SIQ2003

Financial Mathematics and Derivatives

Chapter 8: Determinants of interest rate

Lecturer: Nadiah Zabri

Institute of Mathematical Sciences

Faculty of Science
University Malaya
 Outline

What is Quotation bases for interest rate for some

investment instruments
1 interest

Term ( Yield curve) Forward vs spot rate

Components
2 of interest
Impact of Supply and Demand
Default Risk
rates Known inflation
Uncertain inflation

3 interest rates Bank's saving and lending rate

in different
financing Government and coupon bonds

instruments

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 Quotation Bases for Interest Rates
• U.S T-Bills • Canada T-Bills
• Quoted rate, d • Quoted rate, i
!"# %&''() (*&+$, &- .$,/)/0, !"9 %&''() (*&+$, &- .$,/)/0,
= ∗ = ∗
$ 1(,+).,2 3('+/ &- 456.'' $ 456.'' 3('+/ (, ,:/ ;/<.$$.$<
!"# 758 !"9 758
=$ ∗ 7
=$ ∗ 8

Basically it is annual simple Basically it is annual simple

discount rate interest rate

The fraction of a year, p=n/360

instead of the actual day of the
year.

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 Quotation Bases for Interest Rates
§ Due to the difference in quotation bases between few markets, its
good practice to find equivalent effective interest rate, i or
equivalent continuous interest rate, !
§ This is for apple to apple comparison.

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 Example
§ The price of a T-bill that matures for 100,000 in 90 days is 99,000. Determine
the following rates in % with 2 decimal places:
a) The quoted rate of US T-bill
b) The quoted rate of Government of Canada T-bill
c) The effective per annum interest rate
d) The continuously compounded rates
Answer: -100,000 99.00
-

!"# %###
a) # = $# ∗ %##,### = 4.00%
b) i=
!"'
$#
∗
%###
= 4.10%
$$,###
365.C,
c) Effective rate,i=99,000(1 + /)$#/!"'= 10,000, so i=4.16%
!" -
-

)(#$%) $# C

d) 99,0001 = 10,000, so 2 !"'

= ln(10000/99000) , 2 = 4.076%

SIQ2003 S1 2022/23
->
 Outline

What is Quotation bases for interest rate

1 interest

Term ( Yield curve) Forward vs spot rate

Components
2 of interest
Impact of Supply and Demand
Default Risk
rates Known inflation
Uncertain inflation

3 interest rates Bank's saving and lending rate

if different
financing Government and coupon bonds

instruments

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 Determinants of interest rates
Impact
of supply
and
demand
Term
(yield
Default curve)
risk

Inflation
rate

Interest rate

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 Determinant 1: TERM of financing/ investment horizon
• Normally yield curve looks like
this, because it is a pattern
expected from rational lenders
and investors. but it can differ
also depending on actual
supply and demand.

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 Forward vs spot rate
§ Spot rate is what we see used to see in yield curves.

§ t-year spot rate or rate for t-year zero-coupon bond, "! is annual
effective interest rate earned on a investment made for t years
§ t does not have to be integer. Usually the first year is split into few
periods with differing spot rates. Though the rate for any period t
is still rate “per annum”

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 Spot rate exercise
• Example
Based on the spot rate table, what is the
price of an investment that provide
quarterly return of 1000 over a one year
-
bulan
period, first return in 3 months?
--
3

6 bulan
-

025- -

pr 9 Gelaw
-1000
-

12 Alan ED
Answer:
1000 1000 1000 1000
8= #.-' + #.' + #..' +
1.01 1.011 1.0122 1.0135

= 3969.69

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 Spot rate exercise
§ We can know the <% from a 1-year zero coupon bond. Lets say it is 6%.
§ Given information from a relevant coupon bonds, we can determine the
relevant spot rates, say <- =>? <!?

§ Example: given the following of a 2-year coupon bond :

at 6.50%, P=50 =- ⃧ + 1,000@ - =972.69 Y
50
C100

§ The 2 year bond can be split to 2 zero coupon bonds. Fr Fr

58

50 1050
972.69 = +
1.06 (1 + <-)- ofd
<-=6.5128% r
972,69
56+ 2+sorgl
=

3
·
r

A Knowing <% &<- , a 3-year coupon bond can help us derive <!
r=
6%, 02:5 ↑ -
r2
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 3-year
r++
·)
x =

misal

2-year
6)

p=
r, tre
 Forward vs spot rate
§ Forward rate is an interest rate that will be earned on an investment made at
a future point in time. It is expressed as an annual effective rate of interest for
the deferred period.
--

§ Example: “3-year forward rate, deferred 2 years is 6%”.

§ It means, if investments is made at time 2, it will earn 6% per annum over the
next 3 years (from time 2 to time 5)

§ Notation:B /& ,/' is the annual effective rate between time C% =>? C-. t 2
=

"3-year forward rate, deferred 2 years": B -,'

"2-year forward rate, deferred 4 years": B 0,"
It also can be as follows:B 0.-',0.'# = 5%.
#.-' at time 4.5
⑳t 57+ =
3

-D This means $1 invested at time 4.25 will be 1.05

+ (2,53:6%
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 Forward rate Exercise
§ Find the accumulated value (to the nearest cent) at the end of 7
years of an investment of $1,000 made 3 years from now, if the 4-
year forward rate, starting in 3 years, is 5%

f53,77 5%
=

1000

t7
=
(1,05) 9. 180 = 11
LD O 3 f
w

fis. t]=5Z

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 Determine forward rate from spot rates
§ Given
• <%=5%
• <- = 5.5%
• Find B %,-

forward
(1 + <-)-= rate: al)
(1 + <%)(1+ B %,- -1
-1=(obst =
5025-1
%.#'' '((+rb)tb
+[1,2]
(1 + B %,- ) = %.#' 1,06 -1
=

= 6,002 of
B %,- = 6.0024%
F

Another way to see this is using the accumulation factor learnt in chapter 2
= C-
1 + B /& ,/' =
=(C%)

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 Forward rate Exercise
§ Given

Find 3-year forward rate, deferred 2 years.

(AB)#)# A.#DE9 #
!
( 1 + % =,9 ) =
( ,!
((,")
= AdEII=
·

(AB)!)! A.#!F9 !
% =,9 =5.5898%

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 § Spot rate and forward rate is always shown as annual rate

f(I, 1,57: 9,11 %

O
§ Answer: 2.15%

x ti.1c)"
+ =

(old
r 0,0215
=

=
2,151%
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 Determinants of Interest rate 2:relationship with
Supply and Demand of financing
§ The yield curve plots the yield across many tenure of investments
§ The common expectation is the smooth increasing curve, but its
not necessarily the case. Why?
§ The actual yield will depend of supply and demand of financing.
Each investment tenure will have their own supply and demand
curve
Fewer
As interest borrowers will
More lenders
will lend (supply
increase borrow
(demand drop)
increase)

More borrowers Fewer lenders

As interest will borrow will lend (supply
drop)
decrease (demand
increase)

SIQ2003 S1 2022/23
 Exercise
i. Supply curve, i= $" + 0.01. i is lending rate, $" is percentage of
money lenders willing to lend.
ii. Demand curve, i= 0.1 − $# . i is borrowing rate, $" is percentage
money of borrowers willing to borrow.
iii. What is the equilibrium interest, i and equilibrium percentage P
of the potential borrower and lender to borrow and lend

Equilibrium, i is achieved the when the supply curve overlaps with

demand curve (*# = *" and $" = $# ).
§ *# = *" , so $" + 0.01 = 0.1 − $# , so $" + $# = 0.09.
§ $" = $# = 0.045 so * = 0.055

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 Theory explaining the difference in yield rate for
different financing terms.
§ Each term of loan will have separate equilibrium rate, each
determined with own demand and supply curve. Why?

§ Based on market segmentation theory, different financing term

involve different segment of lender and borrower with different supply
and demand curve.
§ Based on preferred habitat theory that differences in interest rates
are attributable to differences in the pools of lenders and borrowers;
however, lenders and borrowers are not rigidly segmented by term.
Given sufficient incentive to do so, market participants are willing to
move to a term that is different from their preferred one.
§ Based on expectation theory, the interest rate on a longer term loan
provides information on the interest rates that shorter term loans are
expected to have in the future.

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 Determinants of interest 3: default risk
§ Interest rate also depends on identity of the borrower
Government rate usually is
referred as risk-free interest
rate and the rest is higher as
they include risk premium

The stated amount is the

maximum amount that
investors will receive.
Investors may receive less if
the company has financial
difficulties and is unable to
fully repay the loan or bond

Bank also charge higher rate

for those with bad credit
score

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 Calculation of effective rate allowing for default risk. Exercise:
For a loan of 1,000, the lender requires a repayment amount of 1,090 at the end of 4 years. The
lender expects 16 defaults for each 1,000 borrowers but with 25% partial recovery. What
effective per annum interest rate should the lender offer, taking into account the expected
defaults?

q is probability of default=0.016
p is partial settlement=25%
Final Avg payment that lender wants to get is $1090
Final Avg payment that lender actually gets allowing default is X

Expected recovery= (1-q)*expected recovery from non-defaulters+ q*expected recovery from

defaulters
Hence: Expected payment=1090=0.984*X+0.016* 25%*X
So X= 1103.24

From there, determine i as follows: 1000(1+i)4=1103.24 so i is 2.49%

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 Determinants of interest 4a: Known inflation
()*!"#$!%&
§ 1 + *$%&' =
()*$!'&%($"!
()*
§ 1 + *′ = ()$ . real i is real return from your investment.
§ What is the logic behind this? Example, your saving accumulate by
15.5% each year but there is an annual inflation of 10%.
§ Did you purchasing power actually grew by 15%?

Example, at time 0, I can buy 1000 item worth RM1 with RM1000. in
((++
a year time I can buy =1050. So my real growth rate is 5%
()* (.(
(1.05=1.155/1.1= ()$ ) + i
1,05
1,55
1 = =

i 0,05=5t
=

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 4b:Unknown inflation
§ In reality, prices do not increase by constant known rates and
inflation rates can only be observed after the fact, so
borrowing, lending and consumption decisions must be made
without complete information.

§ When inflation is uncertain, lenders supply curve most likely move

upward as lender require more compensation for the uncertainty

§ Demand curve might not move in the same direction hence the
equilibrium rate is more uncertain.

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 Recap
Nominal rate, the rate required by lenders usually will allow for:
1) r = interest rate without default risk, dependant on term
2) ie = expected inflation rate
3) iu =compensation for unexpected inflation
4) s=Credit spread, dependant on supply and demand

If the rate is continuous form, the required rate, x= r+ ie+ iu +s

If the rate is effective rate, 1+x=(1+r)(1+ ie)(1+ iu)(1+s)

Then, to determine the rate to be offered to consumer, derive the rate to

be charged by adjusting for Default risk. Sometime the default risk
already included in the credit spread.

SIQ2003 S1 2022/23
 Outline

What is Quotation bases for interest rate

1 interest

Term ( Yield curve) Forward vs spot rate

2 Components Impact of Supply and Demand
of interest Default Risk
rates Known inflation
Uncertain inflation
Bank's saving and lending rate
3 Interest rate
in practice Government and coupon bonds

Role of Central Banks

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 Bank’s saving and lending rate
§ Banks are intermediaries between depositors and borrowers

Borrowers get money

Depositors deposit money from lending products
via saving products

Profit to bank= interest from lending- interest from deposits - expenses

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 Interest of saving products

Main type of
saving product

Certificate of
Saving account deposits
(defined term)
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 What are some of the factors influencing saving product interest
rate?

• Supply of deposits and demand for loans

• Strategy of the bank. Example: if they increase financing given,
they might pay more for deposits
• Bank’s credit rating
• inflation

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 Lending products

Main type of
lending
product

Secured loan Unsecured guaranteed

(eg.mortgage, loan (eg:credit (eg. student
auto..) card) loan)

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 What are some of the potential factors influencing lending rate
(credit spread)?

1) Type of loan (secured, unsecured, guaranteed)

2) Credit worthiness of borrower
3) Relationship of borrower with bank

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 Bonds

§ Issuers can be government, state, large corporations etc

§ 2 types of bond:
• Zero coupon bonds (example: US T-bill)
• Coupon bonds (example: US T-note)

§ Usually each issuer (banks, corporate, government etc) will have

their own yield curve.
§ After issuance, bond only can be traded in secondary market OTC

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 Role of Central bank
§ Banks are required to deposit some reserve to the central bank
• This will be used to ensure the liquidity of banks by lending this between
banks, in case withdrawal for a bank is too high.
• The central bank control this “interbank lending rate”, which will
encourage/ discourage banks to borrow it, hence influencing the money
supply in the economy.
§ Lender of last resort
• When banks having liquidity problem and the reserves mentioned earlier
is not sufficient, central banks offer back up financing to banks

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 Summary
§ Quotation basis

US T bills d 360 6 − 8
∗
4 6
Canada T-bills i 365 6 − 8
∗
4 8

§ t-year spot rate, "! vs forward rate, 2 !),!*

(()$(* )(*
§ 2 !),!* =
(()$() )()

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 Determinants of interest rate
§ Term
§ Supply and demand
§ Default risk
§ Inflation
• Known inflation
• Unknown inflation

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