• BEO2000 Financial Institutions & Monetary Theory
• Lecture 4: Determination and Term Structure of Interest Rates
• Primary Source:
• Viney & Phillips , 2015, Ch. 13, Financial Institutions, Instruments and Markets
• Learning Outcomes
• With respect to learning outcomes, you should be able to:
a. Apply the loanable funds theory to explain why interest rates change;
b. Explain the term structure theories pertaining to the shape and slope of the yield
curve;
c. Explain the relationship between interest rates, yield curves and financial institution
decision-making.
• Loanable Funds Theory
a. Loanable funds are the funds available in the financial system for lending.
• Includes all forms of credit
b. Loanable funds market assumption:
• as interest rates rise demand for credit falls (i.e. inverse relationship)
• as interest rates rise supply of credit increases.
c. Loanable Funds Theory
• Net demand for loanable funds
a. Comprises two sectors
• Business demand for funds (B)
– Short-term working capital
– Longer-term capital investment
• Government demand for funds (G)
– Finance budget deficits and intra-year liquidity
b. Net demand for loanable funds (B + G)
• Loanable Funds Theory
• Loanable Funds Theory
• Net supply of loanable funds
a. Comprises three principal sources
• Savings of household sector (S)
• Changes in money supply (M)
, • Dishoarding (D)
– Hoarding is the proportion of total savings in economy held as
currency
– Dishoarding occurs (i.e. currency holdings decrease) as interest rates
rise.
• Loanable Funds Theory
• Term Structure of Interest Rates
• The relationship between interest rates or bond yields and different terms or maturities.
a. also known as a yield curve and it plays a central role in an economy.
b. Yield is the total rate of return on an investment, comprising interest received and
any capital gain (or loss).
c. Term Structure Characteristics
• The term structure of interest rates has three important characteristics:
a. Yields for different bond maturities tends to move together over time (i.e., same
direction).
b. Yields on short-term bonds are more volatile than yields on long-term bonds.
c. Long term bond yields tend to be higher than short-term bond yields (i.e., yield
curves are typically upward sloping).
• Term Structure Characteristics 1, 2 and 3
• Yield Curves: Normal and Inverse
• Normal yield curve occurs when longer term interest rates are higher than shorter term
rates.
a. Inverse yield curve occurs when short-term interest rates are higher than longer
term rates.
• Term Structure of Interest Rates
• To explain the characteristics, and the shape and slope of yield curves, three theories are
reviewed:
a. Expectations theory
b. Market segmentation theory
c. Liquidity premium theory.
• 1. Expectations Theory
• Expectations theory is based on assumptions below:
a. large number of investors with similar expectations about value of future short-term
rates.
• Lecture 4: Determination and Term Structure of Interest Rates
• Primary Source:
• Viney & Phillips , 2015, Ch. 13, Financial Institutions, Instruments and Markets
• Learning Outcomes
• With respect to learning outcomes, you should be able to:
a. Apply the loanable funds theory to explain why interest rates change;
b. Explain the term structure theories pertaining to the shape and slope of the yield
curve;
c. Explain the relationship between interest rates, yield curves and financial institution
decision-making.
• Loanable Funds Theory
a. Loanable funds are the funds available in the financial system for lending.
• Includes all forms of credit
b. Loanable funds market assumption:
• as interest rates rise demand for credit falls (i.e. inverse relationship)
• as interest rates rise supply of credit increases.
c. Loanable Funds Theory
• Net demand for loanable funds
a. Comprises two sectors
• Business demand for funds (B)
– Short-term working capital
– Longer-term capital investment
• Government demand for funds (G)
– Finance budget deficits and intra-year liquidity
b. Net demand for loanable funds (B + G)
• Loanable Funds Theory
• Loanable Funds Theory
• Net supply of loanable funds
a. Comprises three principal sources
• Savings of household sector (S)
• Changes in money supply (M)
, • Dishoarding (D)
– Hoarding is the proportion of total savings in economy held as
currency
– Dishoarding occurs (i.e. currency holdings decrease) as interest rates
rise.
• Loanable Funds Theory
• Term Structure of Interest Rates
• The relationship between interest rates or bond yields and different terms or maturities.
a. also known as a yield curve and it plays a central role in an economy.
b. Yield is the total rate of return on an investment, comprising interest received and
any capital gain (or loss).
c. Term Structure Characteristics
• The term structure of interest rates has three important characteristics:
a. Yields for different bond maturities tends to move together over time (i.e., same
direction).
b. Yields on short-term bonds are more volatile than yields on long-term bonds.
c. Long term bond yields tend to be higher than short-term bond yields (i.e., yield
curves are typically upward sloping).
• Term Structure Characteristics 1, 2 and 3
• Yield Curves: Normal and Inverse
• Normal yield curve occurs when longer term interest rates are higher than shorter term
rates.
a. Inverse yield curve occurs when short-term interest rates are higher than longer
term rates.
• Term Structure of Interest Rates
• To explain the characteristics, and the shape and slope of yield curves, three theories are
reviewed:
a. Expectations theory
b. Market segmentation theory
c. Liquidity premium theory.
• 1. Expectations Theory
• Expectations theory is based on assumptions below:
a. large number of investors with similar expectations about value of future short-term
rates.
