2 determinant of int rate

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DETERMINANTS OFINTEREST RATE

PROF. AMRUTA R. GAIKAR


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Nominal Interest Rate

Nominal Interest Rates are determined by:

v Real rate f interest

v Expected Inflation

v Maturity Risk

v Default Risk

v

Liquidity Risk


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Real Interest Rate

Compensates for the lenders lost opportunity to consume.

The minimum rate Im willing to accept in this market (overand above inflation) that convinces me to invest rather thanspend my money.

The real rate of interest, by definition, would be risk free .

In this market, risk free can drive the real rate of interest tozero.


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Expected Inflation Inflation erodes the purchasing power of money.

Example: If you loan someone $1,000 and they pay itback one year later with 10% interest, you will have

$1,100. But if prices have increased by 5%, thensomething that would have cost $1,000 at the outset ofthe loan will now cost $1,000(1.05) = $1,050.


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Nominal Risk-Free Rate The real rate of interest, plus

The inflation risk premium

Example: The T-Bill

Current Yield: 2.125%

So, if inflation rate is 1.80%, then

Real Rate of return is 2.125 1.80 or .325%


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Maturity Risk If interest rates rise, lenders may find that their loans are earning

rates that are lower than what they could get on new loans.

The risk of this occurring is higher for longer maturity loans.

Lenders will demand a premium to cover this risk depending on if

they think long term rates will go up or down.

10 years Treasury Note yielding 2.84% (0.7% premium over T-Billrate)


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Default Risk For most securities, there is some risk that the borrower

will not repay the interest and/or principal on time, or at

all.

The greater the chance of default, the greater the interestrate the investor demands and the issuer must pay.

(risk/return trade-off)

Example: Junk bonds have a high risk of default and

requires a high default risk premium. Current yield12.20%


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Liquidity Risk Investments that are easy to sell without losing value are

more liquid.

Illiquid securities have a higher interest rate premium tocompensate the lender for the inconvenience of not beingable to sell the bond easily.

Mortgage backed securities became illiquid! Cause ofmarket collapse!


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Term Structure of Interest Rate

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


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Expectation Theory The Expectation theory hypothesises that investors expectation alone

shape the yield curve. This theory assumes that the yield on a long-term bond is an average of the short-term yields that are expected toprevail over the life of the long-term bond. Its validity rests on theassumption that investors are indifferent to any variation in risks

associated with different maturities. They consider long term andshort-term bonds to be perfect substitutes for one another, and,therefore, move freely from one maturity to another always lookingfor highest expected return.

This implies that when all investors expect the rates to -

i) rise, the yield curve would slope upward

ii) remain unchanged, the yield would be horizontal or

iii) fall, the yield curve would slope downward.


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5/5/12Liquidity Preference Theory

Lenders prefer short-term securities over long term securities,unless the yield on the longer-term securities are high enough tocompensate for the greater interest rate risk.

Risk is related to variability of return or dispersion of market value.

So interest rate risk increases with term to maturity of a bond. Thelong-term bonds have more interest rate risk than short term bondsbecause of their long duration and because their interest elasticity islarger. As a result, the prices of long-term bonds fluctuate more thanthe prices of short-term bonds. The large price fluctuations are the

basis of liquidity premium hypothesis.

Thus, generally, lenders are averse to long-term securities (becauseof the higher risk involved), and borrowers are averse to short-termsecurities. These aversions on the part of lenders and borrowersinfluence the term structure of interest rates. However, the term


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Market Segmentation Theory According to market segmentation theory, interest rates

for various maturities are determined by demand and

supply conditions in the relevant segments of the market.

Investors are not indifferent to difference in maturities.

Instead they have definite maturity preferences, which are

based largely on the nature of their business.


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Uses of Term Structure

Forecast interest rates

The market provides a consensus forecast of expected futureinterest 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/financingbased on ex ectations shown by the yield curve


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Monetary Policy Monetary policy is the set of actions a government takes

usually through some form of a central bank that influencesthe economy.

A government has several options at its disposal and mostconcentrate on establishing short-term interest rates intended toexpand or contract the economy, depending on the latestinflation concerns.

By influencing the demand for currency through interest rates,the central bank attempts to maintain a favorable environmentfor economic growth as well as the preservation of value for the

currency.


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Role played by Central Bank Direct purchase of foreign currency the central bank

buys foreign currency and holds it in reserve to be sold ata time when it wants to decrease the supply of its owncurrency. Foreign currency is a common security forcentral banks to hold as it can easily be converted back tonative currency.

Reverse Operations or Repos Repos are contracts for

the temporary lending of money and are traded on theRepo market. Repos are an agreement between the buyerand seller with a fixed maturity (usually one week or onemonth).


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Factors affecting Market InterestRateThere are many interest rates in the market andthey do not always move in the same direction or to

the same extent. Therefore, it is sometimes useful toselect one rate to represent the short-term market.It is commonly believed that four factors aredominant in determining interest rate levels.


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These are:

1) Economic Condition

2) Monetary Policy

Bank rate

Open market operations

Cash Reserve Ratio

Supply of Money


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Money Supply

The money supply is controlled by the Fed through:

Open-market operations

Changing the reserve requirements

Changing the discount rate

Thus the quantity of money supplied does not depend on the


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Money Demand Money demand is determined by several factors.

According to the theory of liquidity preference,one of the most important factors is the interestrate.

People choose to hold money because money can

be used to buy other goods and services. The opportunity cost of holding money is the

interest that could be earned on interest-earning

assets.


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Equilibrium in the Money Market

According to the theory of liquidity preference:

v The interest rate adjusts to balance the supply anddemand for money.

v There is one interest rate, called the equilibrium

interest rate, at which the quantity of money demanded

equals the quantity of money supplied.

Harcourt Inc items and derived items copyright 2001 by


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5/5/12Equilibrium in the Money Market...

Quantityof Mon

Interest Rate

0

MoneyemandQuantityfixedy the

Moneyupply

r2

M2

r1

Md1

Equilibriuminterestrate

Harcourt, Inc. items and derived items copyright 2001 byHarcourt, Inc.


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Measures of Money Supply


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2 determinant of int rate

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