expressed as a percentage of the

rental amount per year.

Financial Markets and the Financial System
● Significance:
○ Debt Markets: Interest rates
● Financial Markets: where funds are
are determined in debt
transferred from people or
markets.
organizations with excess funds to
○ Valuation: Interest rates are
those needing funds.
crucial for valuing
● Purpose: Financial markets promote
(determining the worth of)
economic efficiency by channeling
financial instruments.
funds to their most productive uses.
● Importance: Well-functioning financial
markets are crucial for economic Loanable Funds Theory
growth. In contrast, poorly performing
markets can hinder growth and ● Purpose: The Loanable Funds Theory
contribute to poverty. explains interest rate movements. It's
particularly useful for understanding
changes in a country's general
Types of Securities
interest rate level.
● Central Idea: Interest rates are
● Securities represent claims on the
determined by the supply of and
issuer's future income or assets. They
demand for loanable funds.
are also referred to as financial
○ Demand for Loanable Funds:
instruments.
Represents the borrowing
● Debt Securities: These securities
activities of households,
represent debt, and the borrower
businesses, and governments.
agrees to make fixed payments at
○ Supply of Loanable Funds:
regular intervals (interest and
Represents funds provided to
principal) until a specified maturity
the market by lenders (savers).
date.
○ Equilibrium Interest Rate: The
○ Examples: Bonds, mortgages,
interest rate at which the
Treasury bills, commercial
demand for loanable funds
paper, certificates of deposit
equals the supply of loanable
○ Maturity:
funds.
■ Short-term: Maturity
less than one year (e.g.,
money market Factors Affecting Interest Rates
securities)
■ Long-term: Maturity of ● Economic Growth: Strong economic
one year or more (e.g., growth usually leads to higher interest
bonds) rates because businesses and
● Equity Securities (Stocks): These individuals borrow more to invest and
securities represent ownership in a spend. Conversely, weak growth
corporation. generally leads to lower rates.
○ Claim: Stockholders have a ● Inflation: High inflation usually results
claim on the corporation's in higher interest rates as lenders
earnings and assets. demand higher returns to
○ Financing: Corporations issue compensate for the eroding value of
stock to raise funds. money. Lower inflation typically leads
to lower interest rates.
● Monetary Policy (Central Bank
Interest Rates Actions): Central banks (like the
Federal Reserve in the U.S.) can
● Definition: Interest rates are the cost influence interest rates by controlling
of borrowing money or the price paid the money supply. For example:
for renting funds. They are typically
 ○ Increasing the Money Supply: Interest rates play a crucial role in valuation,
This can lower interest rates, which involves determining the worth of
making borrowing cheaper assets, especially debt securities. The
and stimulating economic underlying concept connecting interest rates
activity. and valuation is present value.
○ Decreasing the Money Supply:
This can raise interest rates, Present Value (PV)
making borrowing more
expensive and potentially Present value is the current worth of a future
slowing inflation. sum of money or a stream of cash flows,
● Government Budget Deficit: Large discounted by a specific rate of return (the
government borrowing to finance a discount rate). In simpler terms, it tells you
budget deficit can increase the how much a future cash flow is worth today.
demand for loanable funds, The higher the discount rate (which is
potentially pushing interest rates influenced by interest rates), the lower the
higher. present value of a future cash flow, and
● Foreign Flows of Funds: Capital flows vice-versa.
between countries can impact interest
rates. For example, if foreign investors Yield to Maturity (YTM)
view a country as a safe haven, they
may invest heavily, increasing the YTM is the most accurate measure of an
supply of loanable funds and interest rate for a debt security. It represents
potentially lowering interest rates. the total return an investor can expect to
receive if they hold the bond until maturity.
Understanding YTM is essential for
Concept of Present Value
comparing different debt instruments.

● Definition: Present value (PV) is the Four Types of Debt Securities and YTM
current worth of a future sum of
money or stream of cash flows, given a While the sources provide formulas for
specific rate of return (discount rate). calculating YTM for various debt instruments,
● Importance: It's a core concept in let's focus on the common thread across
finance used to compare the value of these calculations:
money received at different points in
time.
● Simple Loan: The simplest form where
● Relationship with Interest Rates: The the lender provides funds for a
present value of a future cash flow is specific time, and the borrower repays
inversely related to the discount rate the principal and interest at maturity.
used:
● Fixed-Payment Loan (e.g., traditional
○ Higher discount rates lead to mortgage): The borrower makes
lower present values. regular, equal payments (usually
○ Lower discount rates result in monthly) that include both principal
higher present values. and interest portions.
● Coupon Bond (e.g., corporate bond):
Remember that these notes provide a broad The bond issuer makes periodic
overview. I recommend reviewing the specific interest payments (coupon payments)
chapters and sections mentioned in the to the bondholder and repays the
sources for a deeper understanding of each face value at maturity.
topic. ● Discount Bond (Zero-Coupon Bond):
Sold at a price discount to its face
Understanding Interest Rates and Their value, it doesn't pay periodic interest.
Effects Instead, the investor profits by
receiving the full face value at
1. Interest Rates and Valuation maturity, which is higher than the
purchase price.
Key Takeaway: The YTM calculation for each Supply and Demand in the Bond Market
instrument considers the time value of money.
This means it takes into account that Similar to other markets, the bond market's
receiving $1 today is more valuable than interest rates are determined by supply and
receiving $1 in the future because you can demand:
invest the dollar today and earn a return.
● Demand Curve: This curve shows the
Real vs. Nominal Interest Rates quantity of bonds demanded at
different interest rates. It's typically
● Nominal Interest Rate: This is the downward-sloping, meaning investors
interest rate that's usually quoted by demand more bonds at lower prices
financial institutions and reported in (higher yields) and fewer at higher
the news. It doesn't take inflation into prices (lower yields).
account. ● Supply Curve: This curve illustrates
● Real Interest Rate: This rate reflects the quantity of bonds supplied at
the nominal interest rate adjusted for various interest rates. It's generally
inflation. It gives a more accurate upward-sloping: as bond prices rise
picture of the return on an investment (yields fall), companies and
or the cost of borrowing. governments are more willing to issue
bonds.
The relationship between real and nominal
interest rates can be expressed as: Market Equilibrium

Real Interest Rate ≈ Nominal Interest Rate - The equilibrium interest rate occurs at the
Inflation Rate intersection of the demand and supply
curves. At this point, the quantity of bonds
Example: If a bond offers a 6% nominal demanded equals the quantity supplied.
interest rate, and inflation is 2%, the real
interest rate is approximately 4%. Interest Rate vs. Return

2. Why Interest Rates Change While our conversation history defines these
terms, it's essential to highlight their
Interest rates are constantly in flux due to the differences within the context of bond
interplay of various economic factors. investments:

Determinants of Asset Demand ● Interest Rate (Yield to Maturity):

Represents the return expected to be
The quantity demanded of an asset like a earned on a bond if held to maturity.
bond is influenced by: ● Return: The actual gain or loss on an
investment over a specific period,
● Wealth: As wealth increases, the factoring in interest payments and
demand for assets, including bonds, any change in the bond's price.
tends to rise.
● Expected Returns: Investors compare Capital Gains/Losses
the expected return of an asset to
those of alternative assets. Higher A capital gain occurs when a bond is sold for
expected returns increase demand. a price higher than its purchase price, while a
● Risk: Higher risk reduces demand, as capital loss happens when it's sold for less.
investors seek assets with a better Changes in interest rates are a primary driver
risk-return trade-off. of capital gains and losses on bonds.
● Liquidity: Highly liquid assets are
easier to buy or sell quickly without Bond Maturity and Volatility of Returns
significant price changes. Higher
liquidity generally increases demand.
Longer-term bonds are more sensitive to
interest rate changes than shorter-term
bonds. This means:

● Higher Volatility: Their prices

fluctuate more dramatically in
response to interest rate movements.
● Higher Interest Rate Risk: Investors in
long-term bonds face a greater risk of
capital losses if interest rates rise.

Reinvestment Risk

This risk arises when an investor receives

coupon payments or the principal back from
a bond and needs to reinvest those funds.

Example: If interest rates have fallen since the

investor bought the bond, they will have to
reinvest their earnings at a lower rate.

In Conclusion: Understanding these factors

helps in making informed decisions about
buying, selling, and holding various debt
securities.