Chapter 8

Structure of Interest RatesStructure of Interest Rates

© 2000 John Wiley & Sons, Inc.

2

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

3

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

4

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

5

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

6

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

7

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)

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Historical Changes in U.S. Interest Rate Levels: 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 (generally declining prices and interest rates)

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Loanable Funds Theory

DEFINITION: States that interest rates are a function of the supply of and demand for loanable funds

SOURCES OF LOANABLE FUNDS:

--current savings

--expansion of deposits by depository institutions

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Interest Rate Determination in the Financial Markets

Int

eres

t ra

te (

r)

Quantity of Loanable Funds

7%

8%9%

S1

D1 D1

S1

D2

A B

C D

S1

D1D3

S1

S2

Int

eres

t ra

te (

r)

Int

eres

t ra

te (

r)

Int

eres

t ra

te (

r)

Quantity of Loanable Funds

Quantity of Loanable Funds Quantity of Loanable Funds

8%

S2

D1

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Factors Affecting the Supply of Loanable Funds

Volume of Savings Expansion of Deposits by Depository

Institutions Liquidity Attitudes

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Determinants of Market Interest Rates

NOMINAL INTEREST RATE (R):NOMINAL INTEREST RATE (R): Interest rate that is observed in the marketplace

BASIC EQUATION:BASIC EQUATION: r = RR + IP + DRP

REAL RATE OF INTEREST (RR):REAL RATE OF INTEREST (RR): Interest rate on a risk-free debt instrument when no inflation is expected

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Determinants of Market Interest Rates (Continued)

BASIC EQUATION:BASIC EQUATION: r = RR + IP + DRP

INFLATION PREMIUM (IP):INFLATION PREMIUM (IP): Average inflation rate expected over the life of the security

DEFAULT RISK PREMIUM (DRP):DEFAULT RISK PREMIUM (DRP): Compensation for the possibility of the borrower’s failure to pay interest and/or principal when due

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Determinants of Market Interest Rates (Concluded)

BASIC EQUATION EXPANDED:BASIC EQUATION EXPANDED: r = RR + IP + DRP + MRP + LP

MATURITY RISK PREMIUM (MRP):MATURITY RISK PREMIUM (MRP): Compensation expected by investors due to interest rate risk on debt instruments with longer maturities

LIQUIDITY PREMIUM (LP):LIQUIDITY PREMIUM (LP): Compensation for securities that cannot easily be converted to cash without major price discounts

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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

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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 = Real Rate (RR) + Inflation Premium (IP)

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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

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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

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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

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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

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Three Term Structure Theories (Continued)

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

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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

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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

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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

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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

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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: DPR = r - RR - IP

BASIC EQUATION EXPANDED: DPR = r - RR - IP - MRP - LP

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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%