Chapter 4

Interest Rates

© 2008 John Wiley and Sons

 Chapter Outcomes

● Describe how interest rates change

in response to shifts in the supply
and demand for loanable funds
● Identify major historical movements
in interest rates in the United States
● Describe what is meant by the
loanable funds theory of interest
rates
2
 Chapter Outcomes (Continued)

● Identify the major determinants of

market interest rates
● Describe the types of marketable
securities issued by the U.S.
Treasury
● Describe the ownership of Treasury
securities and the maturity
distribution of the federal debt
3
 Chapter Outcomes (Continued)

● Explain what is meant by the term or

maturity structure of interest rates
● Identify and briefly describe the three
theories used to explain the term
structure of interest rates
● Identify broad historical price level
changes in the U. S. and other
economies and discuss their causes
4
 Chapter Outcomes (Concluded)

● Describe the various types of

inflation and their causes
● Discuss the effect of default risk
premiums on the level of long-term
interest rates

5
Supply and Demand for Loanable
Funds

Basic Interest Rate Concepts:

● INTEREST RATE:
Price that equates the demand for
and supply of loanable funds
● ROLE OF FINANCIAL MARKETS:
Interest rates are determined by the
supply and demand for loanable
funds in financial markets
6
 Interest Rate Determination in the
Financial Markets
A B
S1
Interest rate (r)

Interest rate (r)

S1
8%
7%
D2
D1 D1
Quantity of Loanable Funds Quantity of Loanable Funds
S2 S1
S2
S1

Interest rate (r)

Interest rate (r)

9%
8%

D1
D3 D1
Quantity of Loanable Funds Quantity of Loanable Funds

C 7D
 Historical Changes in U.S.
Interest Rate Levels
Periods of Rising Interest Rates:
● 1864-1873 (rapid economic expansion
after the Civil War)
● 1905-1920 (pre-war expansion and World
War I-related inflation)
● 1927-1933 (economic boom in late 1920s
followed by major depression)
● 1946-early 1980s (rapid economic
expansion after World War II)
8
 Historical Changes in U.S.
Interest Rate Levels (continued)
Periods of Falling Interest Rates:
● 1873-1905 (supply of funds exceeded
demand for funds and prices fell)
● 1920-1927 (rapid growth in supply of funds
and falling prices)
● 1933-1946 (actions taken to fight the
depression and finance World War II)
● Since early 1980s (after 1982, generally
declining prices and interest rates)
9
 Loanable Funds Theory

● Loanable Funds Theory Definition:

States that interest rates are a
function of the supply of and demand
for loanable funds
● Two Basic Sources of Loanable
Funds:
--current savings
--expansion of deposits by depository
institutions
10
 Factors Affecting the Supply of
Loanable Funds
● Volume of Savings
Major factor is the level of national income
● Expansion of Deposits by Depository
Institutions
Amount of short-term credit available depends
on lending policies of depository institutions
and the Fed
● Liquidity Attitude
Refers to how lenders see the future
11
 Determinants of Market
Interest Rates
● NOMINAL INTEREST RATE (r):
Interest rate that is observed in the
marketplace
● BASIC EQUATION:
r = RR + IP + DRP
● REAL RATE OF INTEREST (RR):
Interest rate on a risk-free debt
instrument when no inflation is
expected
12
 Determinants of Market
Interest Rates (continued)
● BASIC EQUATION:
r = RR + IP + DRP
● INFLATION PREMIUM (IP):
Average inflation rate expected over
the life of the security
● DEFAULT RISK PREMIUM (DRP):
Compensation for the possibility of
the borrower’s failure to pay interest
and/or principal when due
13
 Determinants of Market
Interest Rates (concluded)
● BASIC EQUATION EXPANDED:
r = RR + IP + DRP + MRP + LP
● MATURITY RISK PREMIUM (MRP):
Compensation expected by investors
due to interest rate risk on debt
instruments with longer maturities
● LIQUIDITY PREMIUM (LP):
Compensation for securities that
cannot easily be converted to cash
without major price discounts 14
 Interest Rate Risk
● DEFINITION:
Possible price fluctuations in
fixed-rate debt instruments
associated with changes in market
interest rates
● REASON:
An inverse relationship exists
between debt instrument values or
prices and nominal interest rates in
the marketplace 15
 Risk-Free Rate of Interest
● DEFINITION:
Interest rate on a debt instrument
with no default, maturity, or liquidity
risks (Treasury securities are the
closest example)
● EQUATION:
Risk-Free Rate (rf) = Real Rate (RR) +
Inflation Premium (IP)

16
 Two Types of U.S. Government
Debt Obligations
● MARKETABLE GOVERNMENT
SECURITIES:
Securities that may be bought and sold
through the usual market channels
● NONMARKETABLE GOVERNMENT
SECURITIES:
Issues that cannot be transferred between
persons or institutions but must be
redeemed with the U.S. government
17
 Types of U.S. Treasury Debt
Obligations
● TREASURY BILLS:
Obligations that bear the shortest (up to
one year) original maturities
● TREASURY NOTES:
Obligations issued for maturities of one to
ten years
● TREASURY BONDS:
Obligations of any maturity but usually
over five years
18
 Term or Maturity Structure of
Interest Rates

● TERM STRUCTURE:
Relationship between interest rates or
yields and the time to maturity for debt
instruments of comparable quality
● YIELD CURVE:
Graphic presentation of the term
structure of interest rates at a given
point in time

19
Term Structure Extremes for U.S.
Treasury Securities
Maturity March 1980 Nov. 2003
6 months 15.0% 1.0%
1 year 14.0% 1.3%
5 years 13.5% 3.3%
10 years 12.8% 4.3%
20 years 12.5% 5.2%
30 years 12.3% NA
20
 Recent Term Structures for U.S.
Treasury Securities
Maturity Nov. 2001 Oct. 2006
6 months 1.9% 4.9%
1 year 2.2% 5.0%
5 years 4.0% 4.7%
10 years 4.7% 4.7%
20 years 5.3% 4.9%
30 years 5.1% NA
21
 Three Term Structure Theories

● EXPECTATIONS THEORY:
Shape of the yield curve indicates
investor expectations about future
inflation rates
● LIQUIDITY PREFERENCE THEORY:
Investors are willing to accept lower
interest rates on short-term debt
securities which provide greater
liquidity and less interest rate risk
22
 Three Term Structure Theories
(continued)

● MARKET SEGMENTATION THEORY:

Interest rates may differ because
securities of different maturities are
not perfect substitutes for each other

23
 Inflation Premiums and
Price Movements
● INFLATION:
Occurs when an increase in the price
of goods or services is not offset by
an increase in quality
● HISTORICAL PRICE MOVEMENTS:
Changes in the money supply or in
the amount of metal in the money
unit have influenced prices since the
earliest records of civilization
24
Periods of Inflation in the U. S.

● Revolutionary War
● War of 1812
● Civil War
● World War I
● World War II
● Postwar Period through Early
1980s (1982)

25
 Types of Inflation

● COST-PUSH INFLATION:
Occurs when prices are raised to
cover rising production costs, such
as wages
● DEMAND-PULL INFLATION:
Occurs during economic expansions
when demand for goods and
services is greater than supply
26
 Types of Inflation (continued)
● SPECULATIVE INFLATION:
Caused by the expectation that
prices will continue to rise, resulting
in increased buying to avoid even
higher future prices
● ADMINISTRATIVE INFLATION:
The tendency of prices, aided by
union-corporation contracts, to rise
during economic expansion and to
resist declines during recessions
27
 Default Risk Premiums
● DEFAULT RISK:
Risk that a borrower will not pay
interest and/or repay the principal
on a loan according to the agreed
contractual terms
● BASIC EQUATION:
DRP = r - RR - IP
● BASIC EQUATION EXPANDED:
DRP = r - RR - IP - MRP - LP
28
 Default Risk Premium Example

● BASIC INFORMATION: nominal

interest rate = 9%; real rate = 3%;
inflation premium = 5%; and market
risk and liquidity premiums = 0%.
What is the default risk premium?
● EXPANDED EQUATION:
DRP = r - RR - IP - MRP - LP
DPR = 9% - 3% - 5% - 0% - 0% = 1%
29
 Risky Corporate Bonds

● Investment Grade Bonds:

Ratings of Baa or higher (Aaa, Aa, or A)
that meet financial institution investment
standards
● High-Yield Bonds:
High-yield or junk bonds that have a
substantial probability of default

30
 Web Links

● www.stls.frb.org
● www.whitehouse.gov/cea

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