Discussion:Theories of Interest Rate Determination.
The five theories that are introduced include:
- Expectations theory suggests that long-term interest rates might act as a predictor of future short-term interest rates.
- Loanable funds theory explains the concept of credit in households, businesses, the capital market, and governments. It refers to money that is loaned and demanded by consumers and investors during a given time. The interest rate is determined by the interaction between potential savers and potential borrowers.
- Liquidity theory explains how interest rates are determined based on the desires of households to hold or save money balances, rather than invest or spend money. Money can be held as cash or in checking accounts.
- Market segmentation theory states that there is no needed relationship between long- and short-term interest rates and that both are determined independently of each other. The interest rate for short maturities is determined by a supply of, and demand for, short-term funds, whereas long-term interest rates are determined by investors who wish to lend long-term loans to borrowers seeking amounts on a long-term basis.
- Preferred habitat hypothesis offers that interest premiums should be established to lure investors from their preferred maturities to other ones; it allows for alternative maturities.
In light of the failure of the credit markets for both investors and consumers from 2004 to 2009 where risk was not ascertained correctly by risk underwriters and there was a significant mismatch between borrowers needs and investors wants, a correction occurred wherein the credit markets froze, asset values became indeterminable, and the ability of borrowers to pay back funds became constrained. We see this continuing again in another cycle, a new wave of borrower defaults is on the horizon.
How might credit managers re-evaluate risk in light of the information available over the past 5 years? Do you see any economic risk over the next 12 to 18 months based on your answer?