CHAPTER 4

THE MEANING OF INTEREST RATES

BY DR. NADIA
MOST FINANCIAL TRANSACTIONS INVOLVE
PAYMENTS IN THE FUTURE

The importance of the interest rate comes from the fact that
most financial transactions involve payments in the future.

The interest rate provides a link between the financial present

and the financial future.
COMPOUNDING AND DISCOUNTING

Future value is the value at some future time of an investment made today.
The future value of an investment (principal) in one year (FV1) with an
interest rate i:

Compounding for More Than One Period

Compounding is the process of earning interest on interest, as savings
accumulate over time.
If you invest the principal for n years, then you will have at the end of n
years:
AN EXAMPLE OF DISCOUNTING

Funds in the future are worth less than funds in the present, so
they have to be reduced, or discounted, to find their present
value.
Present value is the value today of funds that will be received
in the future.
Time value of money is the way that the value of a payment
changes depending on when the payment is received.
LOANS, BONDS, AND THE TIMING OF
PAYMENTS

In this section, we discuss four basic categories of debt

instruments:
1. Simple loans
2. Discount bonds
3. Coupon bonds
4. Fixed-payment loans
SIMPLE LOAN
Simple loan is a debt instrument in which the borrower receives from the
lender an amount called the principal and agrees to repay the lender the
principal plus interest on a specific date when the loan matures.
PV = amount borrowed = $100
CF = cash flow in one year = $110
n = number of years = 1
$110
$100 =
(1 + i )1
(1 + i ) $100 = $110
$110
(1 + i ) =
$100
i = 0.10 = 10%
For simple loans, the simple interest rate equals the
yield to maturity
DISCOUNT BOND

Discount bond is a debt instrument in which the borrower

repays the amount of the loan in a single payment at maturity
but receives less than the face value of the bond initially.
 COUPON BONDS (1 OF 2)

A coupon bond is a debt instrument that requires multiple

payments of interest on a regular basis, and a payment of the face
value at maturity.
FIXED-PAYMENT LOAN

A fixed-payment loan is a debt instrument that requires the

borrower to make regular periodic payments of principal and
interest to the lender.
• Example: You are repaying a $10,000 10-year student loan
with a 9% interest rate, so your monthly payment is
approximately $127.
YIELD TO MATURITY

Yield to maturity is the interest rate that makes the present

value of the payments from an asset equal to the asset’s price
today.
The interest rate is on a financial asset for financial markets
participants.
SECONDARY MARKETS, ARBITRAGE, AND THE
LAW OF ONE PRICE

 A trader buys and sells securities to profit from small differences in

prices.
 During the period before bond prices fully adjust to changes in interest
rates, there is an opportunity for arbitrage.
Financial arbitrage is the process of buying and selling securities to
profit from price changes over a brief period of time.
 The prices of financial securities at any given moment allow little
opportunity for arbitrage profits, so that investors receive the same yields
on comparable securities.
 This rationale follows the principle of the law of one price: identical
products should sell for the same price everywhere.
 INTEREST-RATE RISK AND MATURITY

Interest-rate risk is the risk that the price of a financial asset

will fluctuate in response to changes in market interest rates.
 Bonds with fewer years to maturity will be less affected by a
change in market interest rates.
NOMINAL INTEREST RATES VERSUS REAL
INTEREST RATES (1 OF 2)

 Nominal interest rate makes no allowance for inflation

 Real interest rate is adjusted for changes in price level so it
more accurately reflects the cost of borrowing
 Ex ante real interest rate is adjusted for expected changes
in the price level
 Ex post real interest rate is adjusted for actual changes in
the price level
WHAT DETERMINES THE LEVEL OF
INTEREST RATE?

 Supply and Demand Determine the Interest Rate:

 Interest rate is price of credit or borrowing money.
 And like all other prices it is determined by Supply and
Demand (of Loan-able Funds). The funds that the lender is
making it available for borrowers to borrow.
WHAT DETERMINES THE LEVEL OF
INTEREST RATE?

 Supply and Demand Determine the Interest Rate: (Cont.)

WHAT DETERMINES THE LEVEL OF
INTEREST RATE?

 Supply and Demand Determine the Interest Rate: (Cont.)

 According to above figure:
-Supply of Funds—Upward sloping, lenders are willing to
extend more credit at higher interest rates.
-Demand for Funds—Downward sloping, borrowers are
willing to borrow less at higher interest rates.
WHAT DETERMINES THE LEVEL OF
INTEREST RATE?

 Supply and Demand Determine the Interest Rate: (Cont.)

 According to above figure: (Cont.)
-Equilibrium—Intersection of supply and demand, no
tendency to change.
-Financial Markets—Competitive so supply and demand
pressures will result in interest rate changes.
WHAT DETERMINES THE LEVEL OF
INTEREST RATE?

 Why Does Interest Fluctuate:

 It fluctuates because of shifts in the demand and/or
supply curves.
 Movement along a single curve—Changes in the
interest rate results in a movement along a single
demand or supply curve.
 See figure:
WHAT DETERMINES THE LEVEL OF
INTEREST RATE?

 Why Does Interest Fluctuate: Movement along

WHAT DETERMINES THE LEVEL OF
INTEREST RATE?

 Why Does Interest Fluctuate: (Cont.)

 Shifts of a Curve—Change in determinants of supply or demand (other than
interest rate) causes the respective curve to shift.
 See figure:
WHAT DETERMINES THE LEVEL OF
INTEREST RATE?

 Why Does Interest Fluctuate: Shift

WHAT DETERMINES THE LEVEL OF
INTEREST RATE?

 Why Does Interest Fluctuate: Equilibrium

 Changes in Equilibrium—Shift of either the supply or
demand curve will reflect a change in the equilibrium interest
rate.
WHAT DETERMINES THE LEVEL OF
INTEREST RATE?

 Behind Supply and Demand

 We know by now that interest rate will rise when demand for
loan-able funds increases and supply decreases.
 Demand (Borrowing)
1. Business Firms borrow to buy finance inventory or buy
capital equipment;
2. Households borrow to buy cars, homes or consumer goods;
WHAT DETERMINES THE LEVEL OF
INTEREST RATE?

 Behind Supply and Demand

 Demand (Borrowing) (Cont.)
3. State and local government borrows to build sewer system,
roads, schools and so on;
4. The federal government, borrows to finance federal budget
deficits.
 These increase in demand shifts the demand for loan-able
funds to the right and drive interest rate higher.
WHAT DETERMINES THE LEVEL OF
INTEREST RATE?

 Behind Supply and Demand

 Supply (Lending)
1. Financial institutions and individual lend to the market;
2. Banks sometimes restrict their lending due to pressures from
government authorities, like federal reserves. Making the
lending process difficult;
WHAT DETERMINES THE LEVEL OF
INTEREST RATE?

 Behind Supply and Demand

 Supply (Lending) (cont.)
3. Individuals lend according to their savings, i.e. limited
lending. Exerting rise in interest rates.
 These decrease in lending shifts the supply for loan-able
funds to the left and drive interest rate higher.
WHAT DETERMINES THE LEVEL OF
INTEREST RATE?

 The Importance of Inflationary Expectations

 Inflation is the best example of increase in demand and
decrease in supply, because:
1. People borrow (demand) more in inflation as they will have
to repay borrowings in depreciated money and desire to
purchase before the prices rise.
2. People lend less (supply) inflation as they will be repaid with
money diminishing purchasing power.
WHAT DETERMINES THE LEVEL OF
INTEREST RATE?

 Cyclical and Long-Term trends in Interest Rates. (Cont.)

1. The level of interest rates tends to rise during periods of
businesses are running good/expansion and fall during
recessions.
 Then firms and households increase their demand for loan-able
funds.
WHAT DETERMINES THE LEVEL OF
INTEREST RATE?

 Cyclical and Long-Term trends in Interest Rates. (Cont.)

 Firms borrow more as they expect increased sales. Household
do the same as they expect a good future. (Shifts Demand to
right)
 In recession, since business is bad and people do not demand
much shifting the demand to left, decreasing the interest rate.
WHAT DETERMINES THE LEVEL OF
INTEREST RATE?

 Cyclical and Long-Term trends in Interest Rates. (Cont.)

 In supply case, the federal tightens lending in business cycle
expansion, shifting supply to left and , raising the interest rate.
 In recession, the federal eases credit, which increases the
supply, lowering the interest rate.
NEXT
THE TERM AND RISK STRUCTURE OF
INTEREST RATES
THANKING YOU