FINANCIAL ECONOMICS
[Econ==]
CHAPTER TWO
INTEREST RATE
DETERMINATION
Wondesen M. (MSc)
OUTLINES
YOUR LOGO
The Foreign Exchange rates Transaction of Foreign
01 05 Exchange
The Determination of Foreign Exchange Regimes, spot versus
02 Exchange Rates
06 forward foreign exchange markets
The Purchasing Power Parity
03 The Foreign Exchange Market
07 Theory
Hedging, Speculation and
04 Function of Foreign Exchange
Market 08 arbitraging
3
2.1. The level of interest rates
Before we can go on with the study of money, banking, and financial
markets, we must understand exactly what the term interest rate
means.
There are essentially three main types of interest rates:
▪ real interest rates,
▪ effective rates and
▪ nominal interest rates.
In this chapter, we‘ll explore the distinction between them. t.
Cont’d 4
An interest rate is the amount due per period, as a proportion of the
amount lent, deposited, or borrowed.
In other words, interest is the cost of borrowing money.
Typically expressed as a percentage, it amounts to a fee or extra charge
the borrower pays the lender for the financed sum.
Interest rate is also the percentage of the lender or bank to the borrower
for the use of its assets or money for a specific time period.
The rate a bank pays to its depositors for keeping money in a savings
account, recurring deposit, or fixed deposit is also termed as interest rate.
Cont’d 5
Nominal interest rate:
▪ is interest rate that you earn (pay) on a loan; this is the amount you
see on a sign advertising interest rates.
Real interest rate:
▪ is the nominal interest rate adjusted for inflation; this is the effective interest
rate that you earn (pay).
▪ A higher real interest rate reduces a borrowing firm‘s profit and hence its
willingness to borrow.
▪ real interest rates shows what actual returns the lender/saver can make
from the market to grow his capital.
6
Cont’d
An effective interest rate:
is the real return on a savings account or any interest-paying
investment when the effects of compounding overtime are
considered.
Increasing the number of compounding periods makes the effective
annual interest rate increase as time goes by.
The effective annual rate is normally higher than the nominal rate
because the nominal rate quotes a yearly percentage rate
regardless of compounding.
7
Cont’d
Based on effective interest rates above, the interest can be either simple or
compounded.
Simple interest is based on the principal amount of a loan or deposit. In
contrast, compound interest (interest on interest) is based on the principal
amount and the interest that accumulates on it in every period.
Generally, simple interest paid or received over a certain period is a fixed
percentage of the principal amount (interest rate) that was borrowed or
lent.
Compound interest accrues and is added to the accumulated interest of
previous periods, so borrowers must pay interest on interest as well as the
principal.
8
Cont’d
From the investor‘s perspective, compound interest is an interest paid on
earlier-received interest which the investor reinvested.
Simple interest is calculated only on the principal amount:
𝑰 = 𝑷𝒓𝒊𝒏𝒄𝒊𝒑𝒂𝒍 𝑷 𝑿 𝒓𝒂𝒕𝒆 𝒓 𝑿 𝒕𝒊𝒎𝒆 𝒕
𝑭𝒖𝒕𝒖𝒓𝒆(𝒕𝒐𝒕𝒂𝒍) 𝒂𝒎𝒐𝒖𝒏𝒕 𝑨 = 𝑷 + 𝑰
Examples:
1. Suppose a student obtains a simple-interest loan to pay one year of college tuition,
which costs Birr 18,000, and the annual interest rate on the loan is 6%. The student
repays the loan over three years. Find the amount of interest paid and total amount?
2. If Sami lends $5000 to his friend for one year and asks an annual interest rate of 2%,
what amount should the friend repay?
9
Cont’d
The compound interest amount can be calculated by the following formula:
𝑪𝑰 = 𝑷(𝟏 + 𝑹)𝑻 − 𝑷 = 𝑷 (𝟏 + 𝑹)𝑻 − 𝟏
P = Principal; R = Rate of interest; T = Time period in a year and CI = Compound Interest.
If the interest at the annual rate of ‘R’ per year is compounded M times a
year on a principal P, then the interest rate per conversion period is:
𝑎𝑛𝑢𝑎𝑙 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑟 𝑟𝑎𝑡𝑒 𝑅
𝐼= =
𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑝𝑒𝑟𝑖𝑜𝑑𝑠 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟 𝑀
Now if the interest is compounded for t years, then there will be N = MT conversion
periods in T years. Thus, we have the future value of compound interest given by:
𝑻𝑴
𝑹
𝑪𝑰 = 𝟏 +
𝑴
10
Cont’d
Examples:
1. take a three-year loan of $10,000 at an interest rate of 5% that compounds
annually. What would be the amount of interest and future value?
2. Find the amount of interest on a deposit of Birr 2000 in an account
compounded annually with annual interest rate of 6% for 3 years.
3. Suppose also that a bank offers to pay a nominal annual interest rate of 6%
if the money stays deposited for 2 years. Assume that a principal (P) of birr
5000 is deposited. Find the total amount (A) after the 2 years term if the
interest is compounded:
a) Semi-annually
b) Quarterly
11
2.3. Bond prices and interest rate risk
Bonds are a form or loans contracted by corporations and governments from
financial markets.
Unlike a bank loan which ties the bank to the corporation that contracted it
bonds are securities which mean that they can be bought and sold freely in
the financial markets.
They are issued in the primary market, where the issuers sell the bonds to
investors, usually through an investment bank.
After issuing, bonds are traded in the secondary market, where investors buy
and sell existing bonds.
Most bonds make regular interest payments (coupons) before the final
payment at maturity (the repayment of the principal).
12
Cont’d
For example, a five-year 4% interest rate coupon bond with a $1000 face value
would pay a total of five $40 coupons every year and a final payment of $1000
along with the last coupon.
The yield of a bond is the return the bond makes.
𝑎𝑛𝑛𝑢𝑎𝑙 𝑐𝑜𝑢𝑝𝑜𝑛 𝑎𝑚𝑚𝑜𝑢𝑛𝑡
𝐴𝑛𝑛𝑢𝑎𝑙 𝐵𝑜𝑛𝑑 𝑦𝑖𝑒𝑙𝑑 =
𝑝𝑟𝑖𝑐𝑒 𝑓𝑜𝑟 𝑤ℎ𝑖𝑐ℎ 𝑡ℎ𝑒 𝑎𝑠𝑠𝑒𝑡 𝑤𝑎𝑠 𝑏𝑜𝑢𝑔ℎ𝑡
When the price of the bond in the secondary market changes, so does the
yield. For example, suppose you buy in the primary market a bond of Y1,000
with 10 years maturity and a 10% coupon. If you keep the bond, it's simple. The
issuer pays you Y100 a year for 10 years, and then pays you back the Y1,000 on
the scheduled date. The yield is therefore 10% (100/1000). If, however, you
decide to sell it on the market, you won't get Y1,000. Because bond prices in
the secondary market change daily (based on the demand).
13
Cont’d
If the price of the bond in the market is Y800, it's selling under face value or at
a discount. If the price of the bond in the market is Y1,200, it's selling above
face value, or at a premium.
Regardless of the market price of a bond, the coupon remains the same. In
our example, the bond holder continues to receive Y100 a year. What
changes is the bond yield.
If you sell it for Y800, the yield will be 12.5% (Y100/Y800) for the person who
buys it.
If you sell it for Y1,200, the yield will be 8.33% (Y100/Y1,200) for the person who
buys it. See also Table 1 for another example of bond.
14
Cont’d
Table1: Example of what is on a government bond. In this case, the government
bond pays an annual coupon amount of $100 to the bond holder at the date stated
on the coupon. Also, it repays the principal (face value) of $10,000 on 1-1-2019 to
whoever is the bondholder at that moment.
The price of this bond is $10,000 when it is issued, and its yield is 10%, but the price of
the bond and the yield may change when the bonds are traded in the secondary
market.
15
What determines the price of a bond on the
secondary market?
The bond price in the primary market is the principal (the amount of the
loan). However, after purchasing the bond on the primary market, it can be
traded in the secondary market, where the price is not fixed but depends on
demand for this bond and supply of this bond.
The price of this bond depends on
i. contract features,
ii. credit risk and
iii. interest rate risk.
16
What determines the price of a bond on the
secondary market?
i. Contract features:
are the first determinants of the price of a bond. Relevant contract features
are: what is the coupon, what is the maturity and what is the face value
(that means: the principal, i.e. the amount that the holder gets at the
maturity date)?
ii. Credit risk (or default risk) of the bond.:
The issuer may not be able to make a coupon or principal payment to its
bond holders. The secondary market translates this risk into the bond prices
Bonds issued by companies that are more likely to default are at a discount
(cheaper, so they give a relatively higher yield, if they pay) than those that
are financially trustworthy (they may become more expensive, leading to a
lower but more secured yield).
17
Cont’d
For example, because of the
Ukraine war sanctions, investors
don‘t consider it likely that the
Russian government pays coupons
and the principal of dollar bonds.
Therefore, the price of Russian
dollar bonds decreased in half a
month from more than 100 dollar
cents ($1) to less than 20 dollar
cents ($0.2) per dollar (see Fig. 8).
Figure 8: Price of dollar bonds issued by the Russian
government
18
Cont’d
iii. The interest rate in the financial market:
This interest rate risk is the possibility that a change in overall interest rates will
reduce the value of a bond. As interest rates rise, it is more attractive to get a
higher interest rate elsewhere, so investors will supply bonds, and investors are
demanding less bonds, which make bond prices fall.
This means that the market price of existing bonds drops to offset the more
attractive rates of newly issued bonds and alternative debt assets.
On the other hand, if interest rates decrease, bonds (with fixed coupon rates)
are attractive, so supply of bonds will decrease and the demand for bonds will
increase. The relation between bond prices and interest rates in the financial
market is displayed in Figure 9.
Cont’d 19
Figure 9: When interest rates rise, bond prices fall. Conversely, when interest rates fall, bond prices
rise. This is because when interest rates rise, investors can get a better rate of return elsewhere.
20
2.3 The structure of interest rates
The term structure of interest rates describes the
annualized rate or yield offered by fixed-income
securities across various maturities, all measured at one
point in time.
Bonds with identical yield, face value, coupons and
credit risk may have different interest rates because
their times remaining to maturity are different.
When these yields are plotted against time to maturity,
from short term to long term, the resulting figure is
called a yield curve.
The yield curve can have three patterns (see Figure 3)
21
Cont’d
A flat yield curve indicates that short-term interest
rates are currently equal to long-term interest rates.
This is usually when the market is uncertain about
which way the economy will go; when investors are
not sure whether interest rates will move up or go
down, the yields for bonds with different terms tend to
converge.
Also, a flat curve indicates slowdown of economy. This
usually happens when central banks try to contain
inflation by increasing interest rates, thus increasing
short term yields.
22
Cont’d
An upward sloping yield curve is considered normal because, investors expect higher
yields for fixed income instruments with long-term maturities that occur farther into the
future.
In other words, the market expects long-term fixed income securities to offer higher
yields than short-term fixed income securities.
This is a normal expectation of the market because short-term instruments generally
hold less risk than long-term instruments; the farther into the future the bond‘s maturity,
the more time and, therefore, uncertainty the bondholder faces before being paid
back the principal.
A downward sloping, or inverted, yield curve is very rare. Such a yield curve indicates
that the market believes interest rates will soon go down. Though short term yields are
greater, few investors may still seek long term bonds as they expect a further
economic slowdown where interest rates will further decline resulting in still lower yields.
23
Cont’d
An example of an upward sloping yield
curve is given in Figure 4 which shows
South Africa‘s yield curve.
The yield on a bond with 12Y (=12 years)
residual maturity is about 10%, in contrary
to the yield on a bond with only 2Y (=2
years) residual maturity, which is only 5.5%.
The investors expect a higher interest rate
in the future and/or they want to get extra
risk premium because they are uncertain
about the interest rate in the future.
24
END OF CHAPTER ONE
THANK YOU!
Any questions, I’m here to help.
