Interest Rate Determination and Money Markets

1. Interest rates – also called required return. It represents the cost of money. It is the
compensation that a supplier of funds expects, and a demander of funds must pay. A rate which
is charged or paid for the use of money.

For example, if a lender (such as a bank) charges a customer $90 in a year on a loan of $1000,
then the interest rate would be 90/1000 *100% = 9%.

the term interest rate is applied to debt instruments such as bank loans or bonds while the term
required return is applied to equity investments, such as common stocks etc.

Factors that influence Interest Rates

a. Inflation - A rising trend in the prices of most goods and services. The annual inflation rate in
the Philippines unexpectedly fell to 2.4% in August 2020 from 2.7% in the prior month and
compared with market consensus of 2.8%. This was the lowest since May, amid sluggish
demand due to the COVID-19 pandemic.

The formula for calculating the Inflation Rate looks like this:

((B - A)/A)*100

Where "A" is the Starting number and "B" is the ending number.

So if exactly one year ago the Consumer Price Index was 178 and today the CPI is 185, then
the calculations would look like this:
((185-178)/178)*100
or
(7/178)*100
or
0.0393*100
= 3.93%

b. Risk - When people perceive that a particular investment is riskier, they will expect a higher
return on that investment as compensation for bearing the risk. Risk is defined in financial
terms as the chance that an outcome or investment's actual gains will differ from an
expected outcome or return. Risk includes the possibility of losing some or all of an original
investment.
c. Liquidity preference - refers to the general tendency of investors to prefer short-term
securities (that is, securities that are more liquid). investors would prefer to buy short-term
rather than long-term securities, interest rates on short-term instruments such as Treasury
bills will be lower than rates on longer-term securities. Investors will hold these securities,
despite the relatively low return that they offer, because they meet investors’ preferences
for liquidity.
2. Real Rate of Interest - The rate that creates equilibrium between the supply of savings and the
demand for investment funds in a perfect world, without inflation, where suppliers and
demanders of funds have no liquidity preferences and there is no risk.

3. Nominal or Actual Rate of Interest - is the actual rate of interest charged by the supplier of
funds and paid by the demander. The nominal rate of interest differs from the real rate of
interest, r*, as a result of two factors, inflation and risk. When people save money and invest it,
they are sacrificing consumption today. When investors expect inflation to occur, they believe
that the price of consuming goods and services will be higher in the future than in the present,
since increasing inflation tends to increase the prices of consumer goods. Investors will demand
a higher nominal rate of return if they expect inflation. This higher rate of return is called the
expected inflation premium (IP).

Similarly, investors generally demand higher rates of return on risky investments as compared to
safe ones. Otherwise, there is little incentive for investors to bear the additional risk. Therefore,
investors will demand a higher nominal rate of return on risky investments. This additional rate
of return is called the risk premium (RP). Therefore, the nominal rate of interest for security 1,
r1, is

Where: r1 = Nominal rate of interest

r* = Real rate of interest
IP = Inflation Premium
Rf = Risk-free rate
RP1 = Risk Premium
A real interest rate is an interest rate that has been adjusted to remove the effects of inflation
to reflect the real cost of funds to the borrower and the real yield to the lender or to an
investor. A nominal interest rate refers to the interest rate before taking inflation into
account. Nominal can also refer to the advertised or stated interest rate on a loan, without
taking into account any fees or compounding of interest.

Comprehensive example:
Marilyn Carbo has $10 that she can spend on candy costing $0.25 per piece. She could buy 40
pieces of candy ($10.00 $0.25) today. The nominal rate of interest on a 1-year deposit is
currently 7%, and the expected rate of inflation over the coming year is 4%. Instead of buying
the 40 pieces of candy today, Marilyn could invest the $10. After one year she would have
$10.70 because she would have earned 7% interest—an additional $0.70 —on her $10 deposit.
During that year, inflation would have increased the cost of the candy by 4%—an additional
$0.01 —to $0.26 per piece. As a result, at the end of the 1-year period Marilyn would be able to
buy about 41.2 pieces of candy ($10.70 $0.26), or roughly 3% more . The 3% increase in
Marilyn’s buying power represents her real rate of return. The nominal rate of return on her
investment (7%), is partly eroded by inflation (4%), so her real return during the year is the
difference between the nominal rate and the inflation rate . (7% - 4% = 3%) (41.2 , 40.0 = 1.03) ,
(0.04 * $0.25) (0.07 * $10.00).

$10.00 r1 = 7% $10.70

$0.25 Inflation = 4% $0.26

40 pcs of candy IP = 3% 41.2 pcs of candy IP = 3%

To give another example, let’s assume you deposit USD 10’000 in your bank account. The
account pays an annual interest rate of 3%. After one year your balance has increased to USD
10’300. That means, you have accumulated USD 300 in interest on your account. The annual
interest rate of 3% in this example is the nominal interest rate. However, if you are familiar with
the concept of inflation, you will know that this does not necessarily mean that you are in fact
USD 300 “richer” now. As implied above, to see how much you can actually profit from a 3%
nominal interest rate, we need to consider the effects of inflation. And that’s where the real
interest rate comes into play.

To illustrate this, let’s revisit our example. In one year, you accumulated USD 300 in interest
with a nominal interest rate of 3%. Now, let’s say during the same period, the overall price level
in the economy has increased by 1%. In this case, your money is worth less now than it was a
year ago. Its buying power has decreased, because now you need more money to buy the same
amount of goods. Therefore, to see how much you can actually profit from the additional USD
300, we need to adjust for the effects of inflation. In our example, that means we subtract 1%
(inflation rate) from 3% (nominal interest rate), which results in a real interest rate of 2%. That
means, your actual buying power has increased by 2%.
4. Term structure of Interest Rates - is the relationship between the maturity and rate of return
for bonds with similar levels of risk. When graphed, the term structure of interest rates is known
as a yield curve, and it plays a crucial role in identifying the current state of an economy. The
term structure of interest rates reflects expectations of market participants about future
changes in interest rates and their assessment of monetary policy conditions.

In general terms, yields increase in line with maturity, giving rise to an upward-sloping, or
normal, yield curve. The yield curve is primarily used to illustrate the term structure of interest
rates for standard U.S. government-issued securities. This is important as it is a gauge of the
debt market's feeling about risk. The most frequently reported yield curve compares the three-
month, two-year, five-year, 10-year, and 30-year U.S. Treasury debt. (Yield curve rates are
usually available at the Treasury's interest rate web sites by 6:00 p.m. ET each trading day),

The term of the structure of interest rates has three primary shapes.

a. Upward sloping—long term yields are higher than short term yields. This is considered to be
the "normal" slope of the yield curve and signals that the economy is in an expansionary
mode.
b. Downward sloping—short term yields are higher than long term yields. Dubbed as an
"inverted" yield curve and signifies that the economy is in, or about to enter, a recessive
period.
c. Flat—very little variation between short and long term yields. Signals that the market is
unsure about the future direction of the economy.

5. Interest Rates Theory

a. Loanable Funds Theory - According to this theory, rate of interest is determined by the
demand for and supply of loanable funds. In this regard this theory is more realistic and
broader than the classical theory of interest.

According to this theory, demand for loanable funds arises from the following purposes:

1. Investment - The main source of demand for loanable funds is the demand for
investment. Investment refers to the expenditure for the purchase of making of new
capital goods including inventories. The price of obtaining such funds for the purpose of
these investments depends on the rate of interest. An entrepreneur while deciding
upon the investment is to compare the expected return from an investment with the
rate of interest. If the rate of interest is low, the demand for loanable funds for
investment purposes will be high and vice- versa. This shows that there is an inverse
relationship between the demands for loanable funds for investment to the rate of
interest.
2. Hoarding - The demand for loanable funds is also made up by those people who want to
hoard it as idle cash balances to satisfy their desire for liquidity. The demand for
loanable funds for hoarding purpose is a decreasing function of the rate of interest. At
low rate of interest demand for loanable funds for hoarding will be more and vice-versa.
 3. Dissaving - Dissaving’s is opposite to an act of savings. This demand comes from the
people at that time when they want to spend beyond their current income. Like
hoarding it is also a decreasing function of interest rate.

The supply of loanable funds is derived from the basic four sources as savings, dishoarding,
disinvestment and bank credit. They are explained as:

1. Savings - Savings constitute the most important source of the supply of loanable funds.
Savings is the difference between the income and expenditure. Since, income is
assumed to remain unchanged, so the amount of savings varies with the rate of interest.
Individuals as well as business firms will save more at a higher rate of interest and vice-
versa.
2. Dishoarding - Dishoarding is another important source of the supply of loanable funds.
Generally, individuals may dishoard money from the past hoardings at a higher rate of
interest. Thus, at a higher interest rate, idle cash balances of the past become the active
balances at present and become available for investment. If the rate of interest is low
dishoarding would be negligible.
3. Disinvestment - Disinvestment occurs when the existing stock of capital is allowed to
wear out without being replaced by new capital equipment. Disinvestment will be high
when the present interest rate provides better returns in comparison to present
earnings. Thus, high rate of interest leads to higher disinvestment and so on.
4. Bank Money - Banking system constitutes another source of the supply of loanable
funds. The banks advance loans to the businessmen through the process of credit
creation. The money created by the banks adds to the supply of loanable funds.

b. Liquidity Preference Theory - Liquidity preference theory is a model that suggests that an
investor should demand a higher interest rate or premium on securities with long-term
maturities that carry greater risk because, all other factors being equal, investors prefer cash
or other highly liquid holdings.

According to this theory, which was developed by John Maynard Keynes in support of his
idea that the demand for liquidity holds speculative power, investments that are more liquid
are easier to cash in for full value. Cash is commonly accepted as the most liquid asset.
According to the liquidity preference theory, interest rates on short-term securities are
lower because investors are not sacrificing liquidity for greater time frames than medium or
longer-term securities.

Understanding Liquidity Preference Theory

World-renowned economist John Maynard Keynes introduced liquidity preference theory in

his book The General Theory of Employment, Interest and Money. Keynes describes the
liquidity preference theory in terms of three motives that determine the demand for
liquidity.
 First, the transactions motive states that individuals have a preference for liquidity in order
to guarantee having sufficient cash on hand for basic day-to-day needs. In other words,
stakeholders have a high demand for liquidity to cover their short-term obligations, such as
buying groceries, paying rent and/or the mortgage. Higher costs of living mean a higher
demand for cash/liquidity to meet those day-to-day needs.

Second, the precautionary motive relates to an individual's preference for additional

liquidity in the event that an unexpected problem or cost arises that requires a substantial
outlay of cash. These events include unforeseen costs like house or car repairs.

Third, stakeholders may also have a speculative motive. When interest rates are low,
demand for cash is high and they may prefer to hold assets until interest rates rise. The
speculative motive refers to an investor's reluctance to tying up investment capital for fear
of missing out on a better opportunity in the future.

When higher interest rates are offered, investors give up liquidity in exchange for higher
rates. As an example, if interest rates are rising and bond prices are falling, an investor may
sell their low paying bonds and buy higher paying bonds or hold onto the cash and wait for
an even better rate of return.

6. Term Structure Theories

a. Expectations Theory - Expectations theory attempts to predict what short-term interest

rates will be in the future based on current long-term interest rates. The theory suggests
that an investor earns the same interest by investing in two consecutive one-year bond
investments versus investing in one two-year bond today. The theory is also known as the
"unbiased expectations theory."

• Expectations theory predicts future short-term interest rates based on current long-
term interest rates
• The theory suggests that an investor earns the same amount of interest by investing
in two consecutive one-year bond investments versus investing in one two-year
bond today
• In theory, long-term rates can be used to indicate where rates of short-term bonds
will trade in the future

Calculating Expectations Theory:

Let's say that the present bond market provides investors with a two-year bond that pays an
interest rate of 20% while a one-year bond pays an interest rate of 18%. The expectations
theory can be used to forecast the interest rate of a future one-year bond.

• The first step of the calculation is to add one to the two-year bond’s interest rate.
The result is 1.2.
 • The next step is to square the result or (1.2 * 1.2 = 1.44).
• Divide the result by the current one-year interest rate and add one or ((1.44 / 1.18)
+1 = 1.22).
• To calculate the forecast one-year bond interest rate for the following year, subtract
one from the result or (1.22 -1 = 0.22 or 22%).

In this example, the investor is earning an equivalent return to the present interest rate of a
two-year bond. If the investor chooses to invest in a one-year bond at 18%, the bond yield
for the following year’s bond would need to increase to 22% for this investment to be
advantageous.

Disadvantage of Expectations Theory

Investors should be aware that the expectations theory is not always a reliable tool. A
common problem with using the expectations theory is that it sometimes overestimates
future short-term rates, making it easy for investors to end up with an inaccurate prediction
of a bond’s yield curve.

Another limitation of the theory is that many factors impact short-term and long-term bond
yields. The Federal Reserve adjusts interest rates up or down, which impacts bond yields,
including short-term bonds. However, long-term yields might be less affected because many
other factors impact long-term yields, including inflation and economic growth expectations.

As a result, the expectations theory does not consider the outside forces and fundamental
macroeconomic factors that drive interest rates and, ultimately, bond yields.

b. Liquidity Premium Theory - The liquidity premium theory of interest rates is a key concept in
bond investing. It follows one of the central tenets of investing: the greater the risk, the
greater the reward. The theory is one of several that collectively seek to explain the shape
of the yield curve – the interest rates that investors receive for buying bonds of different
maturities.

The liquidity premium theory focuses on the question of how quickly an asset can be sold in
the market without lowering its stated price.

One of the most closely watched graphs among investors is the yield curve, also known as
the term structure of interest rates. It plots the yields, or investment returns, of a specific
category of bonds on the y-axis against time on the x-axis. The most popular version of the
yield curve tracks U.S. Treasury debt from three-month Treasury bills through 30-year
Treasury bonds. Yield curves can be constructed for all bond types, such as municipal bonds
or corporate bonds with different credit ratings, such as AAA-rated corporate bonds.

Liquidity refers to how quickly an asset can be sold without lowering its price. Generally
speaking, markets with many participants are highly liquid relative to markets with fewer
participants. The liquidity premium theory states that bond investors prefer highly liquid,
short-dated securities that can be sold quickly over long-dated ones. The theory also
 contends that investors are compensated for higher default risk and price risk from changes
in interest rates.

An upward-sloping yield curve supports the liquidity premium theory. Suppose that the yield
curve for U.S. Treasuries offers the following yields: 2.5 percent for three-month bills, 2.75
percent for one-year notes, 3.25 percent for five-year bonds, 4.5 percent for 10-year bonds
and 6.25 percent for 30-year bonds. The rising yield curve is consistent with the liquidity
premium theory, with the U.S. government paying investors progressively higher rates for
debt with longer maturities.

However, the yield curve isn’t always upward-sloping: sometimes it zigzags, flattens out or
even becomes inverted. In these cases it’s clear that the liquidity premium theory alone is
insufficient to explain the shape of the curve.

Economists have devised other theories to account for these situations, including the
expectations theory, which states that the yield curve reflects future expectations about
interest rates. Another approach is the market segmentation theory, which argues that
financial institutions prefer to invest in bonds with maturities that match their liabilities.

c. Market Segmentation Theory - is a theory that long and short-term interest rates are not
related to each other. It also states that the prevailing interest rates for short, intermediate,
and long-term bonds should be viewed separately like items in different markets for debt
securities.
• Market segmentation theory states that long- and short-term interest rates are not
related to each other because they have different investors.
• Related to the market segmentation theory is the preferred habitat theory, which
states that investors prefer to remain in their own bond maturity range due to
guaranteed yields. Any shift to a different maturity range is perceived as risky.

Understanding Market Segmentation Theory

This theory's major conclusions are that yield curves are determined by supply and demand
forces within each market/category of debt security maturities and that the yields for one
category of maturities cannot be used to predict the yields for a different category of
maturities.

Market segmentation theory is also known as the segmented markets theory. It is based on
the belief that the market for each segment of bond maturities consists mainly of investors
who have a preference for investing in securities with specific durations: short,
intermediate, or long-term.

Market segmentation theory further asserts that the buyers and sellers who make up the
market for short-term securities have different characteristics and motivations than buyers
and sellers of intermediate and long-term maturity securities. The theory is partially based
on the investment habits of different types of institutional investors, such as banks and
 insurance companies. Banks generally favor short-term securities, while insurance
companies generally favor long-term securities.

A Reluctance to Change Categories

A related theory that expounds upon the market segmentation theory is the preferred
habitat theory. The preferred habitat theory states that investors have preferred ranges of
bond maturity lengths and that most shift from their preferences only if they are
guaranteed higher yields. While there may be no identifiable difference in market risk, an
investor accustomed to investing in securities within a specific maturity category often
perceives a category shift as risky.

Implications for Market Analysis

The yield curve is a direct result of the market segmentation theory. Traditionally, the yield
curve for bonds is drawn across all maturity length categories, reflecting a yield relationship
between short-term and long-term interest rates. However, advocates of the market
segmentation theory suggest that examining a traditional yield curve covering all maturity
lengths is a fruitless endeavor because short-term rates are not predictive of long-term
rates.

d. Preferred Habitat Theory - is a term structure theory suggesting that different bond investors
prefer one maturity length over another and are only willing to buy bonds outside of their
maturity preference if a risk premium for the maturity range is available. The theory also
suggests that when all else is equal, investors prefer to hold short-term bonds in place of
long-term bonds and that the yields on longer-term bonds should be higher than shorter-
term bonds.
• Preferred habitat theory says that investors prefer certain maturity lengths over
others when it comes to the term structure of bonds.
• Investors are only willing to buy outside of their preferences if enough of a risk
premium (higher yield) is embedded in the other bonds.
• The preferred habitat theory suggests that all else equal, investors should prefer
shorter-term bonds over longer-term—meaning yields on long-term bonds should be
higher.
• Meanwhile, market segmentation theory suggests that investors only care about
yield, willing to buy bonds of any maturity.

Securities in the debt market can be categorized into three segments—short-term,

intermediate-term, and long-term debt. When these term maturities are plotted against
their matching yields, the yield curve is shown. The movement in the shape of the yield
curve is influenced by a number of factors including investor demand and supply of the debt
securities.

The market segmentation theory states that the yield curve is determined by supply and
demand for debt instruments of different maturities. The level of demand and supply is
influenced by the current interest rates and expected future interest rates. The movement
in supply and demand for bonds of various maturities causes a change in bond prices. Since
 bond prices affect yields, an upward (or downward) movement in the prices of bonds will
lead to a downward (or upward) movement in the yield of the bonds.

If current interest rates are high, investors expect interest rates to drop in the future. For
this reason, the demand for long-term bonds will increase since investors will want to lock-
in the current prevalent higher rates on their investments. Since bond issuers attempt to
borrow funds from investors at the lowest cost of borrowing possible, they will reduce the
supply of these high interest-bearing bonds. The increased demand and decreased supply
will push up the price for long-term bonds, leading to a decrease in long-term yield. Long-
term interest rates will, therefore, be lower than short-term interest rates. The opposite of
this phenomenon is theorized when current rates are low and investors expect that rates
will increase in the long-term.

7. Money Market - refers to trading in very short-term debt investments. At the wholesale level, it
involves large-volume trades between institutions and traders. At the retail level, it includes
money market mutual funds bought by individual investors and money market accounts opened
by bank customers.

In all of these cases, the money market is characterized by a high degree of safety and relatively
low rates of return.

• The money market involves the purchase and sale of large volumes of very short-term
debt products, such as overnight reserves or commercial paper.
• An individual may invest in the money market by purchasing a money market mutual
fund, buying a Treasury bill, or opening a money market account at a bank.
• Money market investments are characterized by safety and liquidity, with money
market fund shares targeted to $1.

The money market is one of the pillars of the global financial system. It involves overnight swaps
of vast amounts of money between banks and the U.S. government. The majority of money
market transactions are wholesale transactions that take place between financial institutions
and companies.

Institutions that participate in the money market include banks that lend to one another and to
large companies in the eurocurrency and time deposit markets; companies that raise money by
selling commercial paper into the market, which can be bought by other companies or funds;
and investors who purchase bank CDs as a safe place to park money in the short term. Some of
those wholesale transactions eventually make their way into the hands of consumers as
components of money market mutual funds and other investments.

In the wholesale market, commercial paper is a popular borrowing mechanism because the
interest rates are higher than for bank time deposits or Treasury bills, and a greater range of
maturities is available, from overnight to 270 days.1 However, the risk of default is significantly
higher for commercial paper than for bank or government instruments.
Types of Money Market Instruments

Money Market Funds

The wholesale money market is limited to companies and financial institutions that lend and
borrow in amounts ranging from $5 million to well over $1 billion per transaction. Mutual funds
offer baskets of these products to individual investors. The net asset value (NAV) of such funds is
intended to stay at $1. During the 2008 financial crisis, one fund fell below that level.3 That
triggered market panic and a mass exodus from the funds, which ultimately led to additional
restrictions on their access to riskier investments.

Money Market Accounts

Money market accounts are a type of savings account. They pay interest, but some issuers offer
account holders limited rights to occasionally withdraw money or write checks against the
account. (Withdrawals are limited by federal regulations. If they are exceeded, the bank
promptly converts it to a checking account.) Banks typically calculate interest on a money
market account on a daily basis and make a monthly credit to the account.

In general, money market accounts offer slightly higher interest rates than standard savings
accounts. But the difference in rates between savings and money market accounts has
narrowed considerably since the 2008 financial crisis. Average interest rates for money market
accounts vary based on the amount deposited. As of August 2020, the best-paying money
market account with no minimum deposit offered 0.99% annualized interest.

Certificates of Deposit (CDs)

Most certificates of deposit (CDs) are not strictly money market funds because they are sold
with terms of up to 10 years. However, CDs with terms as short as three months to six months
are available.

As with money market accounts, bigger deposits and longer terms yield better interest rates.
Rates in August 2020 for twelve-month CDs ranged from about 0.5% to 1.5% depending on the
size of the deposit.5 Unlike a money market account, the rates offered with a CD remain
constant for the deposit period. There is a penalty associated with any early withdrawal of funds
deposited in a CD.

Commercial Paper

The commercial paper market is for buying and selling unsecured loans for corporations in need
of a short-term cash infusion. Only highly creditworthy companies participate, so the risks are
low.

Banker's Acceptances

The banker's acceptance is a short-term loan that is guaranteed by a bank. Used extensively in
foreign trade, a banker's acceptance is like a post-dated check and serves as a guarantee that an
exporter can pay for the goods. There is a secondary market for buying and selling banker's
acceptances at a discount.
Eurodollars

Eurodollars are dollar-denominated deposits held in foreign banks, and are thus, not subject to
Federal Reserve regulations. Very large deposits of eurodollars are held in banks in the Cayman
Islands and the Bahamas. Money market funds, foreign banks, and large corporations invest in
them because they pay a slightly higher interest rate than U.S. government debt.

Repos

The repo, or repurchase agreement, is part of the overnight lending money market. Treasury
bills or other government securities are sold to another party with an agreement to repurchase
them at a set price on a set date.