Chapter 8

Structure of Interest Rates

*Chapter OutcomesDescribe how interest rates change in response to shifts in the supply and demand for loanable fundsIdentify major historical movements in interest rates in the United StatesDescribe what is meant by the loanable funds theory of interest rates

*Chapter Outcomes (Continued)Identify the major determinants of market interest ratesDescribe the types of marketable securities issued by the U.S. TreasuryDescribe the ownership of Treasury securities and the maturity distribution of the federal debt

*Chapter Outcomes (Continued)Explain what is meant by the term or maturity structure of interest ratesIdentify and briefly describe the three theories used to explain the term structure of interest ratesIdentify broad historical price level changes in the U. S. and other economies and discuss their causes

*Chapter Outcomes (Concluded)Describe the various types of inflation and their causesDiscuss the effect of default risk premiums on the level of long-term interest rates

*Basic Interest Rate ConceptsINTEREST RATE: Price that equates the demand for and supply of loanable fundsROLE OF FINANCIAL MARKETS: Interest rates are determined by the supply and demand for loanable funds in financial markets

*Historical Changes in U.S. Interest Rate Levels: Periods of Rising Interest Rates1864-1873 (rapid economic expansion after the Civil War)1905-1920 (pre-war expansion and World War I-related inflation)1927-1933 (economic boom in late 1920s followed by major depression)1946-early 1980s (rapid economic expansion after World War II)

*Historical Changes in U.S. Interest Rate Levels: Periods of Falling Interest Rates1873-1905 (supply of funds exceeded demand for funds and prices fell)1920-1927 (rapid growth in supply of funds and falling prices)1933-1946 (actions taken to fight the depression and finance World War II)Since early 1980s (generally declining prices and interest rates)

*Loanable Funds TheoryDEFINITION: States that interest rates are a function of the supply of and demand for loanable fundsSOURCES OF LOANABLE FUNDS: --current savings--expansion of deposits by depository institutions

*Interest Rate Determination in the Financial Markets Interest rate (r)Quantity of Loanable Funds7%8%9%S1D1D1S1D2ABCDS1D1D3S1S2 Interest rate (r) Interest rate (r) Interest rate (r)Quantity of Loanable FundsQuantity of Loanable FundsQuantity of Loanable Funds8%S2D1

*Factors Affecting the Supply of Loanable FundsVolume of SavingsExpansion of Deposits by Depository InstitutionsLiquidity Attitudes

*Determinants of Market Interest RatesNOMINAL INTEREST RATE (R): Interest rate that is observed in the marketplaceBASIC EQUATION: r = RR + IP + DRPREAL RATE OF INTEREST (RR): Interest rate on a risk-free debt instrument when no inflation is expected

*Determinants of Market Interest Rates (Continued)BASIC EQUATION: r = RR + IP + DRPINFLATION PREMIUM (IP): Average inflation rate expected over the life of the securityDEFAULT RISK PREMIUM (DRP): Compensation for the possibility of the borrowers failure to pay interest and/or principal when due

*Determinants of Market Interest Rates (Concluded)BASIC EQUATION EXPANDED: r = RR + IP + DRP + MRP + LPMATURITY RISK PREMIUM (MRP): Compensation expected by investors due to interest rate risk on debt instruments with longer maturitiesLIQUIDITY PREMIUM (LP): Compensation for securities that cannot easily be converted to cash without major price discounts

*Interest Rate RiskDEFINITION: Possible price fluctuations in fixed-rate debt instruments associated with changes in market interest ratesREASON: An inverse relationship exists between debt instrument values or prices and nominal interest rates in the marketplace

*Risk-Free Rate of Interest DEFINITION: Interest rate on a debt instrument with no default, maturity, or liquidity risks (Treasury securities are the closest example)EQUATION: Risk-Free Rate = Real Rate (RR) + Inflation Premium (IP)

*Two Types of U.S. Government Debt ObligationsMARKETABLE GOVERNMENT SECURITIES: Securities that may be bought and sold through the usual market channelsNONMARKETABLE GOVERNMENT SECURITIES: Issues that cannot be transferred between persons or institutions but must be redeemed with the U.S. government

*Types of U.S. Treasury Debt ObligationsTREASURY BILLS: Obligations that bear the shortest (up to one year) original maturitiesTREASURY NOTES: Obligations issued for maturities of one to ten yearsTREASURY BONDS: Obligations of any maturity but usually over five years

*Term or Maturity Structure of Interest RatesTERM STRUCTURE: Relationship between interest rates or yields and the time to maturity for debt instruments of comparable qualityYIELD CURVE: Graphic presentation of the term structure of interest rates at a given point in time

*Three Term Structure TheoriesEXPECTATIONS THEORY: Shape of the yield curve indicates investor expectations about future inflation ratesLIQUIDITY PREFERENCE THEORY: Investors are willing to accept lower interest rates on short-term debt securities which provide greater liquidity and less interest rate risk

*Three Term Structure Theories (Continued)MARKET SEGMENTATION THEORY: Interest rates may differ because securities of different maturities are not perfect substitutes for each other

*Inflation Premiums and Price MovementsINFLATION: Occurs when an increase in the price of goods or services is not offset by an increase in qualityHISTORICAL PRICE MOVEMENTS: Changes in the money supply or in the amount of metal in the money unit have influenced prices since the earliest records of civilization

*Periods of Inflation in the U. S.Revolutionary WarWar of 1812Civil WarWorld War IWorld War IIPostwar Period through Early 1980s

*Types of InflationCOST-PUSH INFLATION: Occurs when prices are raised to cover rising production costs, such as wagesDEMAND-PULL INFLATION: Occurs during economic expansions when demand for goods and services is greater than supply

*Types of Inflation (Continued)SPECULATIVE INFLATION: Caused by the expectation that prices will continue to rise, resulting in increased buying to avoid even higher future pricesADMINISTRATIVE INFLATION: The tendency of prices, aided by union-corporation contracts, to rise during economic expansion and to resist declines during recessions

*Default Risk PremiumsDEFAULT RISK: Risk that a borrower will not pay interest and/or repay the principal on a loan according to the agreed contractual termsBASIC EQUATION: DPR = r - RR - IPBASIC EQUATION EXPANDED: DPR = r - RR - IP - MRP - LP

*Default Risk Premium ExampleBASIC INFORMATION: nominal interest rate = 9%; real rate = 3%; inflation premium = 5%; and market risk and liquidity premiums = 0%. What is the default risk premium?EXPANDED EQUATION: DRP = r - RR - IP - MRP - LP DPR = 9% - 3% - 5% - 0% - 0% = 1%