1. Chapter 8 Interest Rates © 2011 John Wiley and Sons

2. 2 Chapter Outcomes n Describe how interest rates change in response to shifts in the supply and demand for loanable funds n Identify major historical movements in interest rates in the United States n Describe the loanable funds theory of interest rates

3. 3 Chapter Outcomes (Continued) n Identify the major determinants of market interest rates n Describe the types of marketable securities issued by the U.S. Treasury n Describe the ownership of Treasury securities and the maturity distribution of the federal debt

4. 4 Chapter Outcomes (Continued) n Explain the term or maturity structure of interest rates n Identify and briefly describe the three theories used to explain the term structure of interest rates n Identify broad historical price level changes in the U. S. and other economies and discuss their causes

5. 5 Chapter Outcomes (Concluded) n Describe the various types of inflation and their causes n Discuss the effect of default risk premiums on the level of long-term interest rates

6. 6 Supply and Demand for Loanable Funds Basic Interest Rate Concepts: n Interest Rate: Price that equates the demand for and supply of loanable funds n Role of Financial Markets: Interest rates are determined by the supply and demand for loanable funds in financial markets

7. 7 Interest Rate Determination in the Financial Markets Interest rate (r) Quantity of Loanable Funds 7% 8% 9% S1S1 D1D1 D1D1 S1S1 D2D2 AB CD S1S1 D1D1 D3D3 S1S1 S2S2 Interest rate (r) Quantity of Loanable Funds 8% S2S2 D1D1

8. 8 Historical Changes in U.S. Interest Rate Levels Periods of Rising Interest Rates: n 1864-1873 (rapid economic expansion after the Civil War) n 1905-1920 (pre-war expansion and World War I-related inflation) n 1927-1933 (economic boom in late 1920s followed by major depression) n 1946- 1982 (rapid economic expansion after World War II)

9. 9 Historical Changes in U.S. Interest Rate Levels (continued) Periods of Falling Interest Rates: n 1873-1905 (supply of funds exceeded demand for funds and prices fell) n 1920-1927 (rapid growth in supply of funds and falling prices) n 1933-1946 (actions taken to fight the depression and finance World War II) n 1982-present (generally declining prices and interest rates)

10. 10 Loanable Funds Theory n Loanable Funds Theory Definition: States that interest rates are a function of the supply of and demand for loanable funds n Two Basic Sources of Loanable Funds: --current savings --expansion of deposits by depository institutions

11. 11 Factors Affecting the Supply of Loanable Funds n Volume of Savings Major factor is the level of national income n Expansion of Deposits by Depository Institutions Amount of short-term credit available depends on lending policies of depository institutions and the Fed n Liquidity Attitude Refers to how lenders see the future

12. 12 Determinants of Market Interest Rates : n Nominal Interest Rate (r): Interest rate that is observed in the marketplace : n Basic Equation: r = RR + IP + DRP : n Real Rate of Interest (RR): Interest rate on a risk-free debt instrument when no inflation is expected

13. 13 Determinants of Market Interest Rates (continued) : n Basic Equation: r = RR + IP + DRP : n Inflation Premium (IP): Average inflation rate expected over the life of the security : n Default Risk Premium (DRP): Compensation for the possibility of the borrower’s failure to pay interest and/or principal when due

14. 14 Determinants of Market Interest Rates (concluded) : n Basic Equation Expanded: r = RR + IP + DRP + MRP + LP : n Maturity Risk Premium (MRP): Compensation expected by investors due to interest rate risk on debt instruments with longer maturities : n Liquidity Premium (LP): Compensation for securities that cannot easily be converted to cash without major price discounts

15. 15 Interest Rate Risk n Definition: Possible price fluctuations in fixed- rate debt instruments associated with changes in market interest rates n Reason: An inverse relationship exists between debt instrument values or prices and nominal interest rates in the marketplace

16. 16 Risk-Free Rate of Interest n Definition: Interest rate on a debt instrument with no default, maturity, or liquidity risks (Treasury securities are the closest example) n Equation: Risk-Free Rate (rf) = Real Rate (RR) + Inflation Premium (IP)

17. 17 Two Types of U.S. Government Debt Obligations n Marketable Government Securities: Securities that may be bought and sold through the usual market channels n Nonmarketable Government Securities: Issues that cannot be transferred between persons or institutions but must be redeemed with the U.S. government

18. 18 Types of U.S. Treasury Debt Obligations n Treasury Bills: Obligations that bear the shortest (up to one year) original maturities n Treasury Notes: Obligations issued with maturities of two to ten years n Treasury Bonds: Obligations issued with maturities usually over five years and up to thirty years

19. 19 Term or Maturity Structure of Interest Rates n Term Structure: Relationship between interest rates or yields and the time to maturity for debt instruments of comparable quality n Yield Curve: Graphic presentation of the term structure of interest rates at a given point in time

20. 20 Term Structure Extremes for U.S. Treasury Securities MaturityMarch 1980Oct. 2008 6 months15.0%0.2% 1 year14.0%0.4% 5 years13.5%2.3% 10 years12.8%3.4% 20 years12.5%4.2% 30 years12.3%4.2%

21. 21 Recent Term Structures for U.S. Treasury Securities MaturityOct. 2006Oct. 2008 6 months4.9%0.2% 1 year5.0%0.4% 5 years4.7%2.3% 10 years4.7%3.4% 20 years4.9%4.2% 30 years4.9%4.2%

22. 22 Three Term Structure Theories n Expectations Theory: Shape of the yield curve indicates investor expectations about future inflation rates n Liquidity Preference Theory: Investors are willing to accept lower interest rates on short-term debt securities which provide greater liquidity and less interest rate risk

23. 23 Three Term Structure Theories (continued) n Market Segmentation Theory: Interest rates may differ because securities of different maturities are not perfect substitutes for each other

24. 24 Inflation Premiums and Price Movements n Inflation: Occurs when an increase in the price of goods or services is not offset by an increase in quality n Historical 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

25. 25 Periods of Inflation in the U. S. n Revolutionary War n War of 1812 n Civil War n World War I n World War II n Postwar Period through Early 1982

26. 26 Types of Inflation n Cost-Push Inflation: Occurs when prices are raised to cover rising production costs, such as wages n Demand-Pull Inflation: Occurs during economic expansions when demand for goods and services is greater than supply

27. 27 Types of Inflation (continued) n Speculative Inflation: Caused by the expectation that prices will continue to rise, resulting in increased buying to avoid even higher future prices n Administrative Inflation: The tendency of prices, aided by union-corporation contracts, to rise during economic expansion and to resist declines during recessions

28. 28 Default Risk Premiums n Default Risk: Risk that a borrower will not pay interest and/or repay the principal on a loan according to the agreed contractual terms n Basic Equation: DRP = r - RR - IP n Basic Equation Expanded: DRP = r - RR - IP - MRP - LP

29. 29 Default Risk Premium Example n Basic Information: nominal interest rate = 9%; real rate = 3%; inflation premium = 5%; and market risk and liquidity premiums = 0%. What is the default risk premium? n Expanded Equation: DRP = r - RR - IP - MRP - LP DPR = 9% - 3% - 5% - 0% - 0% = 1%

30. 30 Risky Corporate Bonds n Investment Grade Bonds: Ratings of Baa or higher (Aaa, Aa, or A) that meet financial institution investment standards n High-Yield Bonds: High-yield or junk bonds that have a substantial probability of default

31. 31 Web Links n www.stlouisfed.org www.stlouisfed.org n www.whitehouse.gov/cea www.whitehouse.gov/cea