Chapter Two

Determination of
Interest Rates

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 Interest Rate Fundamentals

• Nominal interest rates: the interest rates

actually observed in financial markets
– affect the values (prices) of securities traded in
money and capital markets
– affect the relationships between spot and
forward FX rates

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 Time Value of Money and Interest Rates

• The time value of money is based on the

notion that a dollar received today is
worth more than a dollar received at
some future date
– Simple interest: interest earned on an
investment is not reinvested
– Compound interest: interest earned on an
investment is reinvested

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 Present Value of a Lump Sum

• Discount future payments using current interest

rates to find the present value (PV)
PV = FVt[1/(1 + r)]t = FVt(PVIFr,t)
PV = present value of cash flow
FVt = future value of cash flow (lump sum) received in t
periods
r = interest rate per period
t = number of years in investment horizon
PVIFr,t = present value interest factor of a lump sum

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 Future Value of a Lump Sum

• The future value (FV) of a lump sum

received at the beginning of an
investment horizon
FVt = PV (1 + r)t = PV(FVIFr,t)
FVIFr,t = future value interest factor of a lump
sum

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 Relation between Interest Rates and
Present and Future Values
Present
Value
(PV)
Future
Value
(FV)

Interest Rate

Interest Rate

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 Present Value of an Annuity

• The present value of a finite series of equal

cash flows received on the last day of equal
intervals throughout the investment horizon
t
PV  PMT  [1 /(1  r )] j  PMT ( PVIFA r ,t )
j 1

PMT = periodic annuity payment

PVIFAr,t = present value interest factor of an annuity

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 Future Value of an Annuity

• The future value of a finite series of equal cash

flows received on the last day of equal intervals
throughout the investment horizon
t 1
FVt  PMT  (1  r ) j  PMT ( FVIFA r ,t )
j 0

FVIFAr,t = future value interest factor of an annuity

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 Effective Annual Return

• Effective or equivalent annual return

(EAR) is the return earned or paid over
a 12-month period taking compounding
into account
EAR = (1 + r)c – 1
c = the number of compounding periods per year

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 Financial Calculators

• Setting up a financial calculator

– Number of digits shown after decimal point
– Number of compounding periods per year
• Key inputs/outputs (solve for one of five)
N = number of compounding periods
I/Y = annual interest rate
PV = present value (i.e., current price)
PMT = a constant payment every period
FV = future value (i.e., future price)

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 Loanable Funds Theory

• Loanable funds theory explains interest rates

and interest rate movements
• Views level of interest rates in financial
markets as a result of the supply and demand
for loanable funds
• Domestic and foreign households, businesses,
and governments all supply and demand
loanable funds

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 Supply and Demand of Loanable Funds

Demand Supply
Interest
Rate

Quantity of Loanable Funds

Supplied and Demanded
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 Shifts in Supply and Demand Curves
change Equilibrium Interest Rates
Increased supply of loanable funds Increased demand for loanable funds
Interest
Interest SS Rate DD* SS
Rate DD DD
SS*

i** E*
i* E
E i*
i** E*

Q* Q** Quantity of Q* Q** Quantity of

Funds Supplied Funds Demanded

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 Determinants of Interest Rates
for Individual Securities

• ij* = f(IP, RIR, DRPj, LRPj, SCPj, MPj)

• Inflation (IP)
IP = [(CPIt+1) – (CPIt)]/(CPIt) x (100/1)
• Real Interest Rate (RIR) and the Fisher
effect
RIR = i – Expected (IP)

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 Determinants of Interest Rates
for Individual Securities (cont’d)
• Default Risk Premium (DRP)
DRPj = ijt – iTt
ijt = interest rate on security j at time t
iTt = interest rate on similar maturity U.S. Treasury
security at time t
• Liquidity Risk (LRP)
• Special Provisions (SCP)
• Term to Maturity (MP)

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 Term Structure of Interest Rates:
the Yield Curve
(a) Upward sloping
Yield to (b) Inverted or downward
Maturity sloping
(c) Flat
(a)

(c)

(b)
Time to Maturity

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 Unbiased Expectations Theory

• Long-term interest rates are geometric averages

of current and expected future short-term
interest rates

1
RN  [(11 R1 )(1  E ( 2 r1 ))...(1  E ( N r1 ))] 1/ N
1
1RN = actual N-period rate today
N = term to maturity, N = 1, 2, …, 4, …
1R1 = actual current one-year rate today

E(ir1) = expected one-year rates for years, i = 1 to N

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 Liquidity Premium Theory

• Long-term interest rates are geometric

averages of current and expected future short-
term interest rates plus liquidity risk premiums
that increase with maturity
1
R N
 [(1 R
1 1
)(1  E ( r
2 1
)  L2
)...(1  E ( r
N 1
)  L N
)]1/ N
1

Lt = liquidity premium for period t

L2 < L3 < …<LN

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 Market Segmentation Theory

• Individual investors and FIs have specific

maturity preferences
• Interest rates are determined by distinct supply
and demand conditions within many maturity
segments
• Investors and borrowers deviate from their
preferred maturity segment only when
adequately compensated to do so

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 Implied Forward Rates

• A forward rate (f) is an expected rate on a

short-term security that is to be originated at
some point in the future
• The one-year forward rate for any year N in
the future is:

N
f1  [(11 RN ) N /(11 RN 1 ) N 1 ]  1

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