterioration in the purchasing
power of money is called inflation.
 Cont’d
However, when the inflation rate
rises, companies or governments
issuing debt instruments would
need to lure investors with a
higher interest rate.
 The Relationship between Interest
 Inflation is anand Inflation
autonomous occurrence that is
impacted by money supply in an economy.
 Central governments use the interest rate to
control money supply and, consequently, the
inflation rate.
 When interest rates are high, it becomes
more expensive to borrow money and savings
become attractive.
 Cont’d
 When interest rates are low, banks are able
to lend more, resulting in an increased
supply of money.
 Alteration in the rate of interest can be used
to control inflation by controlling the supply
of money in the following ways:
1. A high interest
Cont’d
rate influences spending patterns
and shifts consumers and businesses from
borrowing to saving mode.
2. A rise in interest rates boosts the return on savings
in building societies and banks. Low interest rates
encourage investments in shares. Thus, the rate of
interest can impact the holding of particular assets.
 Cont’d
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