1. Loanable fund theory: - It is used to explain interest rate movements.

Market interest rate is determined by the

supply of and the demand for the loanable funds. The phase “demand for loanable funds” is widely used in financial
markets to refer to the borrowing activities of households, businesses, and governments.
1. Household demand for loanable funds
2. Business demand for loanable funds
3. Government demand for loanable funds
4. Foreign demand for loanable funds

2. Demand for loanable funds: -

Household demand for loanable funds: Household demand for loanable fund to finance housing expenditures
(purchase automobile, household items through instalment) Household demand a greater quantity of loanable fund if
the interest rate is lower and vies-versa. Various events can cause household borrowing preferences to change. E.g. tax
rate on household income decreases. If the demand for the fund increases then there will be an outward shift (to the
right) in the demand schedule.
Interest rate

DH
Quantity loanable fund

Business demand for loanable funds: Business demand for loanable fund to invest in long term and short-term assets.
The demand for loanable fund is depends on the availability of positive NPV projects as well as the interest rate.
NPV= -INV + ∑ CFt/ (1+k) n
If interest rate is lower, the cost of fund will be lower and the required rate of return to implement the projects are also
lower.
So, business will demand more loanable fund if the interest rate is lower and vies-versa.
Business also needs loanable fund for short term assets in order to support the ongoing operations.
If interest rate ↑ or ↓= the demand for loanable fund ↓ or ↑
Shift in demand for loanable funds: Business demand for loanable
funds schedule can shift in reaction to any event that affect borrowing
preference. E.g., If economic condition is favourable than business
will demand more fund. The increased demand will shift the demand
curve outward or to the right.

3. Government demand for loanable funds: - If government‘s planned

expenditures is higher than its tax revenue (budget deficit), it demands
loanable fund.
Municipal (State and local) Government Issue municipal bonds to obtain
funds.
Federal Government and its agencies issue Treasury securities and federal
agency security.
Federal government‘s demand for loanable fund is inelastic or insensitive to interest rate. But Municipal government’s
demand for loanable fund is sensitive to interest rate.
4. Aggregate demand for loanable funds:
-The aggregate demand for loanable funds is
the sum of the quantities demanded by the
separate sectors at any given interest rate.
If the interest rate increases then the
aggregate demand for loanable fund will
decreases and vies-versa. If the demand
schedule of any sector changes, then the
aggregate demand schedule will be affected
as well.
5. Supply of loanable fund: -When the funds are provided by the savers to the financial market is known as “Supply
of loanable fund”.
Funds are supplied by-----
Household: the largest supplier of loanable fund.
Government units: When generate more tax revenue than they spend.
Business: Whose cash inflow exceed cash outflows.
Suppliers will supply more fund if the interest rate higher.
Household supplies the fund from their own savings. Foreign household, government, and corporation supply funds to
their domestics’ market by purchasing domestics securities.
Effect of the Fed: Supply of loanable fund In the U.S. is also influenced by the monetary policy implemented by the
Federal Reserve System. The Fed conduct the monetary policy in an effort to control U.S. economic conditions.
Aggregate Supply of funds: It is the combination of all sector supply schedules alone with the supply of fund provided
by the Fed’s monetary policy. The steep slope of the aggregate supply schedule indicates that it is interest –inelastic, or
more insensitive to interest rates.
The supply curve can shift in or out in response to various conditions. If the tax rate on interest income is reduced, the
supply curve will shift to the right (outward) as households save more funds at each possible interest rate level. And
visa-versa.
6. Equilibrium interest rate: -Equilibrium interest rate: The determination of an equilibrium interest rate can be
presented by both the algebraic and the graphic prospective.
Algebraic prospective: The equilibrium interest rate is the rate that equals the aggregate demand for fund with the
aggregate supply of loanable fund. That means, Da = Sa.
Da = Dh + Db + Dg + Dm + Df (D= demand for loanable fund)
Sa = Sh + Sb + Sg + Sm + Sf. (s= supply of loanable fund)
7. Algebraic prospective: -The aggregate demand for loan able fund can be written as ----------
Da= Dh+ Db+ Dg+ Dm+ Df
Where—
Dh= Household demand for loan able fund.
Db= Business demand for loan able fund.
Dg= Government demand for loan able fund.
Dm= Municipal demand for loan able fund.
Df= Foreign demand for loan able fund.
The aggregate Supply for loan able fund can be written as ----------
Sa= Sh+ Sb+ Sg+ Sm+ Sf
Where—
Sh= Household supply for loan able fund.
Sb= Business supply for loan able fund.
Sg= Government supply for loan able fund.
Sm= Municipal supply for loan able fund.
Sf= Foreign supply for loan able fund.
If the aggregate demand for loan able fund increases without a corresponding increase in aggregate supply, there will
be a shortage of loan able funds. Interest rates will rise until an additional supply of loan able funds are available to
accommodate the excess demand.
That is, if Da› Sa= interest rate↑.
And if Da‹ Sa= interest rate ↓.

8. demand for loan able fund: -

9.Graphic prospective: At the equilibrium interest rate of i, the supply of
loan able fund is equal to the demand of loan able fund.
If the interest rate is above i, there will be a surplus of loan able fund.
Some potential supplier may not be able to supply their fund at the
prevailing interest rate. As the demand decreases the interest rate will also
decreases. Once the market interest rate decreases to i, the quantity of
funds is sufficiently reduced and the quantity of funds demanded is
sufficiently increased such that there is no longer a surplus of funds. When
disequilibrium situation exist, market forces should cause an adjustment
in interest rates until equilibrium is achieved.

If the interest rate is below i, there will be a shortage of loan able fund as the
demand for loan able fund is higher than the supply. As the demand increases,
the interest rate starts increasing. With an increasing interest rate, the supply
of fund begins to increase and the demand for the fund decreases. Once again,
an equilibrium position achieved.

10. Economic Forces That Affect Interest Rates: -

Economic growth
 Shifts the demand schedule outward (to the right)
 There is no obvious impact on the supply schedule
 Supply could increase if income increases as a result of the expansion
 The combined effect is an increase in the equilibrium interest rate
Inflation
 Shifts the supply schedule inward (to the left)
 Households increase consumption now if inflation is expected to increase
 Shifts the demand schedule outward (to the right)
 Households and businesses borrow more to purchase products before prices rise
Fisher effect: (Irving Fisher)
Nominal interest payments compensate savers for:
Reduced purchasing power
A premium for forgoing present consumption
The relationship between interest rates and expected inflation is often referred to as the Fisher effect
Fisher effect equation:
I=E(INF) + iR
The difference between the nominal interest rate and the expected inflation rate is the real interest rate:
iR= E(INF)-
Money supply
If the Fed increases the money supply, the supply of loanable funds increases
If inflationary expectations are affected, the demand for loanable funds may also increase
If the Fed reduces the money supply, the supply of loanable funds decreases
Budget deficit
A high deficit means a high demand for loanable funds by the government
Shifts the demand schedule outward (to the right)
Interest rates increase
The government may be willing to pay whatever is necessary to borrow funds, but the private sector may not
Crowding-out effect
The supply schedule may shift outward if the government creates more jobs by spending more funds than it collects
from the public
Foreign flows of funds
The interest rate for a currency is determined by the demand for and supply of that currency
Impacted by the economic forces that affect the equilibrium interest rate in a given country, such as:
Economic growth
Inflation
Shifts in the flows of funds between countries cause adjustments in the supply of funds available in each country
11. Forecasting Interest Rates: -It is difficult to predict the precise change in the interest rate due to a particular event
Being able to assess the direction of supply or demand schedule shifts can help in understanding why rates changed
To forecast future interest rates, the net demand for funds (ND) should be forecast:
ND  DA  S A

 Dh  Db  Dg  Dm  D f 
 S h  Sb  S g  S m  S f 
A positive disequilibrium in ND will be corrected by an increase in interest rates
A negative disequilibrium in ND will be corrected by a decrease in interest rates
12. Characteristics of Debt Securities: -Debt securities offer different yields because they exhibit different
characteristics that influence the yield to be offered. The yields on debt securities are affected by the following
characteristics:
1. Credit Risk 2. Liquidity 3. Tax status 4. Term to maturity.
1. Credit (default) risk
Securities with a higher degree of risk have to offer higher yields to be chosen
Credit risk is especially relevant for longer-term securities
Investors must consider the creditworthiness of the security issuer
Can use bond ratings of rating agencies
The higher the rating, the lower the perceived credit risk
Ratings can change over time as economic conditions change
Ratings for different bond issues by the same issuer can vary
Credit (default) risk (cont’d)
Rating agencies
Moody’s Investor Service and Standard and Poor’s Corporation are the most popular
Agencies use different methods to assess the creditworthiness of firms and state governments
A particular bond issue could have different ratings from each agency, but differences are usually small
Financial institutions may be required to invest only in investment-grade bonds rated Baa or better by Moody’s and
BBB or better by Standard and Poor’s
Credit (default) risk (cont’d)
Shifts in credit risk premiums.
The risk premium corresponding to a particular bond rating can chance over time
Accuracy of credit ratings.
In general, credit ratings have served as reasonable indicators of the likelihood of default.
Credit rating agencies do not always detect financial problems of firms.
2. Liquidity: -Liquid securities can be easily converted to cash without a loss in value
Short-maturity securities with an active secondary market are liquid
Securities with lower liquidity have to offer a higher yield to be preferred
3. Tax status
Investors are more concerned with after-tax income than before-tax income
Taxable securities have to offer a higher before-tax yield to be preferred
The after-tax yield is equal to:
Tax status
Computing the equivalent before-tax yield
The before-tax yield necessary to match the after-tax yield on a tax-exempt security is:
Yat
Ybt 
(1  T )
State taxes should be considered along with federal taxes
4. Term to maturity
The term structure of interest rates defines the relationship between maturity and annualized yield
Special provisions
A call feature allows the issuer of bonds to buy the bonds back before maturity
The yield on callable bonds should be higher than on non-callable bonds
A convertibility clause allows investors to convert the bond into a specified number of common stock shares
The yield on convertible bonds is lower than on nonconvertible bonds
14. Explaining Actual Yield Differentials: -Yield differentials are often measured in basis points
100 basis points equal 1 percent
Yield differentials of money market securities
Commercial paper rates are higher than T-bill rates
Eurodollar deposit rates are higher than yields on other money market securities
Market forces cause the yields of all securities to move in the same direction.
Yield differentials of capital market securities
Municipal bonds have the lowest before-tax yield
After-tax yield is higher than that of Treasury bonds
Treasury bonds have the lowest yield
No default risks
Very liquid
Investors prefer municipal or corporate bonds over Treasury bonds only if the after-tax yield compensates for default
risk and lower liquidity
15. Estimating the Appropriate Yield: -The yield on a debt security is based on the risk-free rate with adjustments to
capture various characteristics:
Maturity is controlled for by matching the maturity of the risk-free security to that of the security of concern
Yn  Rf ,n  DP  LP  TA  CALLP  COND
16. A Closer Look at the Term Structure: -Pure expectations theory suggests that the shape of the yield curve is
determined solely by expectations of future interest rates
Assuming an initially flat yield curve:
The yield curve will become upward sloping if interest rates are expected to rise
The yield curve will become downward sloping if interest rates are expected to decline
Liquidity premium theory
According to the liquidity premium theory, the yield curve changes as the liquidity premium changes over time due to
investor preferences
Investors who prefer short-term securities will hold long-term securities only if compensated with a premium
Short-term securities are typically more liquid than long-term securities
The preference for short-term securities places upward pressure on the slope of the yield curve
Segmented market theory
According to segmented markets theory, investors and borrowers choose securities with maturities that satisfy their
forecasted cash needs.
Pension funds and life insurance companies prefer long-term investments
Commercial banks prefer short-term investments
Shifting by investors or borrowers between maturity markets only occurs if the timing of their cash needs change
17. Bond Valuation Process: - Bonds: Are debt obligations with long-term maturities issued by government or
corporations to obtain long-term funds
Are commonly purchased by financial institutions that wish to invest for long-term periods
The appropriate bond price reflects the present value of the cash flows generated by the bond (i.e., interest payments
C C C  Par
PV of bond    ....
and repayment of principal):
(1  k ) (1  k )
1 2
(1  k )n
Bond valuation with a present value table
Present value interest factors can be multiplied by coupon payments and the par value to determine the present value of
the bond
Impact of the discount rate on bond valuation
The appropriate discount rate for valuing any asset is the yield that could be earned on alternative investments with
similar risk and maturity
Investors use higher discount rates to discount the future cash flows of riskier securities
The value of a high-risk security will be lower than the value of a low-risk security.
Impact of the timing of payments on bond valuation
Funds received sooner can be reinvested to earn additional returns
A dollar to be received soon has a higher present value than one to be received later
Valuation of bonds with semi-annual payments
First, divide the annual coupon by two
Second, divide the annual discount rate by two
Third, double the number of years

C/2 C/2 C / 2  Par

PV of bond    ....
(1  k / 2)1 (1  k / 2)2 (1  k / 2)2n
Use the annuity tables for valuation
A bond can be valued by separating its payments into two components:
PV of bond = PV of coupon payments + PV of principal
The bond’s coupon payments represent an annuity (an even stream of payments over a given period of time)
The present value can be computed using PVIFAs
18. Relationship between Coupon Rate, Required Return, and Price: -
If the coupon rate of a bond is below the investor’s required rate of return, the present value of the bond should be below
par value (discount bond).
If the coupon rate equals the required rate of return, the price of the bond should be equal to par value.
If the coupon rate of a bond is above the required rate of return, the price of the bond should be above par value.

19. Explaining Bond Price Movements: -The price of a bond should reflect the present value of future cash flows
based on a required rate of return:
Pb  f ( k )  f ( Rf , RP )
- - -
An increase in either the risk-free rate or the general level of the risk premium results in a decrease in bond prices
Factors that affect the risk-free rate
Inflationary expectations
Economic growth
Money supply
Budget deficit
Factors that affect the risk-free rate (cont’d)
Impact of inflationary expectations
An increase in expected inflation will increase the required rate of return on bonds
Indicators of inflation are closely monitored
Consumer price index
Producer price index
Oil prices
A weak dollar (own currency)
Factors that affect the risk-free rate (cont’d)
Impact of economic growth
Strong economic growth places upward pressure on the required rate of return
Signals about future economic conditions affect bond prices immediately
Employment
GDP
Retail sales
Industrial production
Consumer confidence
Factors that affect the risk-free rate (cont’d)
Impact of money supply growth
If there is no simultaneous increase in the demand for loanable funds, an increase in money supply growth should place
downward pressure on interest rates
In high inflation environments, an increased money supply may increase the demand for loanable funds and place
upward pressure on interest rates
Impact of budget deficit
An increase in the budget deficit places upward pressure on interest rates
Bond market efficiency
In an efficient market, bond prices should fully reflect all available information
In general bond prices should reflect information that is publicly available
Prices may not reflect information about firms that is known only by managers of the firms
20. Bond Investment Strategies Used by Investors: - Matching strategy
The bond portfolio generates periodic income that can match expected periodic expenses
Involves estimating future cash outflows and developing a bond portfolio that can generate sufficient payments to cover
those outflows
Laddered strategy
Funds are evenly allocated to bonds in each of several different maturity classes
Achieves diversified maturities and different sensitivities to interest rate risk
Barbell strategy
Funds are allocated to bonds with a short term to maturity and bonds with a long term to maturity
Allocates some funds to achieving relatively high returns and other funds to cover liquidity needs
Interest rate strategy
Funds are allocated to capitalize on interest rate forecasts
Requires frequent adjustment in the bond portfolio to reflect current forecasts
21. Return and Risk of International Bonds: -
The value of an international bond is influenced by:
Changes in the risk-free rate of the currency denominating the bond
Changes in the perceived credit risk of the bond
Exchange rate risk
Influence of foreign interest rate movements
An increase in the risk-free rate of the foreign currency results in a lower value for bonds denominated in that currency
Influence of credit risk
An increase in risk causes a higher required rate of return on the bond and lowers the present value of the bond
Influence of exchange rate fluctuations
The most attractive foreign bonds offer a high coupon rate and are denominated in a currency that strengthens over the
investment horizon
International bond diversification
Reduction of interest rate risk
International diversification of bonds reduces the sensitivity of the overall bond portfolio to any single country’s interest
rate movements
Reduction of credit risk
Because economic cycles differ across countries, there is less chance of a systematic increase in the credit risk of
internationally diversified bonds
Reduction of exchange rate risk
Financial institutions attempt to reduce their exchange rate risk by diversifying among foreign securities denominated
in various foreign currencies