Nm NOMINAL INTEREST RATES

• Interest rates actually observed in financial markets

• Directly affect value of securities
• The figure shows a decreasing interest rates to stimulate the economy- more economic
agents are participating in the market
LOANABLE FUNDS THEORY

• Views equilibrium interest rates in financial markets as a result of the supply of and
demand for loanable funds
• Explains interest rates movements
• Consumers, businesses, governments, and foreign participants- as net suppliers or
demanders of funds

LOANABLE FUNDS THEORY

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1
0
1 2 3 4 5

Supply Demand

SUPPLY OF LOANABLE FUNDS

• Funds provided by net suppliers of funds

• ↑ interest rates ↑ loanable funds supplied – the reward for supplying funds is higher so
more funds are supplied
• ↑ total wealth of a consumer ↑ total supply of loanable funds from that consumer
• ↑interest rates ↑ supply ng loanable funds – matutuwa ang mga may excess fund
kasi pag nagpautang sila Malaki ang return
• ↓ interest rate ↓ supply of loanable funds – bakit nila ipapautang yung excess funds
nila ay mababa ang interest?
• Households – supply income – kapag may excess funds
• Households determine their supply of loanable funds NOT ONLY on level of interest
rates BUT ALSO on risk of securities investments
• ↑ risk ↓ supply of loanable funds
• Near-term needs ↓supply of loanable demands
• ↑ loanable funds – kung gusto ng government ma-rescue ang government
• During financial crisis: yung ibang investors ay naghahanap ng “safe haven” for their
funds - ↓ yield sa treasury bills — BINABAYARAN NG INVESTORS ANG
GOVERNMENT TO BORROW MONEY
DEMAND FOR LOANABLE FUNDS

• ↓ interest rates ↑ demand for loanable funds

• ↑ interest rates – mas gusto ng businesses ang internally generated funds
• OFHC - ↑interest rates ↓ demand of loanable funds – kasi nga mataas ang interest, konti
lang ang users or mangungutang
• ↓ interest rates ↑ demand of loanable funds – matutuwa yung users kasi makakautang
sila at lower rate
•
• BETTER overall economic conditions ↑ demand for loanable funds
• Foreign borrowers – gusto nila ng cheapest source of dollar funds

EQUILIBRIUM INTEREST RATE

• Aggregate supply of loanable funds = sum of quantity supplied by separate fund

supplying sectors ( ganito din sa demand)
• Interest rate: higher than the equilibrium rate – financial system has SURPLUS of
loanable funds
• Bababa ↓ ang interest rate tapos yung demanders i-ABSORB nila yung surplus
• Interest rate: lower sa equilibrium – merong DEFICIT of loanable funds
• Tataas ↑ ang interest rate para mag-invest ang mga suppliers ng loanable funds,
tapos bababa ↓ naman ang demanders – MERON NA ULIT EQUILIBRIUM

LOANABLE FUNDS THEORY

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5
4
3 Equilibrium interest rate

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1
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1 2 3 4 5

Supply Demand

• Yellow – surplus
• Green – deficit
FACTORS THAT CAUSE THE SUPPLY AND DEMAND CURVES FOR LOANABLE FUNDS
TO SHIFT
1. SUPPLY OF FUNDS
a. Wealth - ↑ wealth of participants ↑ absolute dollar value available for investment
purposes ↑ supply of loanable funds – shifts DOWN and to the RIGHT

SUPPLY
5
Interest rate 4
3
2
1
0
1 2 3 4 5
Supply of Loanable funds

b. Risk - ↑ risk ↓ supply of loanable funds

SUPPLY
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5
Interest rate

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1 2 3 4 5
Supply of Loanable funds

c. Near-term spending needs – ↑ near-term spending needs ↓ supply of loanable

funds

SUPPLY
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Interest rate

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3
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1
0
1 2 3 4 5
Supply of Loanable funds
 d. Monetary Expansion – when monetary policy ALLOW economy to EXPAND, ↑
supply of funds
• Pag nirestrict ang rate of economic expansion (inflation), ↓ supply of
funds

SUPPLY
5
4

Interest rate 3
2
1
0
1 2 3 4 5
Supply of Loanable funds

e. Economic Conditions - ↓ inflation rate, unemployment rate or ↑ economic growth

↑ supply of loanable funds

SUPPLY
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4
Interest rate

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2
1
0
1 2 3 4 5
Supply of Loanable funds

2. DEMAND OF FUNDS
a. Utility Derived from Assets Purchased with Borrowed Funds - ↑ level of
satisfaction ↑ demand for loanable funds

DEMAND
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4
Interest rate

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2
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1 2 3 4 5
Demand of Loanable funds
 b. Restrictiveness of Non-price Conditions on Borrowed Funds- ↑ restrictions ↓
demand

DEMAND
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4

Interest rate 3
2
1
0
1 2 3 4 5
Demand of Loanable funds

c. Economic Conditions - ↓ unemployment rate, inflation rate ↑ demand for

loanable funds

DEMAND
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4
Interest rate

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2
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0
1 2 3 4 5
Demand of Loanable funds

EFFECT OF INTEREST RATE IN FINANCIAL MARKETS

1. Cost of Borrowing (stock prices)
• POV: CONSUMER - ↑ COB ↓ disposable income ↓ spending ↓ gross sales ng
businesses ↓ income (why would you invest at high price for a decreasing
income?) ↓ stock prices
• POV: BUSINESS - ↑ COB ↓ expansion ↓ gross sales ↓ income ↓ stock price
2. Bond prices – inverse (dating na-issue ng funds ang tinutukoy dito, yung price before
maturity) – IKAW ANG BORROWER
• With same maturity and amount – PREFER LOWER RATE
• With same maturity and rate – PREFER LOWER AMOUNT

FACTORS AFFECTING NOMINAL INTEREST RATES

a. Inflation
 • ↑inflation ↑ interest rates
• An investor who buys a financial asset must EARN HIGHER INTEREST when
inflation increases to COMPENSATE for increased cost of foregoing
consumption of real goods and services today and buying these more highly
priced goods and services in the future
𝐶𝐶𝐶𝐶𝐶𝐶 −𝐶𝐶𝐶𝐶𝐶𝐶𝑡𝑡
• 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 (𝐼𝐼𝐼𝐼) = 𝑡𝑡+1 × 100
𝐶𝐶𝐶𝐶𝐶𝐶𝑡𝑡
• A pinautang si B ng 10,000 at 5% interest edi 10,500 tapos ang inflation ay 6%
edi 10,600 – TALO pa ng 100 – ang real interest ay 1% (100/10000)
b. Real risk-free rate
• Interest rate on a risk-free security if NO INFLATION were expected over the
holding period
c. Default risk
• ↑default risk ↑interest rate demanded by buyer of security
• POV: lender
• A ay government employee, financial analyst
• B ay freelancer
• Both needed 10,000, sinong papautangin mo?
• Syempre kung magpapautang ka both kay A at B, hindi parehas ang rate
• Higher interest kay B para ma-compensate yung risk nab aka hindi sya
makabayad
• Si A ay mataas ang credit worthiness kaya mababa ang risk of default
• Kay A – walang reason to increase default risk premium kasi hindi tatakbo sa
utang
d. Liquidity risk
• Kapag illiquid, nagdadagdag ng liquidity risk premium sa interest rate ang
investor
• Kumuha ka ng dalawang security
• Yung security 1 ay liquid, madaling mabenta
• Yung security 2 ay illiquid, umaabot ng 3 yrs bago mo mabenta
• Saan ka magpapatong ng mas mataas na interest?
• Syempre KUNG SAAN BENEFICIAL, LOW NOMINAL INTEREST RATE
• Mas mababa ang interest rate kay 1 than security 2
• Kapag gusting mabenta ang bonds quickly, expect lower price kasi mas mataas
ang price kung hihintayin nila ang maturity
• Nagdedemand ng liquidity premium ang investors para ma-compensate yung
lack ng liquidity
e. Special Provision/Covenants
» Taxability
• Bank A may 10 % tax
• Bank B, malakas sa government, mababa ang tax
• Doon tayo kay Bank B kasi mas mababa ang tax, bababa ang loss
• ↑ taxability ↑ real interest rate
» Convertibility
• Bond holders to stockholders (preference) – beneficial
• ↑ convertibility ↓ interest rate
 »Callable
• 10-year bond, after 10 years pa ang bayaran
• Kay A, strict 10 years – BENEFICIAL SA LENDER to enjoy interest
income
• Kay B, pwedeng i-call anytime – pabor sa borrower
• ↑ callability ↑ interest rates
b. Term of maturity
• NO ABSOLUTE GENERAL RULE na pag-ikli ng maturity ay pagbaba or pagtaas
ng interest

Fisher Effect

• Relationship of real risk-free rate (RFR), expected rate of inflation [E(IP)], and nominal
interest rate (i)
• Nominal risk-free rate must compensate investors for
• any reduced purchasing power on funds lent due to inflationary price changes
• and an additional premium above expected rate of inflation for forgoing present
consumption
• nominal risk-free rate > real risk-free rate due to inflation
• 𝑖𝑖 = 𝑅𝑅𝑅𝑅𝑅𝑅 ÷ 𝐸𝐸(𝐼𝐼𝐼𝐼)
• Kapag ZERO ang inflation rate then RFR = i
• Kapag ZERO ang RFR then I = E(IP)

TERM STRUCTURE OF INTEREST RATES

a. Unbiased Expectations Theory
• At some point in time – yung yield curve reflects market current expectations of
future short-term rates
• Kapag may 4-year investment horizon ang isang investor, pwedeng bumili ng
current 4-year bond tapos mag-earn ng spot yield on a 4-year bond O mag-invest
nang 4 beses sa 1-year bonds na ang alam lang nila ay yung 1-year spot rate
pero meron silang expectations nung future 1-year rates
• Dapat yung return of holding 4-year bond ay mag-equal sa expecting return nung
4 an 1-year bond
• Kung mas mataas ang kikitain kung 1-year bond edi ipagbenta na nya yung 4-
year bond nya tapos gamitin ang proceeds para bilhin yung 1-year bonds
• ↑future 1-year rates ↑magslope-upward ang yield curve
• Kapag naman constant, yung 4-year bonds ay magiging equal sa 3-year bond
b. Liquidity premium theory
• Ang weakness ng unbiased = it assumes na equally willing to invest in short-term
at long-term ang isang investor – assumes they are RISK NEUTRAL
• Ditto naman, yung mga investors daw ay maghohold lang ng long-term kung may
premium to compensate yung future uncertainty
• Kasi mas marketable ang short-term kasi mababa ang uncertainty
 •Kasi mas sensitive sa interest rate changes ang long-term
•Longer maturity - ↑risk ↑ liquidity premium
•Kapag expectations sa short-term rates ay FLAT, yung yield curve ay sloping
upward
• Kapag yung liquidity premiym ay nag increase with maturity, upward din ang
yield curve
c. Market Segmentation Theory
• Weakness nung dalwa: inaassume nila na walang preference ang investors to
different maturities
• Ditto naman, inargue na merong preference
• Para maka-hold sila ng securities with maturities other than sa preferred nila,
dapat ↑ interest rate
• Inaassume na investors at borrowers ay unwilling to shift from maturity sector to
another kung walang compensation like higher interest rate
• ↓ supply of short-term securities ↑ supply of long-term market – STEEPER ang
yield curve
• ↑ supply of short-term securities ↓supply of long-term securities – FLATTER ang
yield curve

TIME VALUE OF MONEY AND INTEREST RATES

Time Value of Money

• “a dollar received today is worth more than a dollar received at some future date.”
• Interest rate or return reflects the fact that people generally prefer to concume now
rather than wait until later
Lump Sum Valuation
𝐹𝐹𝐹𝐹
• 𝑡𝑡
𝑃𝑃𝑃𝑃 = (1+𝑟𝑟) 𝑡𝑡

• ↑ Interest rate ↓ PV of investment at a decreasing rate

• 𝐹𝐹𝐹𝐹 = 𝑃𝑃𝑃𝑃(1 + 𝑟𝑟)𝑡𝑡
• ↑ interest rate ↑ FV of investment at increasing rate

BONDS
Advantages
• Less risky
• More flexible
• Debt instrument/fixed income security
• Priority to corporate liquidation
• Has maturity value
 • Can be traced prior to maturity
Coupon Payment
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 × 𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣
𝑪𝑪𝑪𝑪𝑪𝑪 =
𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁 𝑜𝑜𝑜𝑜 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 𝑝𝑝𝑝𝑝𝑝𝑝 𝑌𝑌𝑌𝑌𝑌𝑌𝑌𝑌
Yield to Maturity
𝐹𝐹𝐹𝐹
𝑷𝑷 = (1+𝑌𝑌𝑌𝑌𝑌𝑌 𝑛𝑛
𝑛𝑛 )
𝐹𝐹𝐹𝐹 1
Or 𝒀𝒀𝒀𝒀𝒀𝒀𝑛𝑛 = ( ) − 1
𝑛𝑛
𝑃𝑃

Coupon Bonds
3. Current price is not equal to face value
Zero-coupon bonds – short maturity (t-bills of P10,000 for 1 year)
Yield to maturity

• IRR
RISK AND RETURN

Probability Distributions

• When investment is risky, there are different returns it may earn

• Each return has likelihood of occurring summarized in probability distributions

Expected Return

• With probability distribution, we can compute expected return

• Is the weighted average of possible returns

• Expected return is the return we would earn on average if we could repeat the
investment many times
• Is the balancing point of distribution if probabilities are weight

Variance and Standard deviatiton

• Measures of risk of a probability distribution

• Variance – expected squared deviation from the mean
• Standard deviation – square root of the variance
• if return is RISK-FREE and NEVER derives from mean – variance is ZERO
• variance – HOW SPREAD OUT is a distribution
 • standard deviation is VOLATILITY

Estimation Error: Using Past Returns to Predict the Future

• If distribution of past returns and distribution of future returns are the same, we could
look at the return investors expected to earn in the past on the same or similar
investments, and assume they will require the same return in the future
• There are 2 difficulties:
o We do not know what investors expected in the past; we can only observe actual
returns that were realized.
o The average return is just an estimate of true expected return, and is subject to
estimation error.
Standard Error

• Estimation error of a statistical estimate

• Is the standard deviation of estimated value of mean of actual distribution around its true
value; that is, it the standard deviation of average return
• Indicates how far a sample average might deviate from expected return.

Limitations of Expected Return Estimates

• Individual stock are more volatile than large portfolios
• Average return investors earned in past is not reliable estimate of security’s expected
return

Trade-off Between Risk and Return

• Investors are risk-averse

• Benefit from increase in income < personal cost of equivalent decrease in income
• Investors will not hold portfolio that is more volatile unless there is higher return
Returns of Large Portfolio

• Excess return- difference of average return for investment and average return for T-bills
• Investors with higher volatility have higher average returns
• Riskier investments must offer investors higher average returns to compensate for the
extra risk
Returns of Individual stocks

• If we look a volatility and return of individual stocks, we DO NOT SEE any clear
relationship
o There is relation between size and risk: larger stock has ↓ volatility overall
 o Even largest stocks are more volatile than portfolio of large stocks
o There is no clear relationship between volatility and return

Common VS. Independent Risk

• Theft versus Earthquake insurance

o There is 1% the house is robbed, and 1% chance the house is damaged by
earthquake – insurance company will pay same claim
o Theft – of 100,000 houses, we would expect 1,000 claims per year – if insurance
company has reserves for 1200 claims, then it has enough to meet obligations
o Earthquake – all homes will be affected and insurance company would expect
100,000 claims – it will need 100,000 reserves
• Theft – will be very close to 1% - has almost no risk
• Earthquake – risky – there is 1% chance that it will pay on all policies it wrote

Types of risk

• Earthquake affects all houses simultaneously – COMMON RISK

• Theft in different houses are not related to each other – INDEPENDENT RISK
• Averaging out independent risks – DIVERSIFICATION
Role of Diversification

• Theft

o There is almost NO RISK

o Diversification is used in insurance
o Insurers can achieve some diversification by selling policies in different
geographical regions
o Diversification REDUCES risk

Diversification in Stock Portfolios

Firm-Specific vs. systematic risk

• Stock prices and dividends fluctuate due to 2 type of news:

1. Firm-specific news – good or bad news about company itself (announce that it is
successful in gaining market share within its industry
 2. Market-wide news – news about the economy as a whole (Federal reserve might
announce that it will lower interest rates to boost economy
• Fluctuations of stock’s return due from firm-specific risk news are INDEPENDENT
RISKS – like theft (firm-specific, idiosyncratic, unique, diversifiable risk)
• Fluctuations of stock’s return due to market-wide – COMMON RISK – like earthquakes
(systematic, undiversifiable, or market risk)

• Pag pinagsama ang mga stocks sa isang portfolio, yung mga firm-specific risk ng each
stock ay magaaverage and madidiversify
• Pag market-risk – maapektuhan lahat ng stocks, at ang buong portfolio

No Arbitrage and the Risk Premium

• In type I firms (affected by firm-specific risk)

• Because each individual type 1 firm is risky, should investors expect to earn a risk
premium when investing in type I firms? – NO kasi nga, mababa naman ang risk kaya
hindi na natin kailangan taasan ang interest rate
• This is close to arbitrage opportunity – mangungutang ang investor at risk-free interest
rate tapos invest nila sa large portfolio of type I firms na may higher return with maliit na
risk
• Kung maraming investors ang ganito ang gagawin, tataas ang current share price
• Law of One Price: Because a large portfolio of type I firms has no risk, it must earn the
risk-free interest rate
• General – “ang risk premium ng diversifiable risk ay ZERO – investors ay hindi
compensated for holding firm-specific risk
• Investors can eliminate risk FOR FREE
• General – “ang risk premium ay determined ng systematic risk at hindi nakadepende sa
diversifiable risk

Measuring Systematic Risk

• Nagccare ang investors sa systematic risk na hindi kayang gamutin ng diversification

• In exchange of bearing systematic risk – investors want to compensate this with higher
return

Identifying Systematic risk

• Aalamin natin kung gaano ka-sensitive ang stock sa systematic shocks

• Example – aalamin natin how much the return tends to change on average for each 1%
change in interest rates
1. Maghanap ng portfolio na merong systematic risk lang – EFFICIENT portfolio
(walang way to reduce the risk) – candidate is MARKET portfolio (portfolio ng
lahat ng stocks traded in capital markets) – use S&P 500
Sensitivity to Systematic Risk: Beta

• Beta of a security is the expected % change in its return given a 1% change in the return
of the market portfolio