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Chapter Two

Determinants of
Interest Rates
Interest Rate Fundamentals

 Nominal interest rates: the interest rates


actually observed in financial markets
 Used to determine fair present value and prices of
securities
 Two types of components
 Opportunity cost on competing investments

 Adjustments for individual security characteristics

2-2
Real Interest Rates

 Additional purchasing power


required to forego current
consumption
 What causes differences in nominal and real interest
rates?
 If you wish to earn a 3% real return and prices are
expected to increase by 2%, what rate must you charge?
 Irving Fisher first postulated that interest rates contain a
premium for expected inflation.
 (1+R) = (1+r)(1+h), where R is nominal, r is real, h is
inflation

2-3
Loanable Funds Theory

 Loanable funds theory explains interest rates


and interest rate movements
 Views level of interest rates in financial markets
as a result of the supply and demand for
loanable funds
 Domestic and foreign households, businesses,
and governments all supply and demand
loanable funds

2-4
Supply and Demand of Loanable
Funds

Demand Supply
Interest
Rate

Quantity of Loanable Funds


Supplied and Demanded

2-5
Determinants of Household
Savings
1. Interest rates – the higher the greater saving
2. Tax policy – the higher, the less saving
3. Income and wealth - the greater the wealth or
income, the greater the amount saved
4. Attitudes about saving versus borrowing
5. Credit availability - the greater the amount of
easily obtainable consumer credit the lower the
need to save
6. Job security and belief in soundness of
entitlements

2-6
Determinants of Foreign Funds
Invested in the U.S.

1. Relative interest rates and returns on


global investments
2. Expected exchange rate changes

3. Safe haven status of U.S. investments

4. Foreign central bank investments in


the U.S.
Why is so much money coming to the US
from abroad right now?
2-7
Federal Government Demand for
Funds (a.k.a. Deficit Financing)

 Source:Source:
CBO CBO 2011
2011 reporthttp://www.cbo.gov/ftpdocs/74xx/doc7492/08-17-
report,
BudgetUpdate.pdf

2-8
Shifts in Supply and Demand Curves
change Equilibrium Interest Rates
Increased supply of loanable funds Increased demand for loanable funds
Interest
Interest SS Rate DD* SS
Rate DD DD
SS*

i** E*
i* E
E i*
i** E*

Q* Q** Quantity of Q* Q** Quantity of


Funds Supplied Funds Demanded

2-9
Factors that Cause Supply and
Demand Curves to Shift
Increase in Affect on Supply Affect on Demand
Wealth & income Increase N/A
As wealth and income increase, funds suppliers are more willing to supply funds
to markets. Result: lower interest rates
Risk Decrease Decrease
As the risk of an investment decreases, funds suppliers are less willing to
purchase the claim. All else equal, demanders of funds would be less willing to
borrow as well. Result: higher interest rates
Near term spending needs Decrease N/A
As current spending needs increase, funds suppliers are less willing to invest.
Result: higher interest rates
Monetary expansion Increase N/A
As the central bank increases the supply of money in the economy, this directly
increases the supply of funds available for lending. Result: lower interest rates
2-10
Factors that Cause Supply and
Demand Curves to Shift
Increase in Affect on Supply Affect on Demand
Economic growth Increase Increase
With stronger economic growth, wealth and incomes rise, increasing the supply of funds
available. As U.S. economic strength improves relative to the rest of the world, foreign
supply of funds is also increased. Business demand for funds increases as more projects
are profitable. Result: indeterminate effect on interest rates, but at more rapid growth
rates interest rates tend to rise.
Utility derived from assets Decrease Increase
As utility from owning assets increases, funds suppliers are less willing to invest and
postpone consumption whereas funds demanders are more willing to borrow. Result:
higher interest rates
Restrictive covenants Increase Decrease
As loan or bond covenants become more restrictive, borrowers reduce their demand for
funds. Result: lower interest rates 2-11
Factors that Cause Supply and
Demand Curves to Shift
Increase in Affect on Supply Affect on Demand
Tax Increase Decrease Increase
Taxes on interest and capital gains reduce the returns to savers and the incentive to save.
The tax deductibility of interest paid on debt increases borrowing demand. Result:
Higher interest rates
Currency Appreciation Increase N/A
Foreign suppliers of funds would earn a higher rate of return if the currency appreciates
and a lower rate of return measured in their own currency if the dollar depreciates.
Foreign central banks often buy U.S. Treasury securities as part of their attempts to
prevent their currency from appreciating against the dollar.
Result: Lower interest rates
Expected inflation Decrease Increase
An increase in expected inflation implies that suppliers will be repaid with dollars that
will have less purchasing power than originally anticipated. Suppliers lose purchasing
power and borrowers gain more than originally anticipated. This implies that supply will
be reduced and demand increased. Result: Higher interest rates
Determinants of Interest Rates
for Individual Securities

 ij* = f(IP, RIR, DRPj, LRPj, SCPj, MPj)


 IP - inflation premium
 RIR – real risk-free rate
 DRP – default risk premium
 LRP – liquidity risk premium
 SCP – special feature premium
 MP maturity premium

 Inflation (IP)
IP = [(CPIt+1) – (CPIt)]/(CPIt) x (100/1)
 Real Interest Rate (RIR) and the Fisher
effect
RIR = i – Expected (IP)
2-13
Determinants of Interest Rates
for Individual Securities (cont’d)

 Default Risk Premium (DRP)


DRPj = ijt – iTt
ijt = interest rate on security j at time t
iTt = interest rate on similar maturity U.S. Treasury
security at time t
 Liquidity Risk (LRP)
 Special Provisions (SCP)
 Term to Maturity (MP)

2-14
Term Structure of Interest Rates:
the Yield Curve

(a) Upward sloping


Yield to
Maturity (b) Inverted or
downward sloping
(a) (c) Flat
(c)
Recessions tend to
(b)
preceded by inverted
Time to Maturity
yield curves

2-15
Unbiased Expectations Theory

 Long-term interest rates are geometric averages


of current and expected future short-term
interest rates

1
RN  [(11 R1 )(1  E ( 2 r1 ))...(1  E ( N r1 ))] 1/ N
1
1RN = actual N-period rate today
N = term to maturity, N = 1, 2, …, 4, …
1R1 = actual current one-year rate today
E(ir1) = expected one-year rates for years, i = 1 to N

2-16
Liquidity Premium Theory

 Long-term interest rates are geometric averages


of current and expected future short-term
interest rates plus liquidity risk premiums that
increase with maturity

1
RN
 [(1 R
1 1
)(1  E ( r
2 1
)  L2
)...(1  E ( r
N 1
)  LN
)]1/ N
1
Lt = liquidity premium for period t
L2 < L3 < …<LN

2-17
Market Segmentation Theory

 Individual investors have specific maturity


preferences
 Interest rates are determined by distinct supply
and demand conditions within many maturity
segments
 Investors and borrowers deviate from their
preferred maturity segment only when
adequately compensated to do so

Also known as Preferred Habitat Theory

2-18
Implied Forward Rates

 A forward rate ( f ) is an expected rate on a


short-term security that is to be originated at
some point in the future
 The one-year forward rate for any year N in the
future is:

N
f1  [(11 RN ) /(11 RN 1 ) ]  1
N N 1

2-19
Question
The 2 year rate is 2% per year
The 1 year rate is 1.5%
What is the implied forward rate for year
2?

Answer
Then 2f1 = (1.02)2 / (1.015) – 1 = .025 or
2.5% next year

2-20
Time Value of Money and Interest
Rates

 The time value of money is based on the


notion that a dollar received today is
worth more than a dollar received at some
future date
 Simple interest: interest earned on an
investment is not reinvested
 Compound interest: interest earned on an
investment is reinvested

2-21
Present Value of a Lump Sum

 Discount future payments using current interest


rates to find the present value (PV)
PV = FVt[1/(1 + r)]t = FVt(PVIFr,t)
PV = present value of cash flow
FVt = future value of cash flow (lump sum) received in t
periods
r = interest rate per period
t = number of years in investment horizon
PVIFr,t = present value interest factor of a lump sum

2-22
Future Value of a Lump Sum

 The future value (FV) of a lump sum


received at the beginning of an
investment horizon
FVt = PV (1 + r)t = PV(FVIFr,t)
FVIFr,t = future value interest factor of a lump sum

2-23
Relation between Interest Rates
and Present and Future Values
Present
Value
(PV)
Future
Value
(FV)

Interest Rate

Interest Rate

2-24
Present Value of an Annuity

 The present value of a finite series of equal


cash flows received on the last day of equal
intervals throughout the investment horizon
t  t 
1  (1  i )
PV  PMT  [1/(1  r )] j  PMT   
j 1  i 

PMT = periodic annuity payment


PVIFAr,t = present value interest factor of an annuity
NOTE: PMT / i is a perpetuity, which lasts only t-periods

2-25
Future Value of an Annuity

 The future value of a finite series of equal cash


flows received on the last day of equal intervals
throughout the investment horizon

t 1  (1  i )  1
t
FVt  PMT  (1  r )  PMT  
j

j 0  i 
FVIFAr,t = future value interest factor of an annuity

2-26
Effective Annual Return

 Effective or equivalent annual return


(EAR) is the return earned or paid over a
12-month period taking compounding
into account
EAR = (1 + rper period)c – 1

c = the number of compounding periods per year

2-27
Financial Calculators

 Setting up a financial calculator


 Number of digits shown after decimal point
 Number of compounding periods per year
 Key inputs/outputs (solve for one of five)
N = number of compounding periods
I/Y = annual interest rate
PV = present value (i.e., current price)
PMT = a constant payment every period
FV = future value (i.e., future price)

Chapter 2 Problems: On page 55, try 20, 22, and all of page 56.

2-28
Chapter Three

Interest Rates and


Security Valuation
Various Interest Rate Measures
 Coupon rate
 periodic cash flow a bond issuer contractually promises to
pay a bond holder
 Required rate of return (r)
 rates used by individual market participants to calculate
fair present values (PV)
 Expected rate of return or E(r)
 rates participants would earn by buying securities at
current market prices (P)
 Realized rate of return ( r )
 rate actually earned on investments

2-30
Required Rate of Return

 The fair present value (PV) of a security is


determined using the required rate of return (r) as
the discount rate
~ ~ ~ ~
CF1 CF2 CF3 CFn
PV     ... 
(1  r )1 (1  r )2 (1  r )3 (1  r )n
CF1 = cash flow in period t (t = 1, …, n)
~ = indicates the projected cash flow is uncertain
n = number of periods in the investment horizon

2-31
Expected Rate of Return
 The current market price (P) of a security is
determined using the expected rate of return or E(r)
as the discount rate

~ ~ ~ ~
CF1 CF2 CF3 CFn
P    ... 
(1  E(r ))1 (1  E(r ))2 (1  E(r ))3 (1  E(r ))n
CF1 = cash flow in period t (t = 1, …, n)
~ = indicates the projected cash flow is uncertain
n = number of periods in the investment horizon

2-32
Realized Rate of Return

 The realized rate of return ( r ) is the discount rate


that just equates the actual purchase price ( P) to
the present value of the realized cash flows (RCFt) t
(t = 1, …, n)

RCF1 RCF2 RCF3 RCFn


P    ... 
1 2 3 n
(1  r ) (1  r ) (1  r ) (1  r )

2-33
Bond Valuation - PV of coupon payments
and PV of Par or Face Value.

 The present value of a bond (Vb) can be written as:


2T t
INT  1  Par
Vb     
2 t 1 (1  (r / 2))  (1  (r / 2))2T

INT 1  1 (1  (r 2))2T  Par


  
2  (r 2)  (1  (r/2)) 2T
Par = the par or face value of the bond, usually $1,000
INT = the annual interest (or coupon) payment
T = the number of years until the bond matures
r = the annual interest rate (often called yield to
maturity (ytm))
2-34
Bond Valuation

 A premium bond has a coupon rate (INT)


greater than the required rate of return (r) and
the fair present value of the bond (Vb) is
greater than the face or par value (Par)
 Premium bond: If INT > r; then Vb > Par
 Discount bond: if INT < r, then Vb < Par
 Par bond: if INT = r, then Vb = Par

2-35
Equity Valuation

 The present value of a stock (Pt) assuming zero


growth in dividends can be written as:

Pt  D / rs
D = dividend paid at end of every year
Pt = the stock’s price at the end of year t
rs = the interest rate used to discount future cash flows

Note: This is a Perpetuity Formula or a Consol. We find this


perfect for preferred stock, which have fixed dividends.

2-36
Equity Valuation
The Dividend Growth Model
or Gordon Model
 The present value of a stock (Pt) assuming
constant growth in dividends can be written as:
t
D0 (1  g) Dt 1
Pt  
rs  g rs  g
D0 = current value of dividends
Dt = value of dividends at time t = 1, 2, …, ∞
g = the constant dividend growth rate

2-37
Equity Valuation
 The return on a stock with zero dividend growth, if
purchased at current price P0, can be written as:

rs  D / P0
 The return on a stock with constant dividend growth,
if purchased at price P0, can be written as:

D0 (1  g) D1
rs  g g
P0 P0
Dividend yield + capital gain yield

2-38
Relation between Interest Rates
and Bond Values
Interest
Rate
12%

10%

8%

874.50 1,000 1,152.47


Bond Value

2-39
Impact of maturity on Price
Volatility in the face of interest
rate changes
Absolute Value of
Percent Change in a
Bond’s Price for a
Given Change in
Interest Rates

Time to Maturity
Impact of Maturity on Price Volatility with increase in yields
Coupon 6.00%
Par $ 1,000
yield rate old 7.00%
yield rate change 0.50%
yield rate new 7.50%
Absolute
Maturity Price old Price new Rate of change
1 $ 990.65 $ 986.05 0.47%
5 $ 959.00 $ 939.31 2.05%
10 $ 929.76 $ 897.04 3.52%
15 $ 908.92 $ 867.59 4.55%
20 $ 894.06 $ 847.08 5.25%
25 $ 883.46 $ 832.80 5.74%
30 $ 875.91 $ 822.84 6.06%
35 $ 870.52 $ 815.91 6.27%
40 $ 866.68 $ 811.08 6.42%
45 $ 863.94 $ 807.72 6.51%
50 $ 861.99 $ 805.38 6.57%
55 $ 860.60 $ 803.75 6.61%
60 $ 859.61 $ 802.61 6.63%
65 $ 858.90 $ 801.82 6.65%
70 $ 858.40 $ 801.27 6.66%
75 $ 858.04 $ 800.88 6.66%
80 $ 857.78 $ 800.61 6.66%
85 $ 857.60 $ 800.43 6.67%
90 $ 857.47 $ 800.30 6.67%
95 $ 857.37 $ 800.21 6.67%
100 $ 857.31 $ 800.14 6.67%
105 $ 857.26 $ 800.10 6.67%
Predicted limit price change =
1 - (r old / r new) 6.67%
IM Figure 3.1 2-41
Impact of Coupon Rates on
Price Volatility

Bond
Value
High-Coupon Bond

Low-Coupon Bond

Interest Rate

2-42
Impact of Coupon on Price Volatility with decrease in yields

Coupon Varies Maturity


Par $1,000 10 years
rate old 7.00%
rate change -0.50%
rate new 6.50% Absolute
Rate of
Coupon rate Price old Price new change
6.00% $ 929.76 $ 964.06 3.69%
5.50% $ 894.65 $ 928.11 3.74%
5.00% $ 859.53 $ 892.17 3.80%
4.50% $ 824.41 $ 856.22 3.86%
4.00% $ 789.29 $ 820.28 3.93%
3.50% $ 754.17 $ 784.34 4.00%
3.00% $ 719.06 $ 748.39 4.08%
2.50% $ 683.94 $ 712.45 4.17%
2.00% $ 648.82 $ 676.50 4.27%
1.50% $ 613.70 $ 640.56 4.38%
1.00% $ 578.59 $ 604.61 4.50%
0.50% $ 543.47 $ 568.67 4.64%
0.00% $ 508.35 $ 532.73 4.80%
IM Figure 2 Coupons and Price Volatility

2-43
Impact of r on Price Volatility
Bond Price

How does volatility change with


interest rates?

Price volatility is
inversely related
to the level of the
initial interest
rate

r
Interest Rate

2-44
Duration

 Duration is the weighted-average time to


maturity (measured in years) on a financial
security
 Duration measures the sensitivity (or
elasticity) of a fixed-income security’s price to
small interest rate changes
 Duration captures the coupon and maturity
effects on volatility.

2-45
Duration – weighted average of coupon and Par value
 Duration (Dur) for a fixed-income security that pays interest
annually can be written as:

T T
CF t t
 (1  r )t  PVt  t
Dur  t 1  t 1
P0 P0
P0= Current price of the security
t = 1 to T, the period in which a cash flow is received
T = the number of years to maturity
CFt = cash flow received at end of period t
r = yield to maturity or required rate of return
PVt = present value of cash flow received at end of period t

2-46
Duration and Volatility
9% Coupon, 4 year maturity annual payment bond with a 8% ytm

T
CFt t
 (1  r)t
Dur  t 1
P0
Weighted % of
PV @8% % of Value Value
Year (T) Cash Flow CFT/(1+r)T PV/Price (PV/Price)*T
1 $ 90 $ 83.33 8.06% 0.0806
2 90 77.16 7.47% 0.1494
3 90 71.45 6.92% 0.2076
4 $1090 $ 801.18 77.55% 3.1020
Totals $1033.12 100.00% 3.5396

Duration = 3.5396 years


What is the Duration if zero coupon 4 year bond?
Duration
 Duration (Dur) (measured in years) for a fixed-
income security, in general, can be written as:

T
CF t t
 mt
Dur  t 1/ m (1  r / m)
P0
m = the number of times per year interest is paid, the sum term
is incremented in m units

2-48
Closed form duration equation:
1  (1  r)  N
PVIFA r, N 
r

 INT 
Dur  N    N  ((1  r)  PVIFA r,N )
(Po  r) 
• P0 = Price
• INT= Periodic cash flow in dollars, normally the semiannual coupon on
a bond or the periodic monthly payment on a loan.
• r = periodic interest rate = APR / m, where m = # compounding periods
per year
• N = Number of compounding or payment periods (or the number of
years * m)
• Dur = Duration = # Compounding or payment periods; Durationperiod is
what you actually get from the formula

2-49
Duration

 Duration and coupon interest


 the higher the coupon payment, the lower the bond’s
duration
 Duration and yield to maturity
 the higher the yield to maturity, the lower the bond’s
duration
 Duration and maturity
 duration increases with maturity but at a decreasing rate

2-50
Duration and Modified Duration

 Given an interest rate change, the estimated


percentage change in a (annual coupon paying)
bond’s price given by

P  r 
 Dur  
P  1  r 

 Note: -Dur is the price elasticity of interest rates.

2-51
Duration and Modified Duration

 Modified duration (DurMod) can be used to predict price


changes for non-annual payment loans or securities:
 It is found as:
DurAnnual
DurMod 
where rperiod = APR/m (1  rperiod )

 Using modified duration to predict price changes:

ΔP
 DurMod  Δrannual
P

2-52
Duration Based Prediction Errors

2-53
Convexity

 Convexity (CX) measures the change in slope of


the price-yield curve around interest rate level R
 Convexity incorporates the curvature of the price-
yield curve into the estimated percentage price
change of a bond given an interest rate change:

P  r  1 2
 Dur    CX( r )
P 1  r  2

2-54
Duration Practice Problem

 $C 
Dur  N    N  ((1  r)  PVIFA r,N )
1  1.035 10  $1000 (Po  r) 
P0  $30     $958.42
10
 0.035  1.035
 
 10  (1.035  8.316605)   8.7548 six monthperiods
$30
Dursemi  10  
($958.42  0.035) 
ΔP  Δrsemi  0.0025
 Dursemi   8.7548    2.1147%
P (1  roldsemi ) 1.035
P1 Predicted  $958.42  (1  0.021147)  $938.15

Using Modified Duration


DurAnnual (8.7548 / 2) 4.3774
DurMod     4.2294
(1  rperiod ) 1.035 1.035
Predicted Price Change Using Modified Duration
ΔP
 DurMod  Δrannual  4.2294  0.0050   2.1147%
P

Try Page 87-89: 7, 11, 18, 26, 32, 40, and 41.