Determination of Interest Rates Interest rates are created and used by the financial markets. They are embodiments of knowledge and expectations. Dr. C. Ertuna

Definition of Interest Rate Interest rate is the price paid to borrow debt capital or in other words it is the cost of Money. To understand it better we can also say that interest rates transforms money-today into money-tomorrow; it is the rate at which it grows when invested. There are 4 main factors that affect interest rates. Dr. C. Ertuna

Factors Affecting Interest Rates There are 4 main factors that affect interest rates Production Opportunities The return (or yield) available within an economy from investments in productive (cash-generating) assets. Time Preference for Consumption The preference of consumers for current consumption as opposed to saving for future consumption. Risk The chance that an investment will not provide the expected return. Inflation The tendency of prices to increase over time Dr. C. Ertuna

Interest Rate Formula Where r = Nominal (quoted) Interest Rate r = r* + DRP + LP + MRP + IP Where r = Nominal (quoted) Interest Rate * = Real Risk Free Rate of Interest, reflects production opportunities and time preference for consumption DRP = Default Risk Premium. This premium reflects the possibility (chances) that the issuer will not pay interest or principle at the stated time and in the stated amount. LP = Liquidity Premium. The premium charged to compensate the fact that some securities cannot be converted to cash on a short notice at a “reasonable” price. LP is relatively high on securities issued by small firms. MRP = Maturity Risk Premium. A premium, which reflects interest rate risk or in other words, a premium charged to compensate the risk stemming from probability of adverse movements in the interest rates that might cause capital losses. IP = Inflation Premium. A premium equal to expected inflation that investors add to the real-risk-free rate of return. Dr. C. Ertuna

Role of the Interest Rates A measure to price the funds (or valuation of the securities) A factor to bring supply of and demand for funds in balance. Dr. C. Ertuna

Risk Free Rate Risk free rate (krf) is a rate of return on risk free (free from default risk) very liquid investment. The interest rates on short term government bonds are commonly used to measure this rate. Dr. C. Ertuna

Fisher Effect (1 +krf) = (1 + r*) * (1 + IP) or a shorter version of it as krf = r* + IP Fisher Effect suggests that the rate of increase in actual purchasing power (r*) can be obtained after adjusting nominal rates for inflation. Dr. C. Ertuna

Technical Aspect of Interest Rate Simple Interest Rate Interest rate is said to be “simple” if interest is paid only on the principle money (or initial investment). 2. Compound Interest Rate Interest rate is said to be “compound” if interest is paid not only on the initial investment, but also on any interest re-invested in the previous period. 3. Real vs. Nominal Interest Rate 4. After- vs. Before-Tax Interest Rate Dr. C. Ertuna

Understanding of Interest Rates Interest rate movements affect value of securities, and therefore affect the performance of all types of companies. It is critical for managers to understand why interest rates change, how their movements affect performance and how to manage according to anticipated interest rate movements. Dr. C. Ertuna

The Loanable Funds Theory The loanable funds theory is commonly used to explain interest rate movements. LF theory suggests that the market interest rates are determined by the factors that control the control the supply of and demand for the loanable funds Dr. C. Ertuna

Interest Rates & Loanable Funds SSLF DDLF Interest Rates r Quantity of Loanable Funds Dr. C. Ertuna

Loanable Funds Approach r = f (SSLF, DDLF) Interest Rate is a function of Supply of Loanable Funds (= SSLF) and Demand for Loanable Funds (= DDLF). Dr. C. Ertuna

SSLF = SSH + SSB + SSG + SSF Supply of LF SSLF = SSH + SSB + SSG + SSF SSLF = Supply of Loanable Funds SSH = Household Supply of loanable Funds SSB = Business Supply of Loanable Funds SSG = Government Supply of Loabale Funds SSF = Foregn Supply of Loanable Funds (foreign lending) Savings of domestic economic units = SSH + SSB + SG Dr. C. Ertuna

DDLF = DDH + DDB + DDG + DDF Demand for LF DDLF = DDH + DDB + DDG + DDF DDLF = Demand for Loanable Funds DDH = Household Demand for loanable Funds DDB = Business Demand for Loanable Funds DDG = Government Demand for Loabale Funds DDF = Foreign Demand for Loanable Funds Dr. C. Ertuna

Impacts on Supply of LF Impacts on Supply of LF: · Households: via savings attitude, propensity to save (differs from country to country) · Foreign Parties: via foreign savings · Central Bank: via Reserve requirement Policy Dr. C. Ertuna

Impacts on Demand for LF Households: as income increases YH  Ability to barrow DDLF-H Businesses: (short term/long term) as r↓ Expected Cash Flow of a project increases↑ → NPV↑ → more projects get accepted →DDLF-B ↑ Government: (cover expenditures) !interest inelastic! BD  DDLF-G Foreign Parties: (benefit from interest rate differentials) Dr. C. Ertuna

Key Issues · Economic Growth : g ↑ → DDLF↑ → r↑ · Impact of inflation : Inf ↑ → Fischer Effect → r↑ · Impact of budget deficit: DDLF-G ↑ → r↑ · Impact of foreign interest rates: r foreign ↑ → DDLF-F↑ → r↑ · Impact of Money Supply: SSM↑ → SSLF↑ → r↓ SSM↑ → Inf↑ → r↑ (mostl of the time the dominant effect for Turkey is r↑) Dr. C. Ertuna

Forecasting Interest Rates Interest rates could be forecasted through: Economic Models T-Bond and T-Notes Future Contracts Dr. C. Ertuna

Main Point - 1 Interest rates can be considered both as: Price of funds determined by supply of and demand for loanable funds, Tool that brings demand and supply of funds into equilibrium. Dr. C. Ertuna

Main Point - 2 Observed nominal interest rates in different financial markets are manifestations of a unique unobservable real interest rate which interconnects all financial markets. The observed differences are due to differences in the characteristics of the related markets, such as risk, time, demand for particular cash flow patter. Dr. C. Ertuna

Summary A required rate represents a single price for all the characteristics of a financial asset. While interest rates are set by market conditions, one’s decision to accept or reject a particular rate affects the market. Dr. C. Ertuna

Relationships between Interest Rates and Security Prices Interest rate is the common element to all security prices. Dr. C. Ertuna

Two Faces of Financial Assets Borrowing and lending money could also mean Selling and buying securities Dr. C. Ertuna

Valuation of Financial Assets Bonds Stocks Futures Options The price of any security is a function of several factors. The required rate is the fundamental element in price determination. Dr. C. Ertuna

Summary On the basis of the price of all securities, we can find the required rate. Parallel relationships between factors can be observed in the different aspects of a security. Dr. C. Ertuna