The Theory and Structure of Interest

Rates
Interest rates are among the most closely watched

variables in the economy. Their movements are

reported almost daily by the news media, because
they directly affect our everyday lives and have
important consequences on the health of the
economy.
They affect personal decisions such as whether to
consume or save, whether to buy a house, and
whether to purchase bonds.
……Interest rates also affect the economic decisions
of businesses and households, such as whether to
use their funds to invest or to save.
 The acts of saving and lending, and
borrowing and investing, are significantly
influenced by and tied together by the
interest rate.

−The interest rate is the price a borrower

must pay to secure scarce loanable funds
from a lender for an agreed-upon time
period.
• Some authors refer to the rate of interest
as the price of credit.
• It is the rental price of money usually
expressed as a percentage of the
principal amount of money borrowed
• It is the reward for parting with the
money and for postponing current
consumption
• Interest rates send price signals to
borrowers, lender, savers, and
investors.
• Whether higher interest rates increase
or decrease savings and investment
depends on the relative strength of its
effect on supply and demand factors.
 Functions of Interest Rate In the Economy

 The interest rate helps guarantee that current

savings will flow into investment to promote

economic growth.

 It allocates the available supply of credit,

generally providing loanable funds to those

investment projects with the highest expected
returns.
 It brings the supply of money into balance

with the public’s demand for money.

 The interest rate serves as an important tool

for government policy through its influence

on the volume of savings and investment.
 Pure or Risk-free rate of Interest
……we assume that there is one fundamental interest rate,

known as the pure or risk-free rate of interest, which is a

component of all interest rates.

• The closest real-world approximation to this pure

rate of return is the market interest rate on

government bonds.
Alternative Theories of Interest
Rates
• There are different theories regarding the
determinants of the risk free (pure) rate of
interest:

 The Classical Theory of interest rate

The Liquidity Preference Theory of interest
rate
The Loanable Funds Theory of interest rate
The Rational Expectations Theory of
interest rate
 The Classical Theory of Interest
Rate

 The classical theory argues that the rate of

interest is determined by two forces:
− the supply of savings, derived mainly from
households, and
− the demand for investment capital, coming mainly
from the business sector.
 According to this theory the rate of interest is
determined by the interaction of savings and
investment.
 Household Savings
Current household savings equal the difference
between current income and current
consumption expenditures.
Individuals prefer current over future
consumption, and the payment of interest is a
reward for waiting.
Higher interest rates encourage the substitution
of current consumption for current saving
 The Demand for Investment Funds

One investment decision-making method involves

the calculation of a project’s expected internal rate
of return, and the comparison of that expected return
with the anticipated returns of alternative projects, as
well as with market interest rates.
The internal rate of return (r) equates the total

cost of an investment project with the future

net cash flows (NCF) expected from that
project discounted back to their present values.
− Accept the project if the IRR is greater than the

cost of capital.

– Reject the project if the IRR is less than the cost of

capital.

– We are indifferent to accept or reject the project

when the IRR is equal to the cost of capital
• Unlike savings, investment is inversely
related to interest. The higher the interest
rate the lower is the demand for investment
capital.
Limitations…..

Factors other than savings and investment

that affect interest rates are ignored.

Today, economists recognize that income is

more important than interest rates in

determining the volume of savings .
 The Liquidity Preference Theory of
Interest Rate

According to this theory the rate of interest

is determined by the demand for and supply

of money. It is payment for the use of money
(liquidity). Keynes has defined interest as
reward for parting with the liquidity.
The supply of money is institutionally given. Hence,
the supply of money represents a vertical line. The
supply of money is independent of level of income and
the change in rate of interest.
 Liquidity preference is the preference to have

an equal volume of cash rather than other

financial claims against others.

 There are three important motives behind the

demand for money (liquidity):

i. The transactions motive - day to day transactions -the
purchase of goods and services
ii. The precautionary motive - to cope with future
emergencies and extraordinary expenses
iii. The speculative motive - a rise in interest rates results
in lower bond prices
It is desire to hold wealth to take advantage of market
movements
... The transaction and precautionary demand for

money depend on the level of national income,

business sales, and prices (but not interest rates). So,

demand due to these motives is fixed in the short

term.
• Speculative demand for money comes as store of

wealth. It is desire to hold wealth to take advantage of

market movements regarding future change in rate of
interest and bond price. Here money is held for
speculation which may lead to possible gain.
• Given the expectation the speculative demand for

money will be higher at lower rate of interest and

lower at higher rate of interest.
Limitations
Only the supply and demand for money is
Considered. A more comprehensive view that
considers the supply and demand for credit by all
actors in the financial system - businesses,
households, and governments - is needed.
 The Loanable Funds Theory of
Interest Rate

The popular loanable funds theory argues that the risk-free

interest rate is determined by the interplay of two forces:
 the demand for credit (loanable funds) by domestic

businesses, consumers, and governments, as well as

foreign borrowers
 the supply of loanable funds from domestic savings,

dishoarding of money balances, money creation by the

banking system, as well as foreign lending
 The Demand for Loanable Funds
 Consumer (household) demand is relatively inelastic with

respect to the rate of interest.

 Domestic business demand increases as the rate of interest

falls.
Government demand does not depend significantly

upon the level of interest rates.

Foreign demand is sensitive to the spread between

domestic and foreign interest rates.

 The Supply of Loanable Funds
Domestic Savings- The net effect of income, and wealth

effects is a relatively interest-inelastic supply of savings.

Dishoarding of Money Balances- When individuals and

businesses dispose of their excess cash holdings, the

supply of loanable funds available to others is increased.
 The Rational Expectations Theory of
interest rate

The rational expectations theory builds on a

growing body of research evidence that

………the money and capital markets are highly

efficient in digesting new information that affects
interest rates and security prices
The public forms rational and unbiased
expectations about the future demand and supply
of credit, and hence interest rates.
• If the money and capital markets are highly efficient,

then interest rates will always be very near their

equilibrium levels, and the optimal forecast of next
period’s interest rate is the current interest rate.
• Interest rates will change only if entirely new and

unexpected information appears, and the direction of

change depends on the public’s current set of
expectations.
Limitations
− At the moment, we do not know very much about how the

public forms its expectations.

− The cost of gathering and analyzing information relevant to

the pricing of assets is not always negligible, as assumed.

− Not all interest rates and security prices appear to display the

kind of behavior implied by the rational expectations theory.

 Measuring and Calculating
Interest Rates and Financial
Asset Prices
 Many different interest-rate measures attached to
different types of financial assets have been developed,
leading to considerable confusion, especially for small
borrowers and savers.

Question: What is interest rate? What methods most

frequently used to measure interest rates and the prices
of financial assets in the money and capital markets?
The interest rate is the price that is charged to
a borrower for the loan of money.

Let’s look at the simplest kind of debt

instrument, which we will call a simple loan.
In this loan, the lender provides the borrower with an

amount of funds (called the principal) that must be repaid

to the lender at the maturity date, along with an additional
payment as an interest. For example, if you made your
friend, H, a simple loan of $100 for one year, you would
require her to repay the principal of $100 in one year’s time
along with an additional payment for interest; say, $10.
• In this case, the interest payment divided by the amount

of the loan is a natural and sensible way to measure the

interest rate.

• Interest rates are usually expressed as annualized

percentages. However, both 360-day and 365-day

years are commonly used. The compounding terms
may also differ
Financial Asset Prices

The prices of common and preferred stock are

measured today in many markets in terms of dollars
(or some other currency unit).

Example $40.25 per share.

Bond prices are usually expressed in points, like
on a $100 basis or a $1000 bond or its
multiplications.
• Many security dealers who act as “market makers”

usually quote two prices for an asset.

….The higher ask price is the dealer’s selling price,

while the lower bid price is the dealer’s buying price.
 The difference between the bid and ask prices –

known as the spread – provides the dealer’s return for

creating a market for the security.
 Measures of return (yield)
 The interest rate on a loan or other financial asset is not

necessarily a true reflection of the yield or rate of return

actually earned by the lender during the life of the
asset.

• Some borrowers may default on all or a portion of their

promised payments.
• The market value of the financial asset may rise or fall.
The perpetuity rate is the return on a financial

instrument that never matures, but promises a fixed

income to its holder every year and infinite into the
future.

Annual rate of return on a perpetual financial

instrument
The coupon rate of a bond or some other debt security is

the contracted interest rate that the security issuer agrees

to pay at the time the security is issued.

Example

A bond with a par value of $1000 and a coupon rate of

9% pays an annual coupon of $90.
The current yield of a financial asset is the ratio of the

annual income (dividends or interest) generated by the

asset to its market value. Current income/ MV

Example

The current yield of a share of common stock selling

for $30 in the market and paying an annual dividend of
$3 to the shareholder is $3/$30 = 0.10, or 10%.
The yield to maturity (YTM) of a financial

asset is the rate of interest that the market is

prepared to pay today for the financial asset.
It is the rate that equates the purchase price

(P) with the present value of all the expected

annual net cash flows (CF) from the asset.
Computing the Promised Yield to Maturity (YTM)
The promised yield to maturity (YTM) can be computed by using the
following formula if:
1. The bond is held to maturity and
2. The dollar coupon interest payments are reinvested at the rate r
(reinvestment assumption):

(FV – P)
C+ n
YTM = __________________
FV + P
2
Where:
C= Periodic dollar coupon payments (i *FV)
FV= Face value of the bonds
P= the market price (present value) of bond
n= the number of periods until maturity of the bond n=m*t
i= the fixed coupon interest rate on the bond i=r/m
A bond trades at a discount from par if its price
is less than its par value, i.e. if its current yield
to maturity(YTM) is higher than its coupon
rate.
A bond trades at a premium over par if its price
is more than its par value, i.e. if its current
yield to maturity is lower than its coupon rate.
A bond trades at par if its price equals its par
value, i.e. if the current market interest rate on
comparable securities equals its coupon rate.
Example
• A 5-year corporate bond has a face value of $1,000. Its

promised annual coupon rate is 10% and it pays $50 in

interest every 6 months. The bond is currently selling for
$900. ….
 (1000 – 900)
50 + 10
YTM = ___________________
1000+ 900
2

YTM = 0.063 Annual YTM =0.1263

 Factors Affecting Interest Rate
 In addition to the expected inflation and maturity, other

factors affecting interest rates include:

• marketability,

• default risk,

• call privileges,

• taxation of security income,

• convertibility
 Marketability – Can an asset be sold quickly?
 Marketability is positively related to the size and

reputation of the institution issuing the securities and

to the number of similar securities outstanding.

However, marketability is negatively related to yield.

Liquidity – A liquid financial asset is readily
marketable.
Moreover, its price tends to be stable over time
and it is reversible.
• Default risk – The risk that a borrower will not make all

the promised payments at the agreed upon times.

Promised yield on a risky asset

• The promised yield on a risky debt security is the yield to

maturity that will be earned by the investor if the borrower

makes all promised payments when they are due.
• Credit ratings by rating companies such as

Moody’s and Standard & Poor’s

• Highly-rated securities are perceived as
having negligible default risk .
Call Privileges and Call Risk

• A call privilege on a bond contract grants the borrower

the option to retire all or a portion of a bond issue by

buying back the securities in advance of maturity at a
specified call price.
• A bond may be callable immediately, or the privilege

may be deferred for a specified period of time.

 Taxation of Security Income
 Taxes imposed by the federal, state, and local

governments can have a profound effect on the

returns earned by investors on financial assets.
 Thus, governments can use their taxing power to

encourage the investment in certain financial assets,

thereby redirecting the flow of savings and
investment toward areas of critical social need.
Convertible (or hybrid) securities are special

issues of corporate bonds or preferred stock

that can be exchanged for a specific number
of shares of the issuing firm’s common stock.
• Convertibles offer the investor the prospect of

a stable interest or dividend income, as well as

capital gains on common stock on conversion.

• Hence, investors are generally willing to pay a

premium for convertibles.

For the corporate bond issuer, the advantages of

convertible bonds is a significantly lower interest

cost and being able to avoid issuing more common

stock.
Interest on convertible bonds is often a tax-

deductible expense in many countries too.

Note that the issuer may call in the securities
early, forcing conversion
 Structure of interest rate
The risk-free interest rate underlies all interest rates

and is a component of all rates.

 All other interest rates are scaled upward by varying

degrees from the risk-free rate, depending on such

factors as inflation, the term (maturity) of a loan, the
risk of borrower default, and the marketability,
liquidity, convertibility, and tax status of the financial
assets to which those rates apply.
“End”