Question

Understanding how capital markets function is critical to the effective management of corporate growth opportunities as the ability to raise funds will have a direct influence on the success or failure of future projects. Discuss the following: Who are the suppliers of loanable funds? What factors influence the supply of funds available to a corporation? What influences changes in the supply and demand curves? What are the six factors that determine the nominal interest rate on a security?

Answer 1

The supply of loanable funds is based on savings and hence the suppliers of loanable funds are primarily the consumer sector (also known as the household sector) in any given economy. The household sector saves a part of their income and in turn provides loanable funds in exchange for holding securities. As and when the wealth of households increase so will the quantum of supply of loanable funds will also increase. Other suppliers of loanable funds are financial businesses and foreign investors.

The factors that affect the supply of funds available to a corporation are rate of economic growth, general level of interest rates, level of total wealth of the household, and risk of the securities investment.

Changes in supply and demand curve are influenced by the quantity of a financial security supplied or demanded which changes at every change in interest rate. I am referring here to the real interest rate. It should be noted that real interest rate is nothing but nominal interest rate that has been adjusted for inflation. As the interest rate decreases the quantity of loans demanded will increase and hence the demand curve will witness an upward shift. So changes in supply and demand curve are influenced by changes in the anticipated rate of return earned on investment spending and by the government policies as well.

The six factors that determine the nominal interest rate on a security are:

1. Inflation
2. Default risk
3. Maturity risk
4. Government intervention
5. Premium for expected inflation and terms
6. Liquidity