CHAPTER THREE

INTEREST RATE DETERMINATION

Introduction
Interest rates are among the most closely watched variables in the economy. Their movements
are reported almost daily by the news media, because they directly affect our everyday lives and
have important consequences for the health of the economy. They affect personal decisions such
as whether to consume or save, whether to buy a house, and whether to purchase bonds or put
funds into a savings account. Interest rates also affect the economic decisions of businesses and
households, such as whether to use their funds to invest in new equipment for factories or to save
their money in a bank.

In this chapter, we see that a concept known as the yield to maturity is the most accurate measure
of interest rates; the yield to maturity is what economists mean when they use the term interest
rate. We discuss, the theories of interest rates, term structure of interest rates, distinctions
between the real and nominal interest rates, and how the yield to maturity is determined

Interest rate can be defined as a rate of return paid by a borrower of funds to a lender of them, or
a price paid by a borrower for a service, the right to make use of funds for a specified period.

3.1. Theories of Interest Rates

There are two economic theories explaining the level of real interest rates in an economy: The
loanable funds theory and Liquidity preference theory

The loanable funds theory

This theory was formulated by the Swedish economist Knut Wicksell in the 1900s. According to
him, the level of interest rates is determined by the supply and demand of loanable funds
available in an economy’s credit market (i.e., the sector of the capital markets for long-term debt
instruments). This theory suggests that investment and savings in the economy determine the
level of long-term interest rates. Short-term interest rates, however, are determined by an
economy’s financial and monetary conditions.

The term ‘loanable fund’ simply refers to the sums of money offered for lending and demanded
by consumers and investors during a given period. The interest rate in the model is determined
by the interaction between potential borrowers and potential savers. According to the loanable
funds theory for the economy as a whole:
 Demand for loanable funds = net investment + net additions to liquid reserves
 Supply of loanable funds = net savings + increase in the money supply.

Given the importance of loanable funds and that the major suppliers of loanable funds are
commercial banks; the key role of this financial intermediary in the determination of interest
rates is vivid. The central bank is implementing specific monetary policy; therefore it influences

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the supply of loanable funds from commercial banks and thereby changes the level of interest
rates. As central bank increases (decreases) the supply of credit available from commercial
banks, it decreases (increases) the level of interest rates.

In an economy, there is a supply of loanable fund (i.e., credit) in the capital market by
households, business, and governments. The higher the level of interest rates, the more such
entities are willing to supply loan funds; the lower the level of interest, the less they are willing
to supply. These same entities demand loanable funds, demanding more when the level of
interest rates is low and less when interest rates are higher.

Liquidity preference theory

It was proposed by J. M. Keynes back in 1936 which explain how interest rates are determined
based on the preferences of households to hold money balances rather than spending or investing
those funds.

Saving and investment of market participants under economic uncertainty may be much more
influenced by expectations and by exogenous shocks than by underlying real forces. A possible
response of risk-averse savers is to vary the form in which they hold their financial wealth
depending on their expectations about asset prices. Since they are concerned about the risk of
loss in the value of assets, they are likely to vary the average liquidity of their portfolios.

Liquidity preference is preference for holding financial wealth in the form of short-term, highly
liquid assets rather than long-term illiquid assets, based principally on the fear that long-term
assets will lose capital value over time.

Money balances can be held in the form of currency or checking accounts, however it does earn
a very low interest rate or no interest at all. A key element in the theory is the motivation for
individuals to hold money balance despite the loss of interest income. Money is the most liquid
of all financial assets and, of course, can easily be utilized to consume or to invest. The quantity
of money held by individuals depends on their level of income and, consequently, for an
economy the demand for money is directly related to an economy’s income. There is a trade-off
between holding money balance for purposes of maintaining liquidity and investing or lending
funds in less liquid debt instruments in order to earn a competitive market interest rate. The
difference in the interest rate that can be earned by investing in interest-bearing debt instruments
and money balances represents an opportunity cost for maintaining liquidity. The lower the
opportunity cost, the greater the demand for money balances; the higher the opportunity cost, the
lower the demand for money balance.

3.2. Measuring Interest Rates

Different debt instruments have very different streams of payment with very different timing.
Thus we first need to understand how we can compare the value of one kind of debt instrument

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with another before we see how interest rates are measured. To do this, we make use of the
concept of present value.

The concept of present value (or present discounted value) is based on the commonsense
notion that a birr paid to you one year from now is less valuable to you than a birr paid to you
today: This notion is true because you can deposit a birr in a savings account that earns interest
and have more than a birr in one year.

Let’s look at the simplest kind of debt instrument, which we will call a simple loan. In this loan,
the lender provides the borrower with an amount of funds (called the principal) that must be
repaid to the lender at the maturity date, along with an additional payment for the interest. For
example, if you made your friend, a simple loan of $100 for one year, you would require him/her
to repay the principal of $100in one year’s time along with an additional payment for interest;
say, $10. In the case of a simple loan like this one, the interest payment divided by the amount of
the loan is a natural and sensible way to measure the interest rate. This measure of the so called
simple interest rate, i, is:
$ 10
i= =0 .10=10 %
100
If you make this $100 loan for one year, two years, three years or for n years, you would have

$ 100×(1+0 .10 )1=$ 110

$ 100×(1+0 .10 )2 =$ 121
$ 100×(1+0 .10 )3=$ 133
FV =PV ×(1+i)n
The process of calculating the future value of dollars received today, as we have seen above, is
called compounding the present

The process of calculating today’s value of dollars received in the futureis called discounting the
future. We can generalize this process by writing today’s (present) value of $100 as PV, the
future value of $133 as FV, and replacing 0.10 (the 10% interest rate) by i. This leads to the
following formula:
FV
PV =
( 1+i )n
In terms of the timing of their payments, there are four basic types of credit market instruments.
1. A simple loan, which we have already discussed, in which the lender provides the borrower
with an amount of funds, which must be repaid to the lender at the maturity date along with
an additional payment for the interest. Many money market instruments are of this type: for
example, commercial loans to businesses.
2. A fixed-payment loan: (which is also called a fully amortized loan) in which the lender
provides the borrower with an amount of funds, which must be repaid by making the same
payment every period (such as a month), consisting of part of the principal and interest for a

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 set number of years. For example, if you borrowed $1,000, a fixed-payment loan might
require you to pay $126 every year for 25 years. Installment loans (such as auto loans) and
mortgages are frequently of the fixed-payment type.
3. A coupon bond pays the owner of the bond a fixed interest payment (coupon payment)
every year until the maturity date, when a specified final amount (face value or par value) is
repaid. The coupon payment is so named because the bond holder used to obtain payment by
clipping a coupon off the bond and sending it to the bond issuer, who then sent the payment
to the holder. Nowadays, it is no longer necessary to send in coupons to receive these
payments. A coupon bond with $1,000face value, for example, might pay you a coupon
payment of $100 per year for ten years, and at the maturity date repays you the face value
amount of $1,000. (The face value of a bond is usually in $1,000 increments.)

A coupon bond is identified by three pieces of information. First is the corporation or

government agency that issues the bond. Second is the maturity date of the bond. Third is the
bond’s coupon rate, the dollar amount of the yearly coupon payment expressed as a percentage
of the face value of the bond. In our example, the coupon bond has a yearly coupon payment of
$100 and a face value of $1,000. The coupon rate is then $100/$1,000 = 0.10, or 10%. Capital
market instruments such as Government Treasury bonds and notes and corporate bonds are
examples of coupon bonds.

4. A discount bond (also called a zero-coupon bond) is bought at a price below its face value
(at a discount), and the face value is repaid at the maturity date. Unlike a coupon bond, a
discount bond does not make any interest payments; it just pays off the face value. For
example, a discount bond with a face value of $1,000 might be bought for $900; in a year’s
time the owner would be repaid the face value of $1,000.Treasury bills and long-term zero-
coupon bonds are examples of discount bonds.

These four types of instruments require payments at different times: Simple loans and discount
bonds make payment only at their maturity dates, whereas fixed-payment loans and coupon
bonds have payments periodically until maturity. How would you decide which of these
instruments provides you with more income? They all seem so different because they make
payments at different times. To solve this problem, we use the concept of present value,
explained earlier, to provide us with a procedure for measuring interest rates on these different
types of instruments.

Now, let us look at how the yield to maturity/interest rate is calculated for the four types of
credit market instruments.

Simple Loan: Using the concept of present value, the yield to maturity on a simple loan is easy
to calculate. For the one-year loan we discussed, today’s value is $100, and the payments in one
year’s time would be $110 (the repayment of $100 plus the interest payment of $10). We can use
this information to solve for the yield to maturity i by recognizing that the present value of the

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future payments must equal today’s value of a loan. Making today’s value of the loan ($100)
equal to the present value of the $110 payment in a year gives us:
110
$ 100=
(1+i)
Solving for i
110−100
i= =0 .10=10 %
100
This calculation of the yield to maturity should look familiar, because it equals the interest
payment of $10 divided by the loan amount of $100; that is, the yield to maturity equals the
simple interest rate on the loan.

Fixed-Payment Loan: Recall that this type of loan has the same payment every period
throughout the life of the loan. On a fixed-rate mortgage, for example, the borrower makes the
same payment to the bank every month until the maturity date, when the loan will be completely
paid off. To calculate the yield to maturity for a fixed-payment loan, we follow the same strategy
we used for the simple loan—we equate today’s value of the loan with its present value. Because
the fixed-payment loan involves more than one payment, the present value of the fixed-payment
loan is calculated as the sum of the present values of all payments

Example; Consider a loan of $1000 with fixed annual payments of $126 for the next 25 years.
Making today’s value of the loan ($1,000) equal to the sum of the present values of all the yearly
payments gives us:
FP FP FP FP
1000= 1
+ 2
+ 3
+ .. .. . .. ..+
(1+i ) (1+i ) (1+i ) (1+i) n
126 126 126 126
1000= 1
+ 2
+ 3
+ .. .. . .. ..+
(1+i ) (1+i ) (1+i ) (1+i) n

For a fixed payment loan amount, the fixed yearly payment and the number of years until
maturity are known quantities, and only the yield to maturity is not. So, solve for i.

[ ]
1
1−
PV =FP [
1−(1+i)−n =FP
i ] ( 1+i )n
i

1000=$126
i[
1−(1+i)−25
i=12 % ]
Coupon Bond- To calculate the yield to maturity for a coupon bond, follow the same strategy for
the fixed payment loan; equate today’s value of the bond with its present value. It is calculated as
the sum of the present values of all the coupon payments plus the present value of the final
payment of the face value of the bond.

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Pb = Price of coupon bond
C C C C FV
Pb = 1
+ 2
+ 3
+. .. . .. .. .+ +
(1+i) (1+i) (1+i) (1+i) (1+i)n
n

C = yearly coupon payment

FV = Face value of the bond
n= Years to maturity date

General formula:

[ ]
1
1−
Pb =C [
1−(1+i)−n
i
+
FV P =C
(1+i )n
b] (1+i )n
i
+
FV
(1+i )n
Example: What is the price ofa 10% coupon bond with a face value of $1000, a 10% yield to
maturity, and eight years to maturity?

Solution: Annual coupon (C) = 10%× 1000 = 100

[ ]
1
1−
(1+0 . 1)8 1000
Pb =100 + =$ 1000
0 .10 (1+0 .10 )8
Three interesting facts:
1. When the coupon bond is priced at its face value, the yield to maturity equals the coupon
rate. In other words, when the coupon rate is equal to the yield to maturity, the price of the
bond will be equal to its par value
2. If the yield to maturity is greater than the coupon rate, the bond will be priced below its face
value. A bond selling below par value is termed as a discount bond. For instance if the
market interest rate in the above example rises to 12.25%, the bond will sell for $889.20.
3. If the yield to maturity is less than the coupon rate, the bond is priced above its par value;
hence a bond selling above par value is called as a premium bond. Assume the market
interest rate falls to 6% in the above example, the price of the bond will be $1249.40

Generally, the price of a coupon bond and the yield to maturity are negatively related; that is, as
the yield to maturity rises, the price of the bond falls. If the yield to maturity falls, the price of
the bond rises.

To explain why the bond price declines when the interest rate rises is that a higher interest rate
implies that the future coupon payments and final payment are worthless when discounted back
to the present; hence the price of the bond must be lower.

Discount Bond: the yield to maturity calculation for a discount bond is similar to that of the
simple loan.

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Example: If a $ 1000 face value, 1 year maturity bond is currently selling at $ 900, what will be
its yield to maturity?

FV −Pd
i=
Pd Where; FV = Face Value of the bond and
Pd = current price of the discount bond
1000−900
i= =0 .111=11. 1 %
900

3.3. Real versus Nominal Interest Rates

So far in our discussion of interest rates, we have ignored the effects of inflation on the cost of
borrowing. What we have up to now been calling the interest rate makes no allowance for
inflation, and it is more precisely referred to as the nominal interest rate, which is distinguished
from the real interest rate, the interest rate that is adjusted by subtracting expected changes in
the price level (inflation) so that it more accurately reflects the true cost of borrowing. The real
interest rate is more accurately defined by the Fisher equation, named for Irving Fisher, one of
the great monetary economists of the twentieth century. The Fisher equation states that the
nominal interest rate i equals the real interest rate i r plus the expected rate of inflation π
e

i=i r +π e
Rearranging terms, we find that the real interest rate equals the nominal interest rate minus the
expected inflation rate:
i r =i− π e
To see why this definition makes sense, let us first consider a situation in which you have made a
one-year simple loan with a 5% interest rate (i =5%) and you expect the price level to rise by 3%
e
over the course of the year ( π =3 % ). As a result of making the loan, at the end of the year you
will have 2% more in real terms, that is, in terms of real goods and services you can buy. In this
case, the interest rate you have earned in terms of real goods and services is 2%; that is,
i r =5 %−3 %=2 %
Now what if the interest rate rises to 8%, but you expect the inflation rate to be 10% over the
course of the year? Although you will have 8% more dollars at the end of the year, you will be
paying 10% more for goods; the result is that you will be able to buy 2% fewer goods at the end
of the year and you are 2% worse off in real terms. This is also exactly what the Fisher definition
tells us, because:
i r =10 %−8 %=−2 %
As a lender, you are clearly less eager to make a loan in this case, because in terms of real goods
and services you have actually earned a negative interest rate of 2%. By contrast, as the
borrower, you fare quite well because at the end of the year, the amounts you will have to pay
back will be worth 2% less in terms of goods and services—you as the borrower will be ahead by

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2% in real terms. When the real interest rate is low, there are greater incentives to borrow and
fewer incentives to lend.

3.4. Risk and Term Structure of Interest Rates

Risk Structure of Interest Rates
The risk structure of interest rates (the relationship among interest rates on bonds with same
maturities) is explained by three factors: default risk, liquidity, and income tax consideration

Default Risk: One attribute of a bond that influences its interest rate is its default risk which
occurs when the issuer of the bond is unable or unwilling to make interest payments when
promised or pay off its face value when the bond matures. As the bonds default risk increases,
the risk premium on that bond (the difference between its interest rate and the interest rate on a
default free treasury bond) rises.

Liquidity: Another attribute of a bond that influences its interest rate is its liquidity. A liquid
asset is one that can be quickly and cheaply converted in to cash if the need arises. The more
liquid an asset is the more desirable it is. Government treasury bonds are the most liquid of all
long term bonds because they are so widely traded that they are the easiest to sell and the cost of
selling them is low. Corporate bonds are not as such liquid because fewer for any one
corporation are traded; thus it can be costly to sell these bonds in an emergency because it may
be hard to find buyers quickly.

Income tax consideration: if a bond has a favorable tax treatment as do municipal bond, whose
interest payments are exempt from federal income taxes, its interest rate will be lower..

Term Structure of Interest Rates

We have seen how risk, liquidity, and tax considerations (collectively embedded in the risk
structure of interest rates) can influence interest rates. Another factor that influences the interest
rate on a bond is its term to maturity. Bonds with identical risk, liquidity and tax characteristics
may have different interest rates because the time remaining to maturity is different. The
relationship between the yields on comparable securities but different maturities is called the
term structure of interest rates. The primary focus here is the Treasury market. The graph
which depicts the relationships between the interest rates payable on bonds with different lengths
of time to maturity is called the yield curve. That is, it shows the term structure of interest rates.

The focus on the Treasury yield curve functions is due mainly because of its role as a benchmark
for setting yields in many other sectors of the debt market. However, a Treasury yield curve
based on observed yields on the Treasury market is an unsatisfactory measure of the relation
between required yield and maturity. The key reason is that securities with the same maturity
may actually provide different yields.

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Hence, it is necessary to develop more accurate and reliable estimates of the Treasury yield
curve. It is important to estimate the theoretical interest rate that the Treasury would have to pay
assuming that the security it issued is a zero-coupon security.

If the term structure is plotted at a given point in time, based on the yield to maturity, or the spot
rate, at successive maturities against maturity, one of the three shapes of the yield curve would
be observed. The type of yield curve, when the yield increases with maturity, is referred to as an
upward-sloping yield curve or a positively sloped yield curve. A distinction is made for upward
sloping yield curves based on the steepness of the yield curve. The steepness of the yield curve is
typically measured in terms of the maturity spread between the long-term and short-term yields.

A downward-sloping or inverted yield curve is the one, where yields in general decline as
maturity increases.

A variant of the flat yield is the one in which the yield on short-term and long-term Treasuries
are similar. But the yield on intermediate-term Treasuries are much lower than, for example, the
six-month and 30-year yields. Such a yield curve is referred to as a humped yield curve.

YTM A: Upward slopping YTM B: Downward slopping

YTM C: Flat YTM D: Humped

Theories of term structure of interest rates

There are several major economic theories that explain the observed shapes of the yield curve:
 Expectations theory
 Liquidity premium theory
 Market segmentation theory

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Expectations theory
The pure expectations theory assumes that investors are indifferent between investing for along
period on the one hand and investing for a shorter period with a view to reinvesting the principal
plus interest on the other hand. For example an investor would have no preference between
making a 12-month deposit and making a 6-month deposit with a view to reinvesting the
proceeds for a further six months so long as the expected interest receipts are the same. This is
equivalent to saying that the pure expectations theory assumes that investors treat alternative
maturities as perfect substitutes for one another.

The pure expectations theory assumes that investors are risk-neutral. A risk-neutral investor is
not concerned about the possibility that interest rate expectations will prove to be incorrect, so
long as potential favorable deviations from expectations are as likely as unfavorable ones. Risk is
not regarded negatively.

However, most investors are risk-averse, i.e. they are prepared to forgo some investment return
in order to achieve greater certainty about return and value of their investments. As a result of
risk-aversion, investors may not be indifferent between alternative maturities. Attitudes to risk
may generate preferences for either short or long maturities. If such is the case, the term structure
of interest rates (the yield curve) would reflect risk premiums.

If an investment is close to maturity, there is little risk of capital loss arising from interest rate
changes. A bond with a distant maturity (long duration) would suffer considerable capital loss in
the event of a large rise in interest rates. The risk of such losses is known as capital risk.

To compensate for the risk that capital loss might be realized on long-term investments, investors
may require a risk premium on such investments. A risk premium is an addition to the interest or
yield to compensate investors for accepting risk. This results in an upward slope to a yield curve.
This tendency towards an upward slope is likely to be reinforced by the preference of many
borrowers to borrow for long periods (rather than borrowing for a succession of short periods).

Some investors may prefer long maturity investments because they provide greater certainty of
income flows. This uncertainty is income risk. If investors have a preference for predictability of
interest receipts, they may require a higher rate of interest on short term investments to
compensate for income risk. This would tend to cause the yield curve to be inverted (downward
sloping).

The effects on the slope of the yield curve from factors such as capital risk and income risk are in
addition to the effect of expectations of future short-term interest rates. If money market
participants expect short-term interest rates to rise, the yield curve would tend to be upward
sloping. If the effect of capital risk were greater than the effect of income risk, the upward slope
would be steeper. If market expectations were that short-term interest rates would fall in the
future, the yield curve would tend to be downward sloping. A dominance of capital-risk aversion

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over income-risk aversion would render the downward slope less steep (or possibly turn a
downward slope into an upward slope).

Liquidity premium theory

Some investors may prefer to own shorter rather than longer term securities because a shorter
maturity represents greater liquidity. In such case they will be willing to hold long term securities
only if compensated with a premium for the lower degree of liquidity. Though long-term
securities may be liquidated prior to maturity, their prices are more sensitive to interest rate
movements. Short-term securities are usually considered to be more liquid because they are more
likely to be converted to cash without a loss in value. Thus there is a liquidity premium for less
liquid securities which changes over time. The impact of liquidity premium on interest rates is
explained by liquidity premium theory.

Market segmentation theory

According to the market segmentation theory, interest rates for different maturities are
determined independently of one another. The interest rate for short maturities is determined by
the supply of and demand for short-term funds. Long-term interest rates are those that equate the
sums that investors wish to lend long term with the amounts that borrowers are seeking on a
long-term basis. According to market segmentation theory, investors and borrowers do not
consider their short-term investments or borrowings as substitutes for long-term ones. This lack
of substitutability keeps interest rates of differing maturities independent of one another. If
investors or borrowers considered alternative maturities as substitutes, they may switch between
maturities. However, if investors and borrowers switch between maturities in response to interest
rate changes, interest rates for different maturities would no longer be independent of each other.
An interest rate change for one maturity would affect demand andsupply, and hence interest
rates, for other maturities.

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