1.2 Determinants of Interest Rates PDF
1.2 Determinants of Interest Rates PDF
1.2 Determinants of Interest Rates PDF
2 Determinants of
Interest Rates
Contents
1.2. Determinants of interest rates
1.2.1 Loanable funds theory
1.2.2 Determinants of interest rates for
individual securities
1.2.3 Term structure of interest rates
1.2.3.1 Unbiased expectations theory
1.2.3.2 Liquidity premium theory
1.2.3.3 Market segmentation theory
1.2.5 Forecasting interest rates
Interest Rate Fundamentals
• Nominal interest rates: the interest rates
actually observed in financial markets
– Used to determine fair present value and
prices of securities
– Changes to it have impact on security values
– Factors determining level of interest and
what causes movements is important
Key interest rates in the
Philippines
Loanable Funds Theory
• Loanable funds theory explains interest
rates and interest rate movements
• Views level of interest rates in financial
markets as a result of the supply and
demand for loanable funds
• Domestic and foreign households,
businesses, and governments all supply
and demand loanable funds
Supply and Demand of Loanable
Funds
Interest
Rate Demand Supply
i* E
Q*
Quantity of Loanable Funds
Supplied and Demanded
Determinants of Household Savings
i** E*
i* E
E i*
i** E*
https://www.youtube.com/watch?v=xiiHjrewXNI&t=14s
Yield curve (cont’d)
o
o Unbiased Expectations Theory- yield curve reflects the market’s
current expectations of future short-term rates. At equilibrium,
investors should expect to earn the same return whether they invest
on LT bonds or a series of ST bonds;
0 1 2 3 4 Year
(1+1R1) 1+E(2r1) 1+E(3r1) 1+E(4r1)
Buy 4 one-year bond
Unbiased Expectations Theory
• Can be expressed in equation as follows:
(1+1RN)N=[(1+1R1)(1+E(2r1))…(1+E(Nr1))]
Questions?
Knowledge Check #1
A particular security’s equilibrium rate of
return is 8%. For all securities, the
inflation risk premium is 1.75% and the
real risk-free rate is 3.5%. The security’s
liquidity risk premium is 0.25% and
maturity risk premium is 0.85%. There is
no special covenants. Calculate the
security’s default risk premium.
Knowledge Check #2
• Suppose that the current one-year rate (one-
year spot rate) and expected one-year T-bill
rates over the following three years (i.e., years
2, 3 and 4 respectively) are as follows: