CHAPTER 2: DETERMINANTS OF INTEREST RATES

2.1 Overview

Def:

  • The price of borrowing/ lending
  • Income for one side, cost for another side

Nominal interest rate: the interest rates actually observed in financial market

  • Purpose: determine fair value and prices of securities
  • 2 components: Opportunity cost and Adjustments for individual security characteristics
  • Fisher equation: Real IR = Nominal IR - Inflation (interest rate contain a premium for expected inflation)

2.2 Loanable Fund Theory

Overview of LF:

  • Used to explain IR and IR movements
  • Def: a theory of IR determination (1) that views equilibrium IR in FM (2) as a result of the Supply and Demand for loanable funds (3)

Supply of loanable funds

IR and quantity supply of loanable funds have positive relationship (IR tăng thì lượng cung LF tăng)

Các thành phần của một nền KT:

  • Households
  • Businesses
  • Foreign
  • Local State Gov
  • Federal Gov

Demand of loanable funds

Households:

  • Borrow for purchases of homes, durable good (car,..) & non durable goods (education, medical,..)
  • Ngân sách cân bằng: thu đủ sponsor cho chi (1) và tích lũy (2)
  • Đi vay trở thành 1 việc bình thường và KHÔNG violate Ngân sách cân bằng <=> Đầu tư cho các khoản chi có giá trị lớn (mua nhà, ô tô,..)
  • IR increase -> Demand decrease

Businesses:

  • Borrow for long-term (plant, equipment,..) and short-term (inventory,..) investments
  • IR increase => finance investment with generate funds (i.e: retained earnings) rather than borrowed funds
  • The more profitable/ good economic condition => the higher demand for LF

Governments

Role:

  • Quản lý
  • Điều tiết
  • Phân bổ
    => Thu (taxation) và Chi (spending)

Budget deficit (Thâm hụt ngân sách):

  • Tăng thu, giảm chi (tight fiscal policy)
  • In tiền
  • Đi vay (i.e: issue T-bills) => lợi ích: tổng chi phí lãi < tổng chi phí giải quyết thâm hụt ngân sách

Perfectly inelastic demand

  • Đường cầu (DA) thẳng đứng => vertical straight line
  • Với mọi IR, CP vẫn sẽ đi vay cho tới khi bù đắp hết thâm hụt ngân sách

"Crowding out"

  • Budget deficit => Gov increase borrowing => Demand for LF increase => IR increase => Compete with private borrowers (firms and indi) and discourage them to borrow => Decrease investment in businesses => Hinder economic growth

Determinants of interest rates (nói chung):

  • Economic growth
  • Inflation
  • Money supply
  • Government expenditure

2.3 Determinants of interest
rates for individual securities

2.4 Term structure of interest rates

Factors cause Supply curve to shift:

  • Wealth:
  • Risk:
  • Near-term spending needs
  • Monetary expansion

Suppliers

Households
(consumer)

Largest supplier of loanable funds:

  • High economic growth => replace cash holdings with earning asset => increase total supply of LF
  • Determinants: IR, wealth, risk of security investment, immediate spending needs

Determinants of household savings:

  • Interest rates (+) and Tax policy (-)
  • Income and wealth (+)
  • Attitudes about saving vs borrowing
  • Credit availability (-)
  • Job security and belief in soundness of entitlements (-)

Governments:

  • Sometimes generate more cash inflows (tax)
  • Loan out to FM fund users (i.e: in financial crisis)

Factors that cause Demand curve to shift:

  • Utility derived from assets purchased with borrowed funds
  • Restrictiveness of nonprice conditions on borrowed funds
  • Economic conditions

Inflation:

  • Higher inflation => Higher IR
  • Def: the (percentage) increase in the price of a standardized basket of goods and services over a given period of time

Real Interest Rates

Default or Credit risk

  • Higher default risk => Higher IR
  • Not all securities exhibit default risk (i.e:T-bills)
  • DRP (Default Risk Premium): tend to increase when economy go down, and decrease when economy expand

Liquidity risk

  • High liquidity: sold at a predictable price (1) with low transaction costs (2) thus can be converted into its full market value at short notice
  • Investors demand liquidity premium on top of all other premium for bond's lack of liquidity

Special provisions or Covenants

  • Provide benefits to security holders (tax-free status and convertibility) => lower IR
  • Provide benefits to security issuers (call provision) => higher IR

Term to maturity

Unbiased expectation theory

Liquidity premium theory

Market segmentation theory

2.5 Time value of money and Interest rates

Time value of money: a dollar receive today is worth more than a dollar received at some future date

  • Simple interest: interest earned on an investment is NOT reinvested
  • Compound interest: reinvested

Lump sum

Lump sum payment: single cash payment receive at the beginning or end of some investment horizon (i.e: $100 at the end of five years)

Lump sum valuation

  • PV of a lump sum
  • FV of a lump sum

Annuity valuation

  • PV of an annuity
  • FV of an annuity