Value & Capital, CHAPTER XI, Section 4

This section continues the discussion of interest rates on loans of various durations, based on the view of a long-duration loan as a series of single-period loans (the text uses a week as the length of a single period).  The text notes that interest rates for loans beginning in a future week "are strictly analogous to the futures prices" discussed in the previous chapter "and are determined in almost exactly the same way."

The previous chapter's discussion of forward trading discusses the role of hedging and speculation in bringing about the coordination of plans in a private enterprise economy. A similar distinction of hedgers and speculators is relevant in discussing the market for long-terms, although the author concedes that "it is not usual" to think of the loan market in this way.  The text notes that, all other things being equal, someone who "[enters into] a long-term loan contract puts himself into a more risky position than he would be in if he refrained from making it;  but there are some persons (and concerns) for whom this will not be true."  For a person or firm already committed to a large project that will require capital over a large number of future time periods, entering into a long-term loan will amount to hedging their future supplies of loan capital.  This opportunity to reduce their risk will give them a strong incentive to borrow long.

The text notes that there does not appear to be a similar incentive on the other side of the market, but it does mention "an important circumstance which demands attention."  The discussion goes on to explain that, essentially, there are some fixed costs of making a loan, regardless of the size of the loan.  Thus "the difficulty of short lending may sometimes have the effect of driving lenders into the long market."  Although this effect may be real, the text implies that it is relatively weak, and therefore, "If no extra return is offered for long lending, most people (and institutions) would prefer to lend short."

The result of these effects on the demand and supply for loan capital will tend toward "a large excess of demands to borrow long which would not be met.  Borrowers would thus need to offer better terms in order to persuade lenders to switch over into the long market (that is to say, enter the forward market)."  As with speculators in the forward commodity market, lenders in the long loan market would only participate if by so doing, they "gain sufficiently to offset the risk incurred."  To balance supply and demand for loanable funds, the interest rate for any particular future week must be high enough to induce a sufficient quantity of loan capital to be available for the loan contracts.  This forward short rate will have to be higher than the short rate the lenders expect to see in that future period, in order to compensate the lenders for the risk they incur.  The excess above the expected rate corresponds to a risk premium analogous to that in forward commodity markets.  If there is an expectation that future rates will rise, the excess will be even greater;  if rates are expected to fall, the premium will be reduced.

The section closes by noting that these rules "must also apply to the long rates themselves, which, as we saw in the last section, are effectively an average of the forward rates."