INTEREST RATES
OBJECTIVES
1. Explain the concept of interest rates
2. Explain the determinants of interest rates
3. Explain the term structure of interest rates
4. Discuss factors that affect interest rates
3
COST OF MONEY
The cost of money is affected by four
fundamental factors:
1. Production opportunities
2. Time preferences for consumption
3. Risk
4. Inflation
4
PRODUCTION
OPPORTUNITIES
Production opportunities are investment
opportunities in cash generating assets.
Example: Stocks of a publicly-listed blue chip
corporations
PRODUCTION 5
OPPORTUNITIES
If businesses have more opportunities to invest
in high-return projects, the demand for capital
increases, pushing interest rates higher.
Conversely, if investment opportunities are
scarce, the demand for money declines, leading
to lower interest rates.
6
TIME PREFERENCES
FOR CONSUMPTION
Preferences of consumers for current
consumption rather than savings for future
consumption
Example: Amount of residual savings after the
holiday-related spending
7
TIME PREFERENCES
FOR CONSUMPTION
If people prefer immediate consumption over
future savings, they save less, reducing the
supply of loanable funds. This scarcity of funds
increases interest rates.
On the other hand, if people are willing to defer
consumption and save more, the supply of funds
increases, lowering the cost of money.
8
RISK
It is the probability that an investment will
provide a low or negative return.
Example: A stock that lost most of its market
value (Enron stocks)
9
RISK
Lenders and investors demand higher returns to
compensate for the possibility of default or loss.
If an investment or borrower is considered risky,
interest rates or required returns rise to reflect
that risk. In contrast, safer investments attract
lower interest rates
10
INFLATION
It is the amount by which prices increase over
time.
Increased change in the consumer price index
Example: PHL inflation averages around 4%
11
INFLATION
Inflation erodes the purchasing power of money,
so lenders demand higher interest rates to
maintain their real returns.
If inflation expectations rise, interest rates tend
to increase to compensate for the declining
value of future cash flows.
12
INTEREST RATE LEVELS
• Savers and borrowers factor in the level if
interest rates in the market before making
their decision.
• Savers want to place their money in financial
institutions if the interest rate is high.
• Borrowers want to take out loans if interest
rates are low.
INTEREST RATE LEVELS
DETERMINANTS OF INTEREST
RATES
QUOTED INTEREST RATE = r* + IP + DRP + LP + MRP
r* = Real-risk free rate of interest
IP = Inflation premium
DRP = Default risk premium
LP = Liquidity premium
MRP = Maturity risk premium
15
REAL RISK FREE RATE
It is the rate of interest that would exist on
default-free treasury securities if no
inflation were expected
16
INFLATION PREMIUM
A premium equal to expected inflation
that investors add to the risk-free rate of
return.
17
DEFAULT RISK PREMIUM
The difference between the interest rate of
government treasury bonds and corporate
bonds of equal maturity and marketability
Default risk is the risk that a borrower will not be
able to meet scheduled payments of interest and
principal.
18
LIQUIDITY PREMIUM
A premium added to the equilibrium interest rate
on a security if that security cannot be converted
to cash on short notice and at close to its “fair
market value”
19
MATURITY RISK PREMIUM
Maturity risk premium is the premium that
reflects interest rate risk
Interest rate risk is the risk of capital
losses to which investors are exposed
because of changing interest rates
SAMPLE PROBLEM 20
Assume that the real risk-free rate
is 2%, the average expected
inflation rate is 3% for each future
year. The DRP and LP for Bond X
are each 1% and the applicable
MRP is 2%. Compute for interest
rate of the bond
ANSWER 21
QUOTED INTEREST RATE = r* + IP + DRP + LP + MRP
Quoted Interest Rate = 2% + 3% + 1% + 1% + 2% = 9%
TERM STRUCTURE OF
22
INTEREST RATES
Term structure of interest rates describe
the relationship between long and short-
term rates.
It is the relationship between bond yields
and maturities
23
TERM STRUCTURE OF
INTEREST RATES
Borrowers and lenders should understand:
1. How long and short-term rates relate to
each other
2. What causes shifts in their relative levels
TERM STRUCTURE OF INTEREST RATES
25
TERM STRUCTURE OF
INTEREST RATES
A normal yield curve (upward-sloping) is when
long-term rates are generally above short-term
rates.
Inverted yield curve (downward-sloping) is
when short-term rates are higher than long-
term rates
TERM STRUCTURE OF INTEREST RATES
27
FACTORS THAT AFFECT INTEREST RATES
BUDGET
CENTRAL BANK SURPLUS OR INTERNATIONAL BUSINESS
POLICY DEFICIT FACTORS ACTIVITY
Interest rates are Interest rates
Central banks can Interest rates
affected by the increase if their is
increase or increase if the
amount of foreign additional demand
decrease key government
trade surplus or for funds to finance
interest rates requires more funds
deficit its operations
ASSIGNMENT
1 WHOLE
29
Imagine that you are a business owner
planning to expand your company.
However, the economy is experiencing
high inflation, and interest rates are rising.
At the same time, there are new
government incentives for businesses that
invest in innovative technologies.
Discuss how these factors—inflation,
interest rates, and government incentives
—would influence your decision to invest
and borrow money. In your response,
consider the risks and potential returns
associated with expansion. Would you
proceed with borrowing, delay the
investment, or seek alternative funding
SEATWORK
1 WHOLE
PROBLEM
Compute for the interest rate for each treasury bond and create a yield curve.
