MSL

LESSON 3: INTEREST RATE THEORIES

INTEREST RATES, DETERMINATION & MONEY LOANABLE FUNDS THEORY
MARKET
• Funds borrowed and lent in an
• Is the rate of return paid by a economy during a specified period of
borrower of funds to a lender of time
them
• Long-term interest rates:
• One form of yield on financial determined by the investments and
instrument. savings in the economy
Interest rate: Debt Instruments • Short-term interest rates:
determined by an economy’s
Required return: Equity instruments
financial and monetary conditions
Demand for Loanable funds =
INTEREST RATE DETERMINATION
net investments + net additions to liquid reserves
SPREAD
Supply for Loanable funds =
• The difference between the offer rate net savings + increase in the money supply
and bid rate.
➢ As the central bank increases (decreases)
• Provides the administrative costs of
the supply of credit available from
financial intermediaries and their
commercial banks, it decreases (increases)
profit.
the level of interest rates.
• Competition in short-term Liquidity Preference Theory
international money markets.
• Liquidity preference- is preference
• Higher interest rate, lower spread.
for holding financial wealth in the
RISK form of short-term, highly liquid
assets rather than long-term illiquid
–Risk Premium- is an addition to the interest rate assets, based on principally fear that
demanded by a lender. long-term assets will lose capital
–Some factors that determines the risk premium. overtime.

• The perceived creditworthiness of • It explains how interest rates are

the issuer. determined based on preferences of
households to money balances
• Provision of securities such as rather than spending or investing
conversion. provision, call provision, those funds.
put provision
• The level of interest rates is
• Interest taxes. determined by the supply and
demand for money balances
• Expected liquidity of a security’s
issue.
INFLATION THE STRUCTURE OF INTEREST RATE
• A rising trend in the prices of most FACTORS INFLUENCING INTEREST RATES
goods and services
1. FUTURE FOREIGN DEMAND FOR FUNDS
• Higher inflation, higher interest
rates ➢ Higher interest rates tend to attract foreign
investments.
REAL INTEREST RATE
2. FUTURE HOUSEHOLD DEMAND FOR FUNDS
–the difference between the nominal rate of
interest and the expected rate of inflation ➢ Inflation affects interest rate levels .
➢ Higher Inflation rate = Higher Interest rate.
3. FUTURE BUSINESS DEMAND FOR FUNDS
INTEREST RATE STRUCTURE
➢ Inflation affects interest rate levels .
➢ Is the relationships between the various ➢ Higher Inflation rate = Higher Interest rate.
rates of interest in an economy on financial
instruments of different lengths of different 4. FUTURE GOVERNMENT DEMAND FOR
degrees of risk. FUNDS
➢ The higher the fiscal deficit, the stronger the
demand to borrow to finance the gap.
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5. FUTURE FOREIGN SUPPLY OF LOANABLE 4. PREFERRED HABITAT THEORY
FUNDS
• Theory suggesting that different
➢ Whenever either the demand or supply of bond investors prefer a particular
loanable funds increases or decreases then maturity length over another.
it will lead to a change in the real interest
rate.

TERM STRUCTURE OF INTEREST RATES FORWARD INTEREST RATES AND YIELD

CURVE
➢ The relationship between the maturity and
SPOT RATE
rate of return for bonds with similar levels of
risk. • The spot rate is the price quoted for
➢ Yield Curve - shows how rates vary immediate settlement on an interest
between short, medium and long term rate, commodity, a security, or a
bonds. currency.
FORWARD INTEREST RATES
YIELDS TO MATURITY (YTM) • are rates for periods commencing at
points of time in the future. They are
➢ Is the compound annual rate of return
implied by current rates for differing
earned on a debt security purchased on a
maturities.
given day and held to maturity.
• The forward rate can be interpreted
as the market expectation of the
future interest rate under the
assumptions that: the expectations
theory of the yield curve is correct
and there is no risk premium.
• EXAMPLE: The one-year interest
rate is 6.5% p.a. and the six-month
interest rate is 6% p.a. What is the
forward six-month interest rate for
the period between six months and
one year from now? Can this
➢ Inverted - is a downward sloping curve .
forward interest rate be taken to be
➢ Normal - is an upward sloping curve .
the interest rate expected by money
➢ Flat - indicates that interest rates do not
market participants?
vary much at different maturities .
SPOT YIELD CURVE
• shows the relationship between the
THEORIES OF TERM STRUCTURE OF
spot rates at different maturities.
INTEREST RATES
FORWARD YIELD CURVE
1. EXPECTATIONS THEORY
• relates forward interest rates to the
• The theory that the yield curve
points of time to which they relate.
reflects investor expectations about
future interest rates.
2. LIQUIDITY PREMIUM THEORY
• Theory suggesting that long-term MONEY MARKET PURPOSE AND STRUCTURE
rates are generally higher than
short-term rates. THE ROLE OF MONEY MARKET

3. MARKET SEGMENTATION THEORY • The purpose of money markets is to

facilitate the transfer of short-term
• Theory suggesting that the market funds from agents with excess funds
for loans is segmented on the basis (corporations, financial institutions,
of maturity and that the supply of individuals, government) to those
and demand for loans within each market participants who lack funds
segment determine its prevailing for short term needs.
interest rate.
• For financial institutions and to some extent
to other non-financial companies money
markets allow for executing such functions
as:
• Fund raising
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• Cash management MAJOR CHARACTERISTICS OF MONEY
MARKET INSTRUMENTS ARE:
• Risk management
• Short-term nature
• Speculation or position financing
• low risk
• Signalling
• high liquidity (in general)
• Providing access to information on
prices • close to money
• Money markets are WHOLESALE MARKETS. Money markets consist of:
• ROLE OF MONETARY POLICY • Tradable
-to manage economic fluctuations and achieve • Non-tradable instruments
price stability.
In terms of risk two specific money market
•To serve public policy objectives segments are:
• Unsecured debt instruments markets
Money market can be divided into several major • Secured debt instruments markets
segments:
• 1. INTERBANK MARKET
MONEY MARKET PARTICIPANTS
- where banks and non-deposit financial institutions
• Ultimate lenders and ultimate
settle contracts with each other and with the central
borrowers
bank, involving temporary liquidity surpluses and
deficits. • Government
• 2. PRIMARY MARKET • Central Bank
- which is absorbing the issues and enabling • Credit Institutions
borrowers to raise new funds.
• Other important market participants
• 3. SECONDARY MARKET are other financial intermediaries
- for different short term securities, which • Non-financial corporations
redistrubutes the ownership, ensures liquidity, and
as a result, increases the supply of lending and
reduces its price. MONEY MARKET INSTRUMENTS
• 4. DERIVATIVES MARKET TREASURY BILLS
- market for financial contracts whose values are • Commonly known as T Bills
derived from the underlying money market
instruments. • Are short-term money market
instruments issued by the
- The money-market instruments are often grouped government and backed by it.
in the following way:
PRIMARY MARKETS
• Treasury bills and other short-term
government securities (up to one • The securities are issued via a
year); regularly scheduled auction process.
Upon the treasury’s announcement
• Interbank loans, deposits and other of the size of upcoming auction,
bank liabilities; tenders or sealed bids are being
• Repurchase agreements and similar solicited.
collateralized short-term loans; COMPETITIVE BIDDER
• Commercial papers, issued by non- • specifies both the amount of the
deposit entities (non-finance security that the bidder wants to buy,
companies, finance companies, local as well as the price that the bidder
government, etc.; wants to pay
• Certificates of deposit;
• Eurocurrency instruments; NON-COMPETITIVE BIDDER
• Interest rate and currency derivative • specifies only the amount of the
instruments security that the bidder wants to buy,
without providing the price, and
automatically pay the defined price
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TWO AUCTION FORMS THE PRICE OF CP IS CALCULATED IN THIS
WAY:
• Uniform price auction
P = PAR X (1- (D X N / 360))
• Discriminatory price auction
THE YIELD ON CP IS CALCULATED IN THIS
SECONDARY MARKET
WAY:
• The trading of already issued D = (PAR - P) / PAR X (360/N)
securities by investors and primary
market participants constitutes the
secondary market
CERTIFICATES OF DEPOSITS
PRICE OF TREASURY BILL
• states that a deposit has been made
• is the price that an investor will pay with a bank for a fixed period of time,
for a particular maturity Treasury at the end of which it will be repaid
security, depending upon the with interest.
investor’s required return on it.
• The price is determined as the
➢ THE ADVANTAGE TO THE DEPOSITOR IS
present value of the future cash
THAT THE CERTIFICATE CAN BE TRADABLE
flows to be received.
➢ THE ADVANTAGE TO THE BANK IS THAT IT
YIELD OF TREASURY BILL HAS THE USE OF A DEPOSIT FOR A FIXED
PERIOD
• is determined taking into account the
difference between the selling price
and the purchase price
YIELD OF SECURITY IS CALCULATED THIS
INTERBANK MARKET LOAN WAY:
• is a market through which banks Y = ( PAR – P )/ P X (360 / N)
lend to each other.
THE PRICE OF CD IS DETERMINED THIS WAY:
P = PAR / (1 – (I X N / 360))
THE MAJOR CHARACTERISTICS OF THE
INTERBANK MARKETS ARE:
• The transfer of immediately available
funds; REPURCHASE AGREEMENT (REPO)
• Short time horizons; ➢ is an agreement to buy any securities from
• Unsecured transfers a seller with the agreement that they will be
repurchased at some specified date and
price in the future.
PARTICIPANTS IN THE INTERBANK MARKET OPEN REPURCHASE AGREEMENT (REPO)
TYPICALLY UNDERTAKE
• is a REPO agreement with no set
2 TYPES OF TRANSACTION maturity date, but renewed each day
upon agreement of both
• reserve management transaction
counterparties.
• portfolio management transaction
TERM REPURCHASE AGREEMENT (REPO)
• is a REPO with a maturity of more
COMMERCIAL PAPERS than one day.

• is a short-term debt instrument REVERSE REPURCHASE AGREEMENT (REPO)

issued only by large, well known,
• is a purchase of securities by one
creditworthy companies and is
party from another with the
typically unsecured
agreement to sell them
• The major issuers of commercial
papers are financial institutions
(finance companies, bank holding EUROCURRENCY INSTRUMENT
companies, insurance companies.)
➢ is any instrument denominated in a currency
which differs from that of the country in
which it is traded
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INTERNATIONAL MONEY MARKET SECURITIES MONEY MARKET INTEREST RATES AND
YIELDS
➢ These are markets in which the borrowing
and lending denominated in a currency of RATE ON A DISCOUNT BASIS
some other country takes place
D = ( PAR – P ) / PAR X (360 / T )
ADD-ON RATE
THE MARKET GROWTH WAS INFLUENCED
Y = ( PAR – P ) / P X (360 / T )
GREATLY BY:
BOND-EQUIVALENT YIELD
1. EUROCURRENCY LIABILITIES OF FINANCIAL
INSTITUTIONS Y = ( PAR – P ) / P X (365 / T )
• Euro Certificates of deposits ANUAL YIELD TO MATURITY
• Interbank placements Y= ( PAR / P ) ^(365 / T ) – 1
• Time deposits SEMIANNUAL YIELD TO MATURITY
• Call money Y= 2 X ( PAR / P ) ^(365 /2 T ) – 2

2. EUROCURRENCY ASSETS OF FINANCIAL

INSTITUTIONS
• Euro Commercial Papers (Euro
CPs)
• Syndicated Euroloans
• Euronotes