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Determinants of Interest Rates LOANABLE FUNDS THEORY RATES OVER TIME RATES FOR INDIVIDUAL SECURITIES TERM STRUCTURE OF RATES Supply Demand = borrowers, issuers of securities, deficit spending unit Supply = lenders, financial investors, buyers

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determinants of interest rates
Determinants of Interest Rates

LOANABLE

FUNDS

THEORY

RATES

OVER TIME

RATES FOR

INDIVIDUAL

SECURITIES

TERM

STRUCTURE

OF RATES

Supply

Demand = borrowers, issuers of securities,

deficit spending unit

Supply = lenders, financial investors, buyers

of securities, surplus spending unit

Slope of demand/supply curves related

to elasticity or sensitivity of interest rates

Demand

Shifts

supply of loanable funds
Supply of Loanable Funds
  • Quantity supplied directly related to interest rates
  • Households are major suppliers of loanable funds
  • Businesses and governments may invest (loan) funds temporarily
  • Foreign sector a net supplier of funds in last twenty years
  • Federal Reserve’s monetary policy impacts supply of loanable funds
  • Sector cash receipts in period greaterthan outlays—lender
demand for loanable funds
Demand for Loanable Funds
  • Quantity demanded inversely related to interest rates
  • Household demand (mortgages, cars, appliances,..)
  • Business demand (working capital, profitable investments: Net present value NPV>0,..)
  • Governments (temporary imbalances, budget deficits, general economic conditions,…)
  • Foreign demand (differential interest rates,…)
equilibrium interest rate
Equilibrium Interest Rate
  • Aggregate Demand

DA = Dh + Db + Dg + Df

  • Aggregate Supply

SA = Sh + Sb + Sg + Sf

In equilibrium, DA = SA

shifts in the supply and demand
Shifts in the Supply and Demand
  • Supply
    • Wealth
    • Risk
    • Near-term spending needs
    • Monetary expansion
    • Economic conditions
  • Demand
    • Utility derived from asset purchases with borrowed funds
    • Restrictiveness on nonprice conditions on borrowed funds
    • Economic conditions
movement of interest rates over time
Movement of Interest Rates Over Time
  • Key interest rates: 1970 -1999
  • Interpret the patterns
  • www.stls.frb.org/fred/index.html
rates for individual securities i
Rates for Individual Securities= i
  • i = IP + RIR +DRP LRP +MP +SCP
  • Inflation premium (IP)
  • Real interest rates (RIR)
  • Default risk premium (DRP)
  • Liquidity risk premium (LRP)
  • Maturity premium (MP)
  • Special covenant premium (SCP)
rates for individual securities i8
Rates for Individual Securities= i
  • Fisher effect: Inflation and Real Interest rates
    • RIR = I – Expected IR
    • http://www.bls.gov/cpi/
  • Default risk: DRP= i – i(gov)
    • ..www.moodys.com and www.standardpoors.com
  • Liquidity risk: ability to sell at predictable price with low transaction cots
  • Maturity risk
    • In general, rates rise with maturity. (Upward sloping yield curve)
  • Special provisions
    • Call premium
    • Conversion premium
    • Tax exemption of municipal bonds
yield curves at various points in time
Yield Curves at Various Points in Time

17

16

15

February 17, 1982

14

13

January 2, 1985

12

1

1

10

Annualized Treasury Security Yields

9

August 2, 1989

8

October 22, 1996

7

October 15, 2000

6

5

September 18, 2001

4

3

2

0

5

10

15

20

25

30

Number of Years to Maturity

term structure of interest rates
Term Structure of Interest Rates

The relationship between maturity and yield.

  • The Yield Curve is the plot of current interest yields versus time to maturity.
  • Unbiased expectation theory
    • Forward rate calculations
    • Forward rate = Expected short rates
    • Different maturities are perfect substitutes
  • Liquidity premium theory
  • Market segmentation theory
upward and downward sloping yield curve
Upward and Downward Sloping Yield Curve
  • Upward
  • Expected higher interest rate levels
  • Expansive monetary policy
  • Expanding economy
  • Downward
  • Expected lower interest rate levels
  • Tight monetary policy
  • Recession soon?
uses of the term structure
Uses of The Term Structure
  • Forecast interest rates
      • The market provides a consensus forecast of expected future interest rates
      • Expectations theory dominates the shape of the yield curve
  • Forecast recessions
      • Flat or inverted yield curves have been a good predictor of recessions.
  • Investment and financing decisions
      • Lenders/borrowers attempt to time investment/financing based on expectations shown by the yield curve
      • Riding the yield curve
      • Timing of bond issuance
treasury debt management
Treasury Debt Management
  • U.S. Treasury attempts to finance federal debt at the lowest overall cost
  • Treasury uses a mixture of Bills, Notes, and Bonds to finance periodic deficits and refinance outstanding securities
  • Treasury focuses on short-term issuance, phasing out 30-year bonds
  • Treasury 10-year bond now the standard issue
  • Leave the long-term issuance to private issuers