FINANCIAL MARKETS AND ANALYSIS [CFI1203]

CHAPTER TWO
2. INTEREST RATES DETERMINATION AND STRUCTURE
1.
Mini Contents  Interest rate determination
 Loanable funds theory
 Liquidity preference theory
 Level of interest rates in the economy
 Understanding of the term structure of interest rates
 Theories of term structure of interest rates
 Spot rates and forwards rates
 Yield curves

2.1 Introduction
 For financing and investing decision making in a dynamic financial environment of market participants, it is crucial to
understand interest rates as one of the key aspects of the financial environment.
 Several economic theories explain determinants of the level of interest rates.
 Another group of theories explain the variety of interest rates and their term structure, i.e. relationship between interest
rates and the maturity of debt instruments.

1.2 Interest rate determination

2.2.1 The rate of interest
 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. Thus it is one form of yield on financial instruments.
 Two questions are being raised by market participants:
1) What determines the average rate of interest in an economy?
2) Why do interest rates differ on different types and lengths of loans and debt instruments?
 Interest rates vary depending on borrowing or lending decision. There is interest rate at which banks are lending (the
offer rate) and interest rate they are paying for deposits (the bid rate).
 The difference between them is called a spread. Such a spread also exists between selling and buying rates in local
and international money and capital markets.
 The spread between offer and bid rates provides a cover for administrative costs of the financial intermediaries and
includes their profit.
 The spread is influenced by the degree of competition among financial institutions. In the short-term international
money markets the spread is lower if there is considerable competition.
Conversely, the spread between banks borrowing and lending rates to their retail customers is larger in general due to
considerably larger degree of loan default risk. Thus the lending rate (offer or ask rate) always includes a risk premium.

Concepts Risk premium is an addition to the interest rate demanded by a lender to take into account the
risk that the borrower might default on the loan entirely or may not repay on time (default risk).
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.

 There are several factors that determine the risk premium for a non-Government security, as compared with the
Government security of the same maturity. These are
(1) the perceived creditworthiness of the issuer,
(2) provisions of securities such as conversion provision, call provision, put provision,
(3) interest taxes, and
(4) expected liquidity of a security’s issue.
 In order to explain the determinants of interest rates in general, the economic theory assumes there is some particular
interest rate, as a representative of all interest rates in an economy.
 Such an interest rate usually depends upon the topic considered, and can represented by e.g. interest rate on government
short-term or long-term debt, or the base interest rate of the commercial banks, or a short-term money market rate (e.g.
EURIBOR). In such a case it is assumed that the interest rate structure is stable and that all interest rates in the economy
are likely to move in the same direction.

2.3 Real vs. Nominal Interest Rates

 The rates of interest quoted by financial institutions are nominal rates, and are used to calculate interest payments to
borrowers and lenders.
 However, the loan repayments remain the same in money terms and make up a smaller and smaller proportion of the
borrower’s income. The real cost of the interest payments declines over time.
 Therefore there is a real interest rate, i.e. the rate of interest adjusted to take into account the rate of inflation. Since the
real rate of return to the lender can be also falling over time, the lender determines interest rates to take into account the
expected rate of inflation over the period of a loan.
 When there is uncertainty about the real rate of return to be received by the lender, he will be inclined to lend at fixed
interest rates for short-term.
  The loan can be ‘rolled over’ at a newly set rate of interest to reflect changes in the expected rate of inflation. On the
other hand, lenders can set a floating interest rate, which is adjusted to the inflation rate changes.

Concept Real interest rate is the difference between the nominal rate of interest and the expected rate of inflation.
It is a measure of the anticipated opportunity cost of borrowing in terms of goods and services forgone.

 The dependence between the real and nominal interest rates is expressed using the following equation:
i =(1+ r)(1+ ie) – 1
where i is the nominal rate of interest, r is the real rate of interest and ie is the expected rate of inflation.

 When simplified, the equation becomes: i = r + ie

 In the example, this would give 3 per cent plus 10 per cent = 13 per cent.
 The real rate of return is thus: r = i - ie
 When assumption is made that r is stable over time, the equation provides the Fisher effect.
 It suggests that changes in short-term interest rates occur because of changes in the expected rate of inflation.
 If a further assumption is made that expectations about the rate of inflation of market participants are correct, then the
key reason for changes in interest rates is the changes in the current rate of inflation.
 Borrowers and lenders think mostly in terms of real interest rates. There are two economic theories explaining the level
of real interest rates in an economy:
 The loanable funds theory
 Liquidity preference theory

Example
Assume that a bank is providing a company with a loan of 1000 thous. Dollars for one year at a real rate of
interest of 3 per cent. At the end of the year it expects to receive back 1030 thous. Dollars of purchasing power at
current prices. However, if the bank expects a 10 per cent rate of inflation over the next year, it will want 1133
thous. Dollars back (10 per cent above 1030 thous. Dollars). The interest rate required by the bank would be 13.3
per cent
i = (1+ 0.03)(1 + 0.1) - 1 = (1.03)(1.1) - 1 = 1.133 – 1 = 0.133 or 13.3 per cent

2.4 Interest rate theories: loanable funds theory

 In an economy, there is a supply loanable funds (i.e., credit) in the capital market by households, business, and
governments.
 The higher the level of interest rates, the more such entities are willing to supply loan funds;
 The lower the level of interest, the less they are willing to supply.
 These same entities demand loanable funds, demanding more when the level of interest rates is low and less when
interest rates are higher.
 The extent to which people are willing to postpone consumption depends upon their time preference.
 The term ‘loanable funds’ simply refers to the sums of money offered for lending and demanded by consumers and
investors during a given period. The interest rate in the model is determined by the interaction between potential
borrowers and potential savers.
 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 credit market (i.e., the sector of the capital markets for long-term debt instruments).
 This theory suggests that investment and savings in the economy determine the level of long-term interest rates.
 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
 Given the importance of loanable funds and that the major suppliers of loanable funds are commercial banks, the key
role of this financial intermediary in the determination of interest rates is vivid.
 The central bank is implementing specific monetary policy, therefore it influences the supply of loanable funds from
commercial banks and thereby changes the level of interest rates.
 As central bank increases (decreases) the supply of credit available from commercial banks, it decreases (increases) the
level of interest rates.
Concepts: Time preference describes the extent to which a person is willing to give up the satisfaction
obtained from present consumption in return for increased consumption in the future.
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.

2.5 Interest rate theories: Liquidity Preference Theory

 Saving and investment of market participants under economic uncertainty may be much more influenced by expectations
and by exogenous shocks than by underlying real forces. A possible response of risk-averse savers is to vary the form in
which they hold their financial wealth depending on their expectations about asset prices. Since they are concerned about
the risk of loss in the value of assets, they are likely to vary the average liquidity of their portfolios.
 Liquidity preference theory is another one aimed at explaining interest rates. 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.
 Money balances can be held in the form of currency or checking accounts, however it does earn a very low interest rate or
no interest at all.
 Concept A liquid asset is the one that can be turned into money quickly, cheaply and for a known monetary value.

 A key element in the theory is the motivation for individuals to hold money balance despite the loss of interest income.
 Money is the most liquid of all financial assets and, of course, can easily be utilized to consume or to invest.
 The quantity of money held by individuals depends on their level of income and, consequently, for an economy
the demand for money is directly related to an economy’s income.
 There is a trade-off between holding money balance for purposes of maintaining liquidity and investing or lending funds
in less liquid debt instruments in order to earn a competitive market interest rate.
 The difference in the interest rate that can be earned by investing in interest-bearing debt instruments and money
balances represents an opportunity cost for maintaining liquidity. The lower the opportunity cost, the greater the demand
for money balances; the higher the opportunity cost, the lower the demand for money balance.
Concept 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

2.6. The structure of interest rates

 The variety of interest rates that exist in the economy and the structure of interest rates is subject to considerable change
due to different factors. Such changes are important to the operation of monetary policy.
 Interest rates vary because of differences in the time period, the degree of risk, and the transactions costs associated
with different financial instruments.
 Figure 3 provides an overview of the factors influencing interest rates and thus the general framework for forecasting
them.
The greater the risk of default associated with an asset, the higher must be the interest rate paid upon it as compensation
for the risk. This explains why some borrowers pay higher rates of interest than others.
 The degree of risk associated with a request for a loan may be determined based upon a company’s size, profitability or
past performance; or, it may be determined more formally by credit rating agencies.
Borrowers with high credit ratings will be able to have commercial bills accepted by banks, find willing takers for their
commercial paper or borrow directly from banks at lower rates of interest. Such borrowers are often referred to as prime
borrowers.
Those less favoured may have to borrow from other sources at higher rates.
 The same principle applies to the comparison between interest rates on sound risk-free loans (such as government bonds)
and expected yields on equities.
The more risky a company is thought to be, the lower will be its share price in relation to its expected average dividend
payment – that is, the higher will be its dividend yield and the more expensive it will be for the company to raise equity
capital.

2.7. Term Structure of Interest Rates

 The relationship between the yields on comparable securities but different maturities is called the term structure of
interest rates. The primary focus here is the Treasury market.
 The graphic that depicts the relationship between the yield on Treasury securities with different maturities is known as
the yield curve and, therefore, the maturity spread is also referred to as the yield curve spread.
 The focus on the Treasury yield curve functions is due mainly because of its role as a benchmark for setting yields in
many other sectors of the debt market.
 However, a Treasury yield curve based on observed yields on the Treasury market is an unsatisfactory measure of the
relation between required yield and maturity.
 The key reason is that securities with the same maturity may actually provide different yields.
 Hence, it is necessary to develop more accurate and reliable estimates of the Treasury yield curve.
 It is important to estimate the theoretical interest rate that the Treasury would have to pay assuming that the security it
issued is a zero-coupon security.
  If the term structure is plotted at a given point in time, based on the yield to maturity, or the spot rate, at successive
maturities against maturity, one of the three shapes of the yield curve would be observed.
 The type of yield curve, when the yield increases with maturity, is referred to as an upward-sloping yield curve or a
positively sloped yield curve.
 A distinction is made for upward sloping yield curves based on the steepness of the yield curve. The steepness of the
yield curve is typically measured in terms of the maturity spread between the long-term and short-term yields.
 A downward-sloping or inverted yield curve is the one, where yields in general decline as maturity increases. A
variant of the flat yield is the one in which the yield on short-term and long-term Treasuries are similar but the yield on
intermediate-term Treasuries are much lower than, for example, the six-month and 30-year yields. Such a yield curve is
referred to as a humped yield curve.

Concept Yield curve: 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.

2.8. Theories of term structure of interest rates

 There are several major economic theories that explain the observed shapes of the yield curve:
 Expectations theory
 Liquidity premium theory
 Market segmentation theory
 Preferred habitat theory

2.8.1 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.
 This is equivalent to saying that the pure expectations theory assumes that investors treat alternative maturities
as perfect substitutes for one another.
 The pure expectations theory assumes that investors are risk-neutral. A risk-neutral investor is not concerned about
the possibility that interest rate expectations will prove to be incorrect, so long as potential favourable deviations from
expectations are as likely as unfavourable ones. Risk is not regarded negatively.
 However, most investors are risk-averse, i.e. they are prepared to forgo some investment return in order to achieve
greater certainty about return and value of their investments. As a result of risk-aversion, investors may not be indifferent
between alternative maturities. Attitudes to risk may generate preferences for either short or long maturities. If such is the
case, the term structure of interest rates (the yield curve) would reflect risk premiums.
Question How would a yield curve shift in response to sudden expectations of rising interest rates
according to pure expectations theory?
 If an investment is close to maturity, there is little risk of capital loss arising from interest rate changes. A bond with a
distant maturity (long duration) would suffer considerable capital loss in the event of a large rise in interest rates. The
risk of such losses is known as capital risk.
 To compensate for the risk that capital loss might be realised on long-term investments, investors may require a risk
premium on such investments.
 A risk premium is an addition to the interest or yield to compensate investors for accepting risk. This results in
an upward slope to a yield curve.
 This tendency towards an upward slope is likely to be reinforced by the preference of many borrowers to borrow
for long periods (rather than borrowing for a succession of short periods).
 Some investors may prefer long maturity investments because they provide greater certainty of income flows. This
uncertainty is income risk. If investors have a preference for predictability of interest receipts, they may require a higher
rate of interest on short-term investments to compensate for income risk. This would tend to cause the yield curve to be
inverted (downward sloping).
 The effects on the slope of the yield curve from factors such as capital risk and income risk are in addition to the effect of
expectations of future short-term interest rates.
 If money market participants expect short-term interest rates to rise, the yield curve would tend to be upward
sloping.
 If the effect of capital risk were greater than the effect of income risk, the upward slope would be steeper.
 If market expectations were that short-term interest rates would fall in the future, the yield curve would tend to
be downward sloping.
 A dominance of capital-risk aversion over income-risk aversion would render the downward slope less steep (or
possibly turn a downward slope into an upward slope).
 Questions Why do interest rates tend to decrease during recessionary periods?
What is the relationship between yield and liquidity of the securities?

2.8.2 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.
 Though long-term securities may be liquidated prior to maturity, their prices are more sensitive to interest rate
movements.
 Short-term securities are usually considered to be more liquid because they are more likely to be converted to cash
without a loss in value.
 Thus there is a liquidity premium for less liquid securities which changes over time. The impact of liquidity premium
on interest rates is explained by liquidity premium theory.
 Figure 5 provides a graphical explanation of impact of liquidity premium on interest rates and yield curve.

2.8.3 Market segmentation theory

 According to the market segmentation theory, interest rates for different maturities are determined independently of one
another.
 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.
 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.
 If investors or borrowers considered alternative maturities as substitutes, they may switch between maturities.
  However, if investors and borrowers switch between maturities in response to interest rate changes, interest rates for
different maturities would no longer be independent of each other.
 An interest rate change for one maturity would affect demand and supply, and hence interest rates, for other
maturities.

2.8.4 The preferred habitat theory

 Preferred habitat theory is a variation on the market segmentation theory.
 This theory allows for some substitutability between maturities.
 However it views that interest premiums are needed to entice investors from their preferred maturities to other
maturities.
 According to the market segmentation and preferred habitat explanations, government can have a direct impact on the
yield curve.
 Governments borrow by selling bills and bonds of various maturities.
 If government borrows by selling long-term bonds, it will push up long-term interest rates (by pushing down
long-term bond prices) and cause the yield curve to be more upward sloping (or less downward sloping).
 If the borrowing were at the short maturity end, short-term interest rates would be pushed up.
Question What factors influence the shape of the yield curve?

2.9 Forward interest rates and yield curve

 The expectations that are relevant to investment decisions are expectations relative to market expectations. An active
portfolio manager bases investment decisions on attempts to forecast interest rates more accurately than the average
participant in the money market. For this reason the manager of an actively managed bond portfolio needs to be able to
ascertain the market consensus forecast. Such market expectations can be deduced from forward interest rates.
 Forward interest rates are rates for periods commencing at points of time in the future.
 They are implied by current rates for differing maturities.
 For example, the current 3-month interest rate and the current 6-month interest rate between them imply a rate
for a 3-month period which runs from a point in time three months from the present until a point in time six
months hence.
 The forward 3-month rate for a period commencing three months from the present is the rate which, when
compounded on the current 3-month rate, would yield the same return as the current 6-month rate.
Example For example if the 3-month rate is 9% p.a. and the 6-month rate is 10% p.a., the forward rate is
shown as x in equation:
(1.0225)(1 + x) = 1.05
The forward rate is calculated as:
x = (1.05/1.0225) - 1 = 0.0269
which is 2.69% over three months and hence 10.76% p.a.

 The forward rate can be interpreted as the market expectation of the future interest rate under the assumptions that: the
expectations theory of the yield curve is correct and there is no risk premium.
 If the expectations theory is seen as a good model, but there is a risk premium, an adjustment is required to remove the
effects of the risk premium before the result can be interpreted as the market forecast of the future interest rate.
Question What is the meaning of the forward rate in the context of the term
structure of interest rates?
 The yield curve based on zero coupon bonds is known as the spot yield curve.
 It is regarded as more informative than a yield curve that relates redemption yields to maturities of coupon
bearing bonds.
 The redemption date is not the only maturity date.

Practice Question
The one-year interest rate is 6.5% p.a. and the six-month interest rate is 6% p.a. What is the forward six-month
interest rate for the period between six months and one year from now? Can this forward interest rate be taken to
be the interest rate expected by money market participants?
Solution:
Let x be the forward interest rate p.a. (so that the rate for six months is x/2).
(1.03)(1 +x/2) =1.065
1 +x/2 = (1.065)/(1.03)
x/2 = [(1.065)/(1.03)] -1
X = 2{ [(1.065)/(1.03)] -1}
Therefore x = 0.068, i.e. 6.8% p.a.
 The forward interest rate of 6.8% p.a. can be taken to be the market expectation if the expectations
theory of the yield curve is correct and there is no risk premium.
 If the expectations theory is correct but there is a risk premium, the risk premium must be removed
before carrying out the calculation.
 Suppose that the six-month rate contains no risk premium, but the one-year rate contains a risk premium
of 0,1% p.a. The one-year interest rate, net of the risk premium, is 6,4% p.a.
 The new calculation would be as follows:
(1.03)(1 + x/2) = (1.064)
x = 2{[(1.064)/(1.03)] -1}
Therefore x = 0.066, i.e. 6.6% p.a.
  Coupon-bearing bonds may have differing redemption yields, despite having common redemption dates, because of
differences in the coupon payments.
 Yield curves based on coupon-bearing bonds may not provide a single redemption yield corresponding to a
redemption (final maturity) date.
 The forward yield curve relates forward interest rates to the points of time to which they relate.
 For example, rates of return on five-year bonds and rates on four-year bonds imply rates on one year
instruments to be entered into four years from the present.
 The implied forward rate can be calculated by means of the formula:
(1 + 4r1) = (1 + 0r5)5 / (1 +0r4)4
where r5 is the five-year interest rate, r4 is the four-year interest rate, and 4r1 is the one-year rate expected in four years’
time.
 This formula arises from the relation:
(1 + 0r5)5 = (1 + 0r4)4 (1 + 4r1)
which states that a five-year investment at the five-year interest rate should yield the same final sum as a four-year
investment at the four-year rate with the proceeds reinvested for one year at the one-year rate expected to be available four years
hence. The value of 4r1 would be related to the point in time, of four years, on the yield curve. Carrying out such a calculation for
a succession of future periods produces a series of forward interest rates.
Questions Why might forward rates consistently overestimate future interest rates?
How liquidity premium affects the estimate of a forward interest rate?

 When plotted against their respective dates, the series of forward rates produces a forward yield curve. The forward yield
curve requires the use of zero coupon bonds for the calculations.
 This forms also the basis for calculation of short-term interest rate futures.
 Short-term interest rate futures, which frequently take the form of three-month interest rate futures, are
instruments suitable for the reduction of the risks of interest rate changes.
 Three-month interest rate futures are notional commitments to borrow or deposit for a three-month period that
commences on the futures maturity date.
 They provide means whereby borrowers or investors can (at least approximately) predetermine interest rates for
future periods.
Example Assume that the three-month interest rate is 4.5% p.a. and the six-month interest rate is 5% p.a.
What is the forward interest rate for the three-month period commencing three months from now?
Response
5% p.a. is 2.5% over six months, and 4.5% p.a. is 1.125% over three months.
(1.025)/(1.01125) = 1.013597
1.013597 - 1 = 0.01359,, i.e. 1.3597% for three months or 5.44% p.a. (to two decimal places).
The forward interest rate is 5.44% p.a.

2.10 Summary
 Level of interest rates in an economy is explained by two key economic theories: the loanable funds theory and the
liquidity preference theory.
 The loanable funds theory states that the level of interest rates is determined by the supply of and demand for
loanable funds.
 According to the liquidity preference theory, the level of interest rates is determined by the supply of and
demand for money balances.
 Interest rates in the economy are determined by the base rate (rate on a Government security) plus a risk premium (or a
spread).
 There are several factors that determine the risk premium for a non- Government security, as compared with the
Government security of the same maturity. These are
(1) The perceived creditworthiness of the issuer,
(2) Provisions of securities such as conversion provision, call provision, put provision,
(3) Interest taxes, and
(4) Expected liquidity of a security’s issue.
 The term structure of interest rates shows the relationship between the yield on a bond and its maturity.
The yield curve describes the relationship between the yield on bonds of the same credit quality but different maturities
in a graphical way.
 Apart from spot rates, forward rates provide additional information for issuers and investors.
 The major theories explain the observed shapes of the yield curve are the expectations theory, liquidity premium, market
segmentation theory and preferred habit theory.
2.11 Key terms
 Interest rates
 Loanable funds
 Spot rate
 Forward rate
 Term structure of interest rates
 Yield curve
 Expectations
 Biased expectations
 Liquidity
 Segmented markets
 Preferred habitat
2.12 Review questions and problems
1. How would you expect an increase in the propensity to save to affect the general level of interest rates in an economy?
2. Explain how an increase in the rate of inflation might affect (a) real interest rates and (b) nominal interest rates.
3. Why are some lenders capital risk averse and others income risk averse? What slope will the yield curve have when the
market is dominated by capital risk aversion?
4. Why might interest rates payable on long-term, ‘risk-free’ government bonds include a term premium?
5. What conclusion might you draw about possible future interest rates if a positive term premium were to increase?
6. Why might interest rate movements of various developed countries be more highly correlated in recent years than in earlier
years?
7. Consider the prevailing conditions for inflation (including oil prices), the economy, and the budget deficit, the central bank
of your country and monetary policy that could affect interest rates. Based on the prevailing conditions, do you think
interest rates will likely increase during the following half a year? Provide arguments for your answer. Which factor do
you think will have the largest impact on interest rates?
8. Assume that a) investors and borrowers expect that the economy will weaken and that inflation will decline; b) investors
require a low liquidity premium; c) markets are partially segmented and the Government prefers to borrow in the short-
term markets. Explain how each of the three factors would affect the term structure of interest rates, holding all other
factors constant. Then explain the overall effect on the term structure.
9. Assume that the yield curves in the US, Germany and Japan are flat. If the yield curve in the US suddenly becomes
positively sloped, do you think the yield curves in Germany and Japan would be affected? If yes, how?
10. Assume that the interest rate for one year securities is expected to be 4 per cent today, 5 per cent one year from now and
7 per cent two years from now. Using only the pure expectations theory find what are the current (spot) interest rates on
two and three year securities.
11. Assume that the spot (annualized) interest rate on a three year security is 8 per cent, while the spot (annualized) interest
rate on a two year security is 5 per cent. Use only this information to estimate the one year forward rate two years from
now.