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Chapter 2
Determinants of
Interest Rates

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 Interest Rate Fundamentals
Nominal interest rates are the interest rates actually
observed in financial markets
• Directly affect the value (price) of most securities
traded in the money and capital markets.
• Changes in interest rates influence the performance
and decision making for individual investors,
businesses, and governmental units.

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 Key U.S. Interest Rates, 1972 to 2022

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 Loanable Funds Theory
Changes in interest rates impact security values
• FI’s spend much time and effort trying to identify
factors that determine the level of interest rates at any
moment in time, as well as what causes interest rate
movements over time.

Loanable funds theory views equilibrium interest rates

in financial markets as a result of the supply of and
demand for loanable funds
• Categorizes financial market participants –
consumers, businesses, governments, and foreign
participants – as net suppliers or demanders of funds.

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 Supply of Loanable Funds
“Supply of loanable funds” describes funds provided to the
financial markets by net suppliers of funds
• Generally, the quantity of loanable funds supplied increases as
interest rates rise.
• Household sector (consumer sector) is one of the largest
suppliers of loanable funds in the U.S. ($84.66t in 2019).
• Business sector often has excess cash that it can invest for
short periods of time ($28.06t for nonfinancial and $98.47t for
financial business in 2019).
• Governments may supply loanable funds ($5.66t in 2019).
• Foreign investors view U.S. markets as alternatives to their
domestic financial markets ($27.20t in 2019).

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 Supply of and Demand for Loanable
Funds

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 Demand for Loanable Funds
“Demand for loanable funds” describes the total net demand for
funds by fund users
• In general, the quantity of loanable funds demanded is higher as
interest rates fall.
• Household demand reflects financing purchases of homes,
durable goods, and nondurable goods ($16.05t in 2019).
• Businesses demand funds to finance investments in long-
term assets and for short-term working capital needs ($66.46t
for nonfinancial and $111.87t for financial in 2019).
• Governments also borrow heavily ($28.86t in 2019).
• Foreign participants, mostly from the business sector, borrow
in U.S. financial markets ($20.81t in 2019).

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 Factors That Cause the Supply and Demand
Curves for Loanable Funds to Shift 1

Factors that cause the supply curve of loanable funds to shift, at

any given interest rate:
1. As wealth of fund suppliers increases (decreases), the
supply of loanable funds increases (decreases).
2. As risk of the financial security increases (decreases), the
supply of loanable funds decreases (increases) .
3. As near-term spending needs increase (decrease), the
supply of loanable funds increases (decreases).
4. When monetary policy objectives allow the economy to
expand (restrict expansion), the supply of loanable funds
increases (decreases).
5. As economic conditions improve in a domestic (foreign)
country, the supply of funds increases (decreases).
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 Factors That Affect the Supply of and Demand
for Loanable Funds for a Financial Security 1

Panel A: The supply of funds

Factor Impact on supply of Equilibrium Interest
Funds Rate*
Interest Rate Movement along the Direct
supply curve
Total wealth Shift supply curve Inverse
Risk of financial security Shift supply curve Direct
Near-term spending Shift supply curve Direct
needs
Monetary expansion Shift supply curve Inverse
Economic conditions Shift supply curve Inverse

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 Factors That Affect the Supply of and Demand
for Loanable Funds for a Financial Security 2

Panel B: The demand for funds

Factor Impact on supply of Equilibrium Interest
Funds Rate*
Interest Rate Movement along the Direct
supply curve
Utility derived from asset Shift demand curve Direct
purchased with borrowed
funds
Restrictiveness of Shift demand curve Inverse
nonprice conditions
Economic condition Shift demand curve Direct

*A “direct” impact on equilibrium interest rates means that as the “factor” increase (decreases) the equilibrium interest
rate increase rate increase (decreases). An “inverse” impact means that as the factor increases (decrease) the
equilibrium interest rate decreases (increases).

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 Factors That Cause the Supply and Demand
Curves for Loanable Funds to Shift 2

Factors that cause the demand curve for loanable funds to

shift include the following:
1. As the utility derived from an asset purchased with
borrowed funds increases (decreases), the demand for
loanable funds increases (decreases).
2. As the restrictiveness of nonprice conditions on borrowed
funds decreases (increases), the demand for loanable
funds increases (decreases)
• Nonprice conditions may include fees, collateral, or
requirements or restrictions on the use of funds (i.e.,
restrictive covenants).
3. When domestic economic conditions result in a period of
growth (stagnation), the demand for funds increases
(decreases).
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 Determinants of Interest Rates for
Individual Securities: Inflation
Inflation is the continual increase in the price level of a
basket of goods and services
• The higher the level of actual or expected inflation, the
higher will be the level of interest rates.
• In the U.S., inflation is measured using indexes.
• Consumer price index (CPI).
• Producer price index (PPI).

• Annual inflation rate using the CPI index between years t

and t+1 would be equal to:
CPI t+1 − CPI t
Inflation ( IP ) = 100
CPI t

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 Determinants of Interest Rates for
Individual Securities: Real Risk-Free Rate
A real risk-free rate is the interest rate that would exist on a
risk-free security if no inflation were expected over the
holding period of a security
• The higher society’s preference to consume today, the
higher the real risk-free rate (RFR).

Relationship among the real risk-free rate (RFR), the

expected rate of inflation [E(IP)], and the nominal interest
rate (i) is referred to as the Fisher effect
• The Fisher effect is often written as the following:

i = RFR + E ( IP )

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 Determinants of Interest Rates for
Individual Securities: Default Risk
Default risk is the risk that a security issuer will fail to make
its promised interest and principal payments to the buyer of a
security
• The higher the default risk, the higher the interest rate that
will be demanded by the buyer of the security to
compensate him or her for this default (or credit) risk
exposure.

• Difference between a quoted interest rate on a security

(security j) and a Treasury security with similar maturity,
liquidity, tax, and other features (such as callability or
convertibility) is called a default or credit risk premium
( DRPj ).

DRPj = i jt − iTt
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 Determinants of Interest Rates for
Individual Securities: Liquidity Risk
Liquidity risk is the risk that a security can be sold at a
predictable price with low transaction costs on short notice
• A highly liquid asset is one that can be sold at a
predictable price with low transaction costs, and thus can
be converted into its full market value at short notice.
• If a security is illiquid, investors add a liquidity risk premium
(LRP) to the interest rate on the security that reflects its
relative liquidity.
• LRP might also be thought of as an “illiquidity” premium.

• LRP may also exist if investors dislike long-term securities

because their prices (present values) are more sensitive to
interest rate changes than short-term securities.

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 Determinants of Interest Rates for Individual
Securities: Special Provisions or Covenants
Special provisions or covenants that may be written into the
contract underlying a security also affect the interest rates on
different securities
• Some of these provisions include the security’s taxability,
convertibility, and callability.
• For investors, interest payments on municipal securities
are free of federal, state, and local taxes.
• A convertible (special) feature of a security offers the
holder the opportunity to exchange one security for
another type of the issuer’s securities at a preset price.
• In general, special provisions that provide benefits to the
security holder (e.g., tax-free status and convertibility) are
associated with lower interest rates.

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 Determinants of Interest Rates for
Individual Securities: Term to Maturity
The term structure of interest rates is a comparison of market
yields on securities, assuming all characteristics except
maturity are the same
• Change in required interest rates as the maturity of a
security changes is called the maturity premium (MP).
• The MP can be positive, negative, or zero.
• The following general equation can be used to determine
the factors that functionally impact the fair interest rate i j *
on an individual (jth) financial security:

i j * = f ( IP, RFR , DRPj , LRPj , SCPj , MPj )

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 Common Shapes for Yield Curves on
Treasury Securities

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 Term Structure of Interest Rates
• Relationship between a security’s interest rate and its
remaining term to maturity (i.e., the term structure of
interest rates) can take a number of different shapes

Explanations for the shape of the yield curve fall

predominately into three theories:
1. Unbiased expectations theory.
2. Liquidity premium theory.
3. Market segmentation theory.

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 Explanations for the Shape of the
Term Structure of Interest Rates
Unbiased expectations theory—at any given point in time, the yield curve
reflects the market's current expectations of future short-term rates. According to
the unbiased expectations theory, the return for holding a four-year bond to
maturity should equal the expected return for investing in four successive one-
year bonds (as long as the market is in equilibrium).
Liquidity premium theory—long-term rates are equal to geometric averages of
current and expected short-term rates, plus liquidity risk premiums that increase
with the security's 'maturity. Longer maturities on securities mean greater market
and liquidity risk. So, investors will hold long-term maturities only when they are
offered at a premium to compensate for future uncertainty in the security’s value.
The liquidity premium increases as maturity increases.
Market segmentation theory—assumes that investors do not consider securities
with different 'maturities as perfect substitutes. Rather, individual investors and
FIs have preferred investment horizons (habitats) dictated by the nature of the
liabilities they hold. Thus, interest rates are determined by distinct supply and
demand conditions within a particular maturity segment(e.g. the short end and
long end of the bond market).

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 Unbiased Expectations Theory
• At a given point in time, the yield curve reflects the market’s current
expectations of future short-term rates

1 RN = [(1 + 1 R1 ) (1 + E ( 2 r1 ))...(1 + E ( N r1 ))]1/ N −1

Therefore:
(1 + 1 RN ) N = (1 + 1 R1 ) (1 + E ( 2 r1 ))... (1 + E ( N r1 ))

Where:

1 RN = Actual N-period rate today (that is, the first day of year 1)

N = Term to maturity, N = 1, 2,. . . . , 4, . . .

1 R1 = Actual current one-year rates today

E (i r1 ) = Expected one-year rates for years, i = 2, 3, 4, . . . , N in the future

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 Liquidity Premium Theory
• A weakness of the unbiased expectations theory is that it
assumes that investors are risk neutral.
Liquidity premium theory is an extension of the unbiased
expectations theory
• Based on the idea that investors will hold long-term maturities
only if they are offered at a premium to compensate for future
uncertainty in a security’s value, which increases with an asset’s
maturity.

1 RN = [(1 + 1R1 ) (1 + E ( 2 r1 ) + L2 )...(1 + E ( N r1 ) + LN )]1/ N −1

Where
Lt = Liquidity premium for a period t
L2  L3  . . . LN

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 Market Segmentation Theory
Market segmentation theory argues that individual
investors and FI’s have specific maturity preferences,
and to get them to hold securities with maturities other
than their most preferred requires a higher interest rate
(maturity premium)
• Does not consider securities with different maturities
as perfect substitutes.
• Individual investors and FI’s have preferred
investment horizons (habitats) dictated by the nature
of the liabilities they hold (i.e., investors have
complete risk aversion for securities outside their
maturity preferences).

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 Market Segmentation and Determination of
the Slope of the Yield Curve

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 Time Value of Money
• Time value of money is the basic notion that a dollar
received today is worth more than a dollar received at
some future date.
• Two forms of time value of money calculations are
commonly used in finance for security valuation purposes:

1. Value of a lump sum

• A lump sum payment is a single cash payment received
at the beginning or end of some investment horizon.
2. Value of annuity payments
• Annuity payments are a series of equal cash flows
received at fixed intervals over the entire investment
horizon.

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 Lump Sum Valuation
• Present Value of a Lump Sum.

PV = FVt / (1 + r )t
• Future Value of a Lump Sump.

FVt = PV (1 + r )t
Where
PV = Present value of cash flows
FVt = Future value of cash flow (lump sum) received in t periods
r = Interest rate earned per period on an investment ( equal the nominal annual interest
rate, i, divided by the number of compounding periods per year-for example, daily,
weekly, monthly, quarterly, semiannually )
t = Number of compounding periods in the investment horizon ( equal the number of years
in the investment horizon times the number of compounding periods per year )

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 Annuity Valuation
• Present Value of an Annuity.

 1 
1 −
 (1 + r ) 
PV = PMT   
 r 
 

Where
P M T = periodic annuity payment received during an
investment horizon

• Future Value of an Annuity.

 (1 + r )t −1 
FVt = PMT   
 r 
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