Chapter Three Interest rates in the Financial System.ppt

Interest rate

1. Chapter Three: INTEREST RATES
IN THE FINANCIAL SYSTEM

2. INTEREST RATES DETERMINATION AND STRUCTURE
Therateofinterest
Interestrateisarateofreturnpaidbyaborrowerof
fundstoalender,orapricepaidbyaborrowerfora
service,ortherighttomakeuseoffundsfora
specifiedperiod.Thus,itisoneformofyieldon
financialinstruments.

3. Cont’d
•Thereisinterestrateatwhichbanksarelending(the
offerrate)andinterestratetheyarepayingfordeposits
(thebidrate).Thedifferencebetweenthemiscalleda
spread.
•Thespreadbetweenofferandbidratesprovidesa
coverforadministrativecostsofthefinancial
intermediariesandincludestheirprofit.Thespreadis
influencedbythedegreeofcompetitionamong
financialinstitutions.

4. Con’d
•Intheshort-terminternationalmoneymarkets,the
spreadislowerifthereisconsiderablecompetition.
•ontheotherhand,thespreadbetweenbanks
borrowingandlendingratestotheirretailcustomers
islargeringeneralduetoconsiderablylargerdegree
ofloandefaultrisk.
•Thus,thelendingrate(offeroraskrate)always
includesariskpremium.

5. Cont’d
•Riskpremiumisanadditiontotheinterestrate
demandedbyalendertotakeintoaccounttherisk
thattheborrowermightdefaultontheloanentirely
ormaynotrepayontime(defaultrisk).

6. Cont’d
•Factorsthatdeterminetheriskpremiumforanon-
Governmentsecurity,ascomparedwiththe
Governmentsecurityofthesamematurityare:
1.Theperceivedcreditworthinessoftheissuer,
2.provisionsofsecurities,suchasconversionprovision,call
provision,putprovision
3.Interesttaxes,and
4.Expectedliquidityofasecurity’sissue.

7. Cont’d
•Inordertoexplainthedeterminantsofinterestrates
ingeneral,theeconomictheoryassumesthereis
someparticularinterestrate,asarepresentativeof
allinterestratesinaneconomy.
•Suchaninterestrateusuallydependsuponthetopic
considered,andcanberepresentedbye.g.
1.interestrateongovernmentshort-termorlong-termdebt,
2.thebaseinterestrateofthecommercialbanks,or
3.ashort-termmoneymarketrate

8. Cont’d
•Insuchacaseitisassumedthattheinterestrate
structureisstableandthatallinterestratesinthe
economyarelikelytomoveinthesamedirection.
•Interestratestructureistherelationshipsbetween
thevariousratesofinterestinaneconomyon
financialinstrumentsofdifferentlengths(terms)or
ofdifferentdegreesofrisk.

9. Cont’d
•Theratesofinterestquotedbyfinancialinstitutions
arenominalrates,andareusedtocalculateinterest
paymentstoborrowersandlenders.
•Theloancanbe‘rolledover’atanewlysetrateof
interesttoreflectchangesintheexpectedrateof
inflation.
•Ontheotherhand,lenderscansetafloatinginterest
rate,whichisadjustedtotheinflationratechanges.

10. Cont’d
•Realinterestrateisthedifferencebetweenthe
nominalrateofinterestandtheexpectedrateof
inflation.Itisameasureoftheanticipated
opportunitycostofborrowingintermsofgoodsand
servicesforgone.

11. Cont’d
•Thedependencebetweentherealandnominal
interestratesisexpressedusingthefollowing
equation:
i=(1+r)(1+i
e
)-1
where i is the nominal rate of interest,
r is the real rate of interest and
i
e
is the expected rate of inflation.

12. Cont,d
Assumethatabankiswillingtomakealoantoyouof
Br1,000foroneyearatarealrateofinterestof3percent.
Thismeansthatattheendoftheyearthebankexpectsto
receivebackBr1,030ofpurchasingpoweratcurrentprices.
However,ifthebankexpectsa10percentrateofinflation
overthenexttwelvemonths,itwillwantBr1,133back(10
percentaboveBr1,030).Theinterestraterequiredto
producethissumwouldbe13.3percent.

13. solution
i = (1+ r)(1+ i
e
) -1

14. The theory and structure of interest rates
Therearetwoeconomictheoriesexplainingthelevel
ofrealinterestratesinaneconomy:
Theloanablefundstheory
Liquiditypreferencetheory

15. Loanable funds theory
Inaneconomy,thereisasupplyofloanablefund(i.e.,
credit)inthecapitalmarketbyhouseholds,business,
andgovernments.
Loanablefundsarefundsborrowedandlentinan
economyduringaspecifiedperiodoftime–theflowof
moneyfromsurplustodeficitunitsintheeconomy.
Thehigherthelevelofinterestrates,themoresuch
entitiesarewillingtosupplyloanfunds;thelowerthe
levelofinterest,thelesstheyarewillingtosupply.

16. Cont,d
•Thesesameentitiesdemandloanablefunds,demanding
morewhenthelevelofinterestratesislowandless
wheninterestratesarehigher.
Accordingtothescholars,thelevelofinterestratesis
determinedbythesupplyanddemandofloanablefunds
availableinaneconomy’screditmarket(i.e.,thesector
ofthecapitalmarketsforlong-termdebtinstruments).
•Thistheorysuggeststhatinvestmentandsavingsinthe
economydeterminetheleveloflong-terminterestrates.

17. Cont,d
•Short-term interest rates, however, are determined
by an economy’s financial and monetary conditions.
According to loanable funds theory for the economy
as a whole:
Demand for loanablefunds = net investment + net
additions to liquid reserves
Supply of loanablefunds = net savings + increase in
the money supply

18. liquidity preference theory
Savingandinvestmentofmarketparticipantsunder
economicuncertaintymaybemuchmoreinfluenced
byexpectationsandbyexogenousshocksthanby
underlyingrealforces.
•Apossibleresponseofrisk-aversesaversistovary
theforminwhichtheyholdtheirfinancialwealth
dependingontheirexpectationsaboutassetprices.

19. Cont,d
•Liquiditypreferencetheory:whichexplainshow
interestratesaredeterminedbasedonthepreferencesof
householdstoholdmoneybalancesratherthan
spendingorinvestingthosefunds.
–Liquiditypreferenceispreferenceforholdingfinancial
wealthintheformofshort-term,highlyliquidassetsrather
thanlong-termilliquidassets,basedprincipallyonthefear
thatlong-termassetswilllosecapitalvalueovertime.

20. Cont,d
•Moneybalancescanbeheldintheformofcurrencyor
checkingaccounts,howeveritdoesearnaverylow
interestrateornointerestatall.Akeyelementinthe
theoryisthemotivationforindividualstoholdmoney
balancedespitethelossofinterestincome.
•Accordingtotheliquiditypreferencetheory,thelevelof
interestratesisdeterminedbythesupplyanddemand
formoneybalances.Themoneysupplyiscontrolledby
thepolicytoolsavailabletothecountry’sCentralBank.

21. Loanablefunds and liquidity preference
•Itiscommonlyarguedthatthetwotheoriesare,infact,
complementary,merelylookingattwodifferentmarkets
whichare:
1.Themarketformoneyand
2.Themarketfornon-moneyfinancialassets,
•Boththeabovetwomarketsofwhichhavetobein
equilibriumifthesystemasawholeisinequilibrium.

22. Structure of interest rates
•Interestratestructureistherelationshipsbetweenthevarious
ratesofinterestinaneconomyonfinancialinstrumentsof
differentlengths(terms)orofdifferentdegreesofrisk.
Thevarietyofinterestratesthatexistintheeconomyandthe
structureofinterestratesaresubjecttoconsiderablechange
duetodifferentfactors.Suchchangesareimportanttothe
operationofmonetarypolicy.

23. cont’d
•Interestratesvarybecauseofdifferencesin
•thetimeperiod,
•thedegreeofrisk,and
•thetransactioncostsassociatedwithdifferentfinancialinstruments
•Thegreatertheriskofdefaultassociatedwithanasset,
thehighermustbetheinterestratepaiduponitas
compensationfortherisk.Thisexplainswhysome
borrowerspayhigherratesofinterestthanothers.

24. cont’d
•The degree of risk associated with a request for a
loan may be determined based up on a
•company’s size,
•profitability or past performance;
•or, it may be determined more formally by credit rating
agencies.
•Borrowerswithhighcreditratingswillbeabletohave
commercialbillsacceptedbybanks,findwillingtakers
fortheircommercialpaperorborrowdirectlyfrombanks
atlowerratesofinterest.

25. Term Structure of Interest Rates
•Therelationshipbetweentheyieldsoncomparable
securitiesbutdifferentmaturitiesiscalledtheterm
structureofinterestrates.
•Itistherelationshipbetweenshort-termandlong-
terminterestrates.
•The primary focus here is the Treasury market.
•The graphic that depicts the relationship between
the yield on Treasury securities with different
maturitiesis known as the yield curve and,
therefore, the maturity spread is also referred to as
the yield curve spread.

26. Cont,d
•Yield curve shows the relationships between the
interest rates payable on bonds with different
lengths of time to maturity. That is, it shows the
term structure of interest rates.

27. Risk structure of interest rates
•Interestratesandyieldsoncreditmarket
instrumentsofthesamematurityvarybecause
ofdifferencesin
–defaultrisk,
–liquidity,
–informationcosts,and
–taxation.
•Thesedeterminantsareknowncollectivelyas
theriskstructureofinterestrates.

28. Theories of Term Structure of
Interest Rates
•There are several major economic theories
that explain the observed shapes of the yield
curve:
Expectations theory
Liquidity premium theory
Market segmentation theory
Preferred habitat theory

29. Expectations theory
•The pure expectations theory assumes that
investors are indifferentbetween investing for
a long periodon the one hand and investing
for a shorterperiod with a view to reinvesting
the principal plus interest on the other hand.

30. Cont,d
•For example an investor would have no preference
between making a 12-month deposit and making a
6-month deposit with a view to reinvesting the
proceeds for a further six months as long as the
expected interest receipts are the same.
•This is equivalent to saying that the pure
expectations theory assumes that investors treat
alternative maturities as perfect substitutes for one
another.

31. Cont,d
•The pure expectations theory assumes that
investors are risk-neutral.
•A risk-neutral investor is not concerned about the
possibilitythat interest rate expectations will prove
to be incorrect, as long as potential favourable
deviations from expectations are as likely as
unfavourable ones. Risk is not regarded negatively.

32. Liquidity Premium Theory
•Some investors may prefer to own shorter
rather than longe term securities because a
shorter maturity represents greater liquidity.
•In such case they will be willing to hold long
term securities only if compensated with a
premium for the lower degree of liquidity.

33. Cont,d
•Though long-term securities may be liquidated
prior to maturity, their prices are more
sensitive to interest rate movements.
•Short-term securities are usually considered to
be more liquid because they are more likely to
be converted to cash without a loss in value.
•Thus there is a liquidity premium for less
liquid securities which changes over time.

34. Market Segmentation Theory
•According to the market segmentation theory,
interest rates for different maturities are
determined independently of one another.
The interest rate for short maturities is
determined by the supply and demand for
short-term funds.
•Long-term interest rates are those that equate
the sums that investors wish to lend long term
with the amounts that borrowers are seeking
on a long-term basis.

35. Cont,d
•According to market segmentation theory,
investors and borrowers do not consider their
short-term investments or borrowings as
substitutesfor long-term ones.
•This lack of substitutability keeps interest rates
of differing maturities independent of one
another.
•If investors or borrowers considered
alternative maturities as substitutes, they may
switch between maturities.

36. Cont,d
•. However, if investors and borrowers switch
between maturities in response to interest
rate changes, interest rates for different
maturities would no longer be independent of
each other. An interest rate change for one
maturity would affect demand and supply, and
hence interest rates, for other maturities.

37. The Preferred Habitat Theory
•Preferred habitat theory is a variation on the
market segmentation theory. The preferred
habitat theory allows for some substitutability
between maturities.However the preferred
habitat theory views that interest premiums
are needed to attract investors from their
preferred maturities to other maturities.

38. Cont,d
•According to the market segmentation and
preferred habitat explanations, government
can have a direct impact on the yield curve.
Governments borrow by selling bills and
bonds of various maturities.
•If government borrows by selling long-term
bonds, it will push up long-term interest rates
(by pushing down long-term bond prices) and
cause the yield curve to be more upward
sloping (or less downward sloping)

39. Cont,d
•. If the borrowing were at the short maturity
end, short-term interest rates would be
pushed up.