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

2. 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

3. 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

4. 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

5. 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

6. 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

7. 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

8. 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

9. 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

10. 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

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

12. 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

13. 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

14. 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

15. 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

16. 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

17. 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

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

19. 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

20. 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

21. 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

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

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

24. 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

25. 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