5.

3 The Determinants of Interest Rates 137

If the interest rate is 9%, the NPV falls to

3 3 3 3
NPV = −10 + + + + = −$0.281 milliion
1.09 1.092 1.093 1.09 4
and the investment is no longer profitable. The reason, of course, is that we are discounting
the positive cash flows at a higher rate, which reduces their present value. The cost of $10
million occurs today, however, so its present value is independent of the discount rate.
More generally, when the costs of an investment precede the benefits, an increase in the
interest rate will decrease the investment’s NPV. All else equal, higher interest rates will
therefore tend to shrink the set of positive-NPV investments available to firms. The Fed-
eral Reserve in the United States and central banks in other countries use this relationship
between interest rates and investment to try to guide the economy. They can raise interest
rates to reduce investment if the economy is “overheating” and inflation is on the rise, and
they can lower interest rates to stimulate investment if the economy is slowing or in reces-
sion.
Monetary Policy, Deflation, and the 2008 Financial Crisis. When the 2008 finan-
cial crisis struck the economy, the U.S. Federal Reserve responded quickly to mitigate its
impact on the broader economy by cutting its short-term interest rate target to 0% by
year’s end. But while this use of monetary policy is generally quite effective, because con-
sumer prices were falling in late 2008, the inflation rate was negative, and so even with a
0% nominal interest rate the real interest rate remained positive. The consequence of this
deflation, and the risk that it might continue, meant that the Federal Reserve was “out of
ammunition” with regard to its usual weapon against an economic slowdown—it could
not lower rates further.5 This problem was one of the reasons the U.S. and other govern-
ments began to consider other measures, such as increased government spending and
investment, to stimulate their economies. Former Federal Reserve Governor Frederic S.
Mishkin further discusses monetary policy during the economic crisis of 2008–2009 in the
interview box on page 139.

The Yield Curve and Discount Rates

You may have noticed that the interest rates that banks offer on investments or charge on
loans depend on the horizon, or term, of the investment or loan. The relationship between
the investment term and the interest rate is called the term structure of interest rates. We
can plot this relationship on a graph called the yield curve. Figure 5.2 shows the term
structure and corresponding yield curve of risk-free U.S. interest rates in November of
2006, 2007, and 2008. In each case, note that the interest rate depends on the horizon,
and that the difference between short-term and long-term interest rates was especially pro-
nounced in 2008.
We can use the term structure to compute the present and future values of a risk-free
cash flow over different investment horizons. For example, $100 invested for one year at
the one-year interest rate in November 2008 would grow to a future value of
$100 × 1.0091 = $100.91

5
Why couldn’t the Federal Reserve go further and make nominal interest rates negative? Since individuals
can always hold cash (or put their money in a savings account) and earn at least a zero return, the nom-
inal interest rate can never be significantly negative. But because storing cash is costly, and because
investors viewed many banks as unsafe, short-term U.S. Treasury interest rates were actually slightly neg-
ative (down to –0.05%) at several points throughout this period! (See Chapter 8 for further discussion.)

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 138 Chapter 5 Interest Rates

Term Structure of Risk-Free U.S. Interest Rates, November 2006, 2007, and 2008
FIGURE 5.2
The figure shows the interest rate available from investing in risk-free U.S. Treasury
securities with different investment terms. In each case, the interest rates differ
depending on the horizon. (Data from U.S. Treasury STRIPS.)

6%
Term Date
(years) Nov-06 Nov-07 Nov-08 November 2006
0.5 5.23% 3.32% 0.47% 5%

Interest Rate (EAR)

1 4.99% 3.16% 0.91%
2 4.80% 3.16% 0.98% 4%
3 4.72% 3.12% 1.26% November 2007
4 4.63% 3.34% 1.69%
3%
5 4.64% 3.48% 2.01%
6 4.65% 3.63% 2.49% November 2008
7 4.66% 3.79% 2.90% 2%
8 4.69% 3.96% 3.21%
9 4.70% 4.00% 3.38% 1%
10 4.73% 4.18% 3.41%
15 4.89% 4.44% 3.86% 0%
20 4.87% 4.45% 3.87% 0 2 4 6 8 10 12 14 16 18 20
Term (Years)

at the end of one year, and $100 invested for ten years at the ten-year interest rate in
November 2008 would grow to6
$100 × (1.0341)10 = $139.84
We can apply the same logic when computing the present value of cash flows with dif-
ferent maturities. A risk-free cash flow received in two years should be discounted at the
two-year interest rate, and a cash flow received in ten years should be discounted at the ten-
year interest rate. In general, a risk-free cash flow of Cn received in n years has present value
Cn
PV = (5.6)
(1 + rn )n
where rn is the risk-free interest rate (expressed as an EAR) for an n-year term. In other
words, when computing a present value we must match the term of the cash flow and term
of the discount rate.
Combining Eq. 5.6 for cash flows in different years leads to the general formula for the
present value of a cash flow stream:
Present Value of a Cash Flow Stream Using a Term Structure of Discount Rates
N
C1 C2 CN Cn
PV = +
1 + r1 (1 + r2 )2
+L+
(1 + rN ) N
= ∑ n
(5.7)
n =1 (1 + rn )

Note the difference between Eq. 5.7 and Eq. 4.4. Here, we use a different discount rate for
each cash flow, based on the rate from the yield curve with the same term. When the yield
curve is relatively flat, as it was in November 2006, this distinction is relatively minor and is
6
We could also invest for 10 years by investing at the one-year interest rate for 10 years in a row. How-
ever, because we do not know what future interest rates will be, our ultimate payoff would not be risk free.

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