Chapter 2: How Interest Rates

Are Determined

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Chapter Objectives
Definition of money, three basic functions of
money
The matter of present value
Define the types of credit instruments
The distinguish between the terms interest rate,
yield to maturity
Economic Forces That Affect Interest Rates
Organization of the Federal Reserve System

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Economists' Meaning of Money

Money is anything that is generally accepted
in payment for goods and services and for the
repayment of debts, as a matter of social
custom.
Money is defined more by its function (what
purposes it serves) than by its form (coin,
paper, gold bars, etc.).

Money must be distinguished from both

"wealth" and "income."
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Economists' Meaning of Money

The wealth of an agent at any given point in time
is the current market value of the total collection of
assets currently owned by that agent. (money
holdings, land, equipment)
On the other hand, income is a flow of value
accrued over some specified period of time.
Example: A student works as a teaching
assistant, earning $900 per month, and has a
checking account balance of $400.
He also owns a car - $1100, Books worth $500
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Economists' Meaning of Money

It means he has
Money holdings = $400;
Wealth = Market value of his asset holdings consisting
of (money holdings, car, books)
= ($400 + $1,100 + $500) = $2,000,
Income = $900 per month
Income is a flow variable, it measures an amount of
value accrued over a specified period of time
In contrast, money and wealth are both stock
variables in the sense that they measure an amount
of value at a given point in time
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Functions of Money
Money performs three basic functions in an
economy:
It serves as a unit of account;
A unit in terms of which a single price for every
good and service can be quoted
It serves as a medium of exchange;
An accepted means of payment for trade of
goods and services.
It serves as a store of value.
A repository of purchasing power for future use .
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Interest Rates, Compounding,

and Present Value
In economics, an interest rate is known as
the yield to maturity.
Compounding is the process that gives us
the value of a sum invested over time at a
positive rate of interest.
Present value is the process that tells us
how much an expected future payment is
worth today.
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Compounding
Assume you have $1 which you place in an
account paying 10% annually.
How much will you have in one year, two
years, etc?
An amount of $1 at 10% interest
Year
1
2
3
n

$1.10

$1.21

$1.33

$1(1 + i)n

Formula: FV = PV(1 + i)n

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Present Value
Present value tells us how much an
expected future payment is worth today.
Alternatively, it tells us how much we
should be willing to pay today to receive
some amount in the future.
For example, if the present value of $1.10 at
an interest rate of 10% is $1, we should be
willing to spend $1 today to get $1.10 next
year.
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Present Value Formula

There is a general relationship between present
value and future value that tells us the present
discounted value of future payment received at
a certain time.
The formula for present value can be found by
rearranging the compounding formula.
FV = PV(1 + i)
FV/(1 + i) = PV
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Present Value Example

Suppose we buy a bond that pays $10
every year for three years and then repays
the $100 principal. What is the present
value of this bond?
$10/(1.10) + $10/(1.10)2 + $110/(1.10)3 =
= $9.09 + $8.26 + $82.64 = $100

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Things to Notice
An increase in the interest rate causes
present value to fall.
Higher rates of interest mean smaller amounts
can grow to equal some fixed amount during a
specified period of time.

A decrease in the interest rate causes present

value to rise.
Lower rates of interest mean larger amounts
are needed to reach some fixed amount during
a specified period of time.
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Examples
How much must I invest today to get $10,000 in five years
if interest rates are 10%?
PV = FV/(1 + i)n
PV = $10,000/(1 +0.10)5 = $10,000/1.6105 = $6,209.2

How much must I invest today to get $10,000 in five years

if interest rates are 5%?
PV = FV/(1 + i)n
PV = $10,000/(1 + .05)5 = $10,000/1.2763 = $7,835.15

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Time Value of Money

The longer the time to maturity, the less
we need to set aside today.
This is the principal lesson of present
value. It is often referred to as the time
value of money.

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Example:
If I want to receive $10,000 in 5 years, how much do I
have to invest now if interest rates are 10%?
$10,000 = PV*(1 + 0.10)5
$10,000/1.5105 = $6209.25

If I want to receive $10,000 in 20 years, how much do I

have to invest now if interest rates are 10%?
$10,000 = PV*(1 + 0.10)20
$10,000/6.7275= $1486.44
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Types of Credit Instruments

There are four types of credit instruments:

the simple loan
the fixed payment loan
coupon bonds
discount bonds

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Types of Credit Instruments

Simple Loan Contracts:
The borrower (contract issuer) receives from
the lender (contract holder) a specified
amount of funds (the principal) for a specified
period of time (the maturity).
The borrower agrees that, at the end of this
period of time -- referred to as the maturity
date -- the borrower will repay the principal to
the lender together with an additional
payment referred to as the interest payment.
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Simple Loan Contracts

Borrower
receives
Principal
MATURITY DATE

START

Principal +
Interest payment

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Lender
receives

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Simple Loan Contracts

A borrower receives a loan on January 1,
1999, in amount $500.00, and agrees to pay
the lender $550.00 on January 1, 2001.
Principal is $500.00, the maturity is 2 years
Interest payment is $50.00.
The simple (annual) interest rate for this loan
is then $50/[$500*2] = 0.05, or 5%.
In this case $500 is PV of $550 in 2 years
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Types of Credit Instruments

Fixed-Payment Loan Contracts:
The borrower (contract issuer) receives
from the lender (contract holder) a specified
amount of funds -- the loan value -- and, in
return, makes periodic fixed payments to
the lender until a specified maturity date.
These periodic fixed payments include both
principal (loan value) and interest (there is
no lump sum repayment of principal)
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Fixed-Payment Loan Contracts

Borrower
receives
Loan value
MATURITY DATE

START
Lender
receives

Fixed
payment

Fixed
payment

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Fixed
payment

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Fixed-Payment Loan Contracts

There is 15-year installment loan with a
finance company to pay for a new car.
Under the terms of this loan, $20,000 now to
finance the purchase of a new car
Payment of $2000 every year for the next 15
years to the finance company.
The simple (annual) interest rate for this loan
is then $10000/[$20000*15] = 0.03, or 3%.

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Coupon Bond
Under the terms of coupon bond, the borrower
(bond issuer) agrees to pay the lender (bond
purchaser) a fixed amount of funds (the coupon
payment) on periodic basis until a specified
maturity date, at which time the borrower must
also pay the lender the face value (or "par
value") of the bond.
The coupon rate of coupon bond is the amount
of the coupon payment divided by the face value
of the bond.
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Coupon Bond
Borrower
receives
Purchase price
MATURITY DATE

START
Lender
receives

Coupon
payment

Coupon
payment

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Coupon
Payment +
Face value
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Example of a Coupon Bond

Suppose a coupon bond has a face value of
$1000, a maturity of five years, and an annual
coupon payment of $60.
Then, at the end of each year for the next five
years, the borrower (bond issuer) must pay the
lender (bond holder) a coupon payment of $60.
In addition, at the end of five years (the maturity
date), the borrower must pay the lender the face
value of the bond, $1000.
The coupon rate for this coupon bond is
$60/$1000 = 0.06, or 6 percent.
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Coupon Bond
PVB = C/(1 + i) + C/(1 + i)2 + C/(1 + i)3 +
..C/(1 + i)n + P/(1 + i)n
where

C is a fixed coupon
i is the rate of interest
PB is the price or present value of the bond
P is the principal
n is years to maturity

When a coupon bond is priced at its face value,

the yield to maturity equals the coupon rate.
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Yield to Maturity
Yield to maturity is the interest rate that
equates the present value of payments
received from a debt instrument with its value
today.
Tells us what the yield on a current
investment is if we hold it until maturity
Yield to maturity can be calculated using the
present value formula.
PV = FV/(1 + i)
i = (FV PV)/PV
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YTM for Simple Loans

What is the yield to maturity on a $100
loan that repays the lender $110 next
year?
$100 = $110/(1 + i)
i = ($110 - $100) / $100 = $10 / $100 =
0.10= 10%

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YTM for Fixed-Payment Loans

What is the yield to maturity on a $1000 loan
that repays the lender $126 per year for 25
years?
By using fin calculator or Excel we could find
YTM RATE(25;-126;1000;0;0) =12%

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YTM for Discount Bonds

A discount bond is one that is sold at a
discount from its face value
Yield formula:
i = (Face Value - Price Paid)/Price Paid

What is the YTM of a one-year discount

bond with a current price of $900 and a
face value of $1000?
$900 = $1000 / (1 + i)
i = ($1000 - $900) / $900 = 0.111= 11.1%
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Bond Price and Yield to Maturity

YTMs on a 10% Coupon Rate Bond Maturing in
Ten Years with Face Value of $1000
How are price and yield to maturity related?

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Price, YTM, and the Coupon Rate

Four interesting facts:
Price and yield are negatively related.
When price is above par, the yield to maturity
is less than the coupon rate.
When price is at par, the yield to maturity
equals the coupon rate.
When price is below par, the yield to maturity
is greater than the coupon rate
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Current Yield
There are also simple formulas that can
approximate yield to maturity such as current
yield
Current yield is an approximation for yield to
maturity that is used to calculate the interest
rate on a bond quickly.
Formula: Current yield = Coupon/Bond Price
A change in current yield always signals a
change in the same direction as yield to
maturity.
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Example
Assume you buy a $1,000 bond today with
a fixed coupon of $100. You are receiving
a 10% return.
Let a year pass, and you find you want to
sell you bond. You call your broker and
say, Sell!
Your broker sighs and tells you that bonds
just like yours now yield 12%. What price
can you expect to receive?
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Example
Use the current yield formula:
0.12 = $100/PB
0.12PB = $100
PB = $100/.12 = $833.33

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Even More Things to Notice

The price of a coupon bond and the yield
to maturity are inversely related.
An increase in the interest rate decreases the
bond price.
A decrease in the interest rate increases the
bond price.

This is the reason the market participants

are so interested in the actions of the
Federal Reserve.
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Interest Rates and Returns

The return to a bond depends on its stream of
coupon payments and the price the bond
receives when it is sold.
If the bond sells at a price in excess of its
original purchase price, the owner receives a
capital gain which increases his/her total return.
If the bond sells at a price below its original
purchase price, the owner suffers a capital loss,
which decreases his/her total return.
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Return on a Bond
Suppose you hold a coupon bond today (i.e. time
t) that you plan to sell one year from today. Its
rate of return would consist of two components

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Return on a Bond
The only bond whose return is certain to
equal the initial yield is the one whose
time to maturity is the same as the holding
period.
A rise in interest rates is associated with a
fall in bond prices, resulting in capital
losses on bonds whose terms to maturity
are longer than the holding period.
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Return on a Bond
The longer the bonds maturity, the greater
is the size of the price change associated
with an interest rate change.
The longer a bonds maturity, the lower is
the rate of return that occurs as a result of
the increase in the interest rate.
Even though the bond had a good interest
rate, its return became negative when
interest rates rose.
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Reinvestment Risk
Reinvestment risk occurs
when an investor holds a series of short
bonds over a long holding period and interest
rates are uncertain.
If interest rates rise, the investor gains
If interest rates fall, the investor loses

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Reinvestment Risk: Example

Assume a holding period of two years and
an investor who has decided to buy two
one year bonds sequentially.
Year 1 bond:
Face = $1000, initial interest rate = 10%
At the end of the year, the investor has $1100.

Year 2 bond:
Face = $1100, interest rate = 20%
At the end of year 2, the investor has $1320.

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Reinvestment Risk: Example

The investors two year return will be:
($1320 - $1000)/$1000 = 0.32 = 32% over two
years.
In this case the investor has benefited by
buying two one year bonds.
Conversely, if interest rates had fallen to 5%,
the investor would done less well.

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Reinvestment Risk: Example

Year 1:
($1000 x (1 + 0.10)) = $1100

Year 2:
($1100 x (1 + 0.05)) = $1155

Return = ($1155 - $1000)/$1000 = 15.5%

over two years.
The investor now loses from a change in
interest rates.
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Real and Nominal Interest

Rates
Nominal interest rate is the rate of interest
that makes no allowance for inflation.
The real interest rate is the rate of interest
that is adjusted for expected changes in
the price level.
It more accurately reflects the true cost of
borrowing and lending.

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Fisher Equation
The Fisher equation states that the nominal
interest rate equals the real interest rate
plus the expected rate of inflation

in = i r +
Rearranging terms we find:

ir = i n -

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Logic behind the Inflation

Premium
Lenders want to be compensated for the
loss in buying power due to inflation.
Buyers understand that they will be
repaying debt with dollars that buy less.
The interest rate must reflect these facts.

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Economic Forces Affected Interest

Rates

Economic Growth
Inflation
Money Supply
Budget Deficit
Foreign Flows of Funds

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Economic Forces Affected Interest

Rates
Inflation
If inflation is expected to increase
Households may reduce their savings to make
purchases before prices rise
Also, households and businesses may borrow more to
purchase goods before prices increase
The Fisher Effect
Nominal rates compensate investors two ways:
compensate for reduced purchasing power
compensate for foregoing current consumption

i n = ir +
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Economic Forces Affected Interest

Rates
Money Supply
When the Fed increases the money supply, it
increases supply of loanable funds
Places downward pressure on interest rates

Budget Deficit
Increase in deficit increases the quantity of
loanable funds demanded

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Economic Forces That Affect

Interest Rates
Foreign Flows
In recent years there has been massive flows
between countries
Driven by large institutional investors seeking
high returns
They invest where interest rates are high and
currencies are not expected to weaken
These flows affect the supply of funds available
in each country
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Origin of the Federal Reserve System

1913 Federal Reserve Act
Goal to solve problems of bank panics
Set up the structure of the Fed
12 district banks, initially decentralized
Reserve requirements for member banks

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Structure of the Federal Reserve

12 Federal Reserve district banks (Boston, New

York, Philadelphia, Atlanta, Cleveland, Chicago,
Dallas, Minneapolis, Kansas City, San
Francisco, St. Louis, and Richmond)
The three largest Fed Banks in terms of assets
are New York, Chicago, and San Francisco.
Member banks, private commercial banks
Board of Seven Governors
Federal Open Market Committee or FOMC
Advisory committees
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Organization of the Federal Reserve

Board of Governors
Seven individuals appointed by the
U.S.president and confirmed by the Senate
U.S. president appoints one of the seven
chair whose 4-year term is renewable
Offices in Washington D.C.
Serve nonrenewable 14-year term

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Board of Governors
District Banks (12)
(7 appointed members)
Propose the level of discount rate
Overall
Control monetary policy:
Keep the reserves of depository
supervision
reserve requirements
Institutions and extent the loans
Discount rate
Clear check, replace old currency,
make discount loans, collect and
Supervise and regulate
analyze data regarding economic
member banks
Situation in their districts
and bank holding companies
Public debt management
Oversight of 12 Fed district banks
Consultation

Consumer advisory
Council
Federal advisory
Council
Thrifts Institutions
Advisory Council

Execution of unified management

Federal Open Market Committee (FOMC)
12 members (7 from the Board of Governors,
President of the NY Fed and
4 other district bank presidents
Make monetary policy decisions to achieve goals
Open market operations are the purchase
or sale of government securities

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Monetary Policy Tools

Tools to decrease or increase the money
supply
Reserve requirements
Open market operations
The discount rate

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How the Fed Controls Money Supply

Banks must maintain reserves as % of
deposits
Reserves kept as deposits in Fed
Fed controls level of member bank reserve
deposits in fed
Fed influences bank deposit portion of money
supply

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Action

Interim result

Increase in
reserves
Net surplus
of reserves
Reduce of
reserve
requirements

Final result

Increase of
Depositary
institutions
assets

Increase of
Money supply

(a) Increase of
investments

Growth of
Bonds price

Drop of
Interest rates
(b) Increase of
Loans volume

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More funds
available
to loans

58

Monetary Policy Tools

Open market operations are the purchase or
sale of government securities based on
FOMC directives sent to NY Fed Trading
Desk
Open market involving the purchase of
government securities
Purchase securities from government
securities dealers
Increases the money supply
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Monetary Policy Tools

Open market operations and interest rates
Most rates are market determined but Fed
influences
Fed purchase of securities results in an
injection of additional funds into the bank
system
More funds available for commercial banks to
loan to customers
Rates drop
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Monetary Policy Tools

Adjusting the discount rate
Discount window at the Fed lends to
depository institutions
Adjustment credit for short-term liquidity
problems
Seasonal credit
Extended credit for longer liquidity problems

Lower rate, money supply increases

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Action

Interim result

Reduce of
discount rate

Increase of
Depositary
institutions
reserves

Increase of
Depositary
institutions
assets
(a) Increase of
Loans volume

Final result
Increase of
Money supply

Growth of
Bonds price

(b) Increase of
investments

Reduce of rate
on FRF

Drop of
Interest rates

The market is
steady

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