Chapter 6. Determination of Interest Rates in Financial Markets

. Interest rates
. The determinants of interest rates
. Term structure of interest rates and yield curves
. What determines the shape of yield curves
. Other factors






. Interest rates


Cost of borrowing money



Factors that affect cost of money:

Production opportunities

Time preference for consumption

Risk

Inflation









. The determinants of interest rates


 The quoted (nominal) interest rate on a debt security is composed of a real risk-free rate, r*, plus several risk premiums



 Risk premium: additional return to compensate for additional risk







 Quoted nominal return = r = r* + IP + DRP + MRP + LP

 where, r = the quoted, or nominal rate on a given security

r* = real risk-free rate

IP = inflation premium (the average expected rate of inflation over the life
time of the security)

 DRP = default risk premium

 MRP = maturity risk premium

 LP = liquidity premium



 and r* + IP = rRF = nominal risk-free rate (T-bill rate)





. Term structure of interest rates and yield curves


Term structure of interest rates: the relationship between yields and maturities



 Yield curve: a graph showing the relationship between yields and maturities



 Normal yield curve (upward sloping)

 Abnormal yield curve (downward sloping)

 Humped yield curve (interest rates on medium-term maturities are higher than
both short-term and long-term maturities)



 Term to maturity   -    Interest rate Interest rate (%)

 1 year 0.4%

 5 years 2.4%

 10 years 3.7%

 30 years 4.6%



. What determines the shape of yield curves?


Term structure theories

(1) Expectation theory: the shape of the yield curve depends on investor’s expectations about future interest rates (inflation rates)



 Forward rate: a future interest rate implied in the current interest rates



 For example, a one-year T-bond yields 5% and a two-year T-bond yields 5.5%, then the investors expect to yield 6% for the T-bond in the second year.



(1+5.5%)2 = (1+5%)(1+X), solve for X(forward rate) = 6.00238%



Approximation: (5.5%)*2 - 5% = 6%






 (2) Liquidity preference theory: other things constant, investors prefer to make short-term loans, therefore, they would like to lend short-term funds at lower rates



 Implication: keeping other things constant, we should observe normal yield curves





. Other factors


Fed policy: money supply and interest rates

Increase in money supply lowers short-term interest rates and stimulates the economy but may lead to inflation in the future



Government budget deficit or surpluses: if government runs a huge deficit and the debt must be covered by additional borrowing, which increases the demand for funds and thus pushes up interest rates


International perspective: trade deficit, country risk, exchange rate risk



Business activity: during recession, demand for funds decreases; during expansion, demand for funds rises



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