Chapter 4
Determination of Interest Rates and
Security Yields
Chapter Objectives
Explain Loanable Funds Theory of Interest Rate
Determination
Identify Major Factors Affecting the Level of Interest Rates
Learn why individual interest rates differ or why security
prices vary or change
Analyze theories explaining why returns (yields) vary by
term or maturity, called the term structure of interest
rates
Relevance of Interest Rate Movements
Changes in interest rates impact the real economy
Investment spending
Interest sensitive consumer spending such as housing
Interest rate changes affect the values of all
securities
Security prices vary inversely with interest rates
Varying interest rates impact retirement funds and
retirement income
Interest rates changes impact the value of financial
institutions
Managers of financial institutions closely monitor rates
Interest rate risk is a major risk impacting financial
institutions
Loanable Funds Theory of
Interest Rate Determination
Theory of how the general level of interest rates are
determined
Explains how economic and other factors influence
interest rate changes
Interest rates determined by demand and supply for
loanable funds
Loanable Funds Theory, cont.
Demand = borrowers, issuers of securities, deficit
spending unit
Supply = lenders, financial investors, buyers of
securities, surplus spending unit
Assume economy divided into sectors
Slope of demand/supply curves related to elasticity or
sensitivity of interest rates
Sectors of the Economy
Household Sector--Usually a net supplier of loanable
funds
Business Sector—Usually a net demander in growth
periods
Government Sectors
States—Borrow for capital projects
Federal—Borrow for capital projects and deficit spending
Demand for Loanable Funds
Sum of sector demand (quantity) at varying levels of
interest rates
Sector cash receipts in period less than outlays =
borrower
Quantity demanded inversely related to interest rates
Variables other than interest rate changes cause shift in
demand curve
Demand for Loanable Funds
Interest
Rate
Quantity of Loanable Funds
Loanable Funds Theory
Household Demand for Loanable Funds
Households demand loanable funds to finance housing, automobiles, household
items
These purchases result in installment debt. Installment debt increases with the
level of income
There is an inverse relationship between the interest rate and the quantity of
loanable funds demanded
Loanable Funds Theory
Business Demand for Loanable Funds
Businesses demand loanable funds to invest in assets
Quantity of funds demanded depends on how many
projects to be implemented
Businesses choose projects by calculating the project’s Net
Present Value
Select all projects with +NPV’s
Loanable Funds Theory: Business Demand for Loanable
Funds
Projects with a positive NPV are accepted because the present value of their
benefits outweighs their costs
If interest rates decrease, more projects will have a positive NPV
Businesses will need a greater amount of financing
Businesses will demand more loanable funds
There is an inverse relationship between interest rates and the quantity of
loanable funds demanded
The curve can shift in response to events that affect business borrowing
preferences
Example: Economic conditions become more favorable
Expected cash flows will increase > more positive NPV projects > increased demand for
loanable funds
Loanable Funds Theory: Government Demand for
Loanable Funds
When planned expenditures exceed revenues from taxes, the government
demands loanable funds
Municipal (state and local) governments issue municipal bonds
Federal government and its agencies issue Treasury securities and federal
agency securities.
Federal government expenditure and tax policies are independent of interest
rates
Government demand for funds is interest-inelastic
Loanable Funds Theory: Foreign
Demand for Loanable Funds
A foreign country’s demand for a certain country’s
funds is influenced by the differential between its
interest rates and the country’s rates
The quantity of local loanable funds demanded by
foreign investors will be inversely related to local
interest rates
Loanable Funds Theory: Aggregate
Demand for Loanable Funds
The aggregate demand for loanable funds is
the sum of the quantities demanded by the
separate sectors
The aggregate demand for loanable funds is
inversely related to interest rates
Sector Supply of Loanable Funds
Households are major suppliers of loanable funds
Businesses and governments may invest (loan) funds temporarily
Foreign sector a net supplier of funds in last twenty years
Federal Reserve’s monetary policy impacts supply of loanable funds
Supply of Loanable Funds
Sum of sector supply (quantity) at varying levels of
interest rates
Sector cash receipts in period greater than outlays—
lender
Quantity supplied directly related to interest rates
Variables other than interest rate changes causes a shift
in the supply curve
Interest
Rate S
Quantity of Loanable Funds
Loanable Funds Theory
Equilibrium Interest Rate
Aggregate Demand
DA = D h + D b + D g + D m + D f
Aggregate Supply
SA = S h + S b + S g + S m + S f
In equilibrium, DA = SA
Graphic Presentation
Graphic
Presentation
When a
Interest disequilibriu
m situation
Rates exists, market
forces should
Supply of cause an
Loanable Funds adjustment in
interest rates
until
Demand for equilibrium is
Loanable Funds
achieved
Quantity of Loanable Funds
Key Factors Impacting
Interest Rates Over Time
Economic Growth—Increased growth; increased
demand for funds; interest rates increase
Expected inflation--security prices fall; interest
rates increase
Government budgets
Deficit—increase borrowing; security prices fall,
interest rates increase
Surplus—decreased borrowing; security prices increase;
interest rates decrease
Increased foreign supply of loanable funds—
security prices increase; interest rates decrease
Factors Affecting Security Yields
Risk-averse investors demand higher yields For added
riskiness
Risk is associated with variability of returns
Increased riskiness generates lower security prices or
higher investor required rates of return
Factors Affecting Debt Security Returns
(Yields)
As time passes, interest rates change in the marketplace. The cash
flows from a bond, however, stay the same. As a result, the value
of the bond will fluctuate.
Debt securities offer different yields because they exhibit different
characteristics that influence the yield to be offered.
Security yields and prices are affected by levels and changes in:
Default risk (also called Credit Risk)
Liquidity
Tax status
Term to maturity
Special contract provisions such as embedded options
Credit Risk
Benchmark—risk-free treasury securities for given
maturity
Default risk premium = risky security yield – treasury
security yield of same maturity
Default risk premium = market expected default loss
rate
Rating agencies set default risk ratings
Anticipated or actual ratings changes impact security
prices and yields
Liquidity
The Liquidity of a security affects the yield/price of the
security
A liquid investment is easily converted to cash At minimum
transactions cost
Investors pay more (lower yield) for liquid investment
Liquidity is associated with short-term, low default risk,
marketable securities
Tax Status
Tax status of income or gain on security impacts the
security yield
Investor concerned with after-tax return or yield
Investors require higher yields For higher taxed
securities
…
Yat = Ybt(1 – T)
Where:
Yat = after-tax yield
Ybt = before-tax yield
T = investor’s marginal tax rate
…
Example: a taxable security that offers a before-tax
yield of 14 percent. The investor’s tax rate is 20
percent. Calculate the after-tax yield.
Yat = 14%(1 – 0.2)
= 11.2%
The fully taxable pre-tax equivalent corporate bond for
a 11.2% municipal bond is:
Ybt = 11.2%/(1 – .2) = 14%
Special Provisions
Call Feature: enables borrower to buy back the bonds before
maturity at a specified price
Call features are exercised when interest rates have
declined
Investors demand higher yield on callable bonds, especially
when rates are expected to fall in the future
Convertible bonds
Convertibility feature allows investors to convert the bond
into a specified number of common stock shares
Investors will accept a lower yield for convertible bonds
because investor returns include expected return on equity
participation
Estimating the Appropriate Yield
The appropriate yield to be offered on a debt security is based on the
risk-free rate for the corresponding maturity plus adjustments to capture
various security characteristics
Yn = Rf,n + DP + LP + TA + CALLP + COND
Where:
Yn = yield of an n-day security
Rf,n = yield on an n-day Treasury (risk-free) security
DP = default premium (credit risk)
LP = liquidity premium
TA = adjustment for tax status
CALLP = call feature premium
COND = convertibility discount
Term To Maturity (Term Structure of
Interest rate)
Another factor that influences the interest rate on a bond is its
term to maturity: Bonds with identical risk, liquidity, and tax
characteristics may have different interest rates because their
times remaining to maturity are different
A plot of the yields on bonds with differing terms to maturity but
the same risk, liquidity, and tax considerations is called a yield
curve.
The yield curve describes the term structure of interest rates for
particular types of bonds, such as government bonds.
The curve may take on a normal, an inverted or a flat pattern as
shown in the following slide.
Yield Curve Shapes
Normal Level or Flat Inverted
The Term Structure of
Interest Rates
Theories Explaining Shape of Yield Curve
Pure Expectations Theory
Liquidity Premium Theory
Segmented Markets Theory
The Term Structure of
Interest Rates
Pure Expectations Theory
Long-term rates are average of current short-term and
expected future short-term rates
Yield curve slope reflects market expectations of future
interest rates
Investors select maturity based on expectations
The Term Structure of
Interest Rates
Pure Expectations Theory
Assumes investor has no maturity preferences and
transaction costs are low
Long-term rates are averages of current short rates and
expected short rates
Forward rate: market’s forecast of the future interest rate
The Term Structure of Interest Rates
Downward-
Upward- Sloping
Sloping Yield Curve
Yield Curve
Expected higher Expected lower
interest rate levels interest rate levels
Expansive monetary Tight monetary
policy policy
Expanding economy Recession soon?
The Term Structure of
Interest Rates
Liquidity Premium Theory
Investors prefer short-term, more liquid, securities
Long-term securities and associated risks are desirable
only with increased yields
Explains upward-sloping yield curve
When combined with the expectations theory, yield curves
could still be used to interpret interest rate expectations
The Term Structure of
Interest Rates
Segmented Markets Theory
Theory explaining segmented, broken yield curves
Assumes investors have maturity preference boundaries,
e.g., short-term vs. long-term maturities
Explains why rates and prices vary significantly between
certain maturities
The Term Structure of
Interest Rates
Uses of the term structure
Forecast interest rates
The market provides a consensus forecast of expected
future interest rates
Expectations theory dominates the shape of the yield curve
Forecast recessions
Flator inverted yield curves have been a good predictor of
recessions. See Exhibit 3.14.
Investment and financing decisions
Lenders/borrowers attempt to time investment/financing
based on expectations shown by the yield curve
Riding the yield curve
Timing of bond issuance
