Chapter 2: Interest rate determination and structure

Interest rate - is a rate of return paid by a borrower of funds to a lender of them, or a price paid
by a borrower for a service, the right to make use of funds for a specified period
Risk premium - is an addition to the interest rate demanded by a lender to take into account the
risk that the borrower might default on the loan entirely or may not repay on time (default risk)
Interest rate structure - is the relationships between the various rates of interest in an economy
on financial instruments of different lengths (terms) or of different degrees of risk
Real interest rate - is the difference between the nominal rate of interest and the expected rate
of inflation. It is a measure of the anticipated opportunity cost of borrowing in terms of goods
and services forgone
Time preference - describes the extent to which a person is willing to give up the satisfaction
obtained from present consumption in return for increased consumption in the future
Loanable funds - are funds borrowed and lent in an economy during a specified period of time –
the flow of money from surplus to deficit units in the economy
liquid asset - is the one that can be turned into money quickly, cheaply and for a known
monetary value
Liquidity preference theory - is another one aimed at explaining interest rates. J. M. Keynes
has proposed (back in 1936) a simple model
Liquidity preference - is preference for holding financial wealth in the form of short-term,
highly liquid assets rather than long-term illiquid assets, based principally on the fear that long-
term assets will lose capital value over time
Yield curve - Shows the relationships between the interest rates payable on bonds with different
lengths of time to maturity. That is, it shows the term structure of interest rates
Downward-sloping or Inverted yield curve - is the one, where yields in general decline as
maturity increases
Variant of the flat yield - is the one in which the yield on short-term and long-term Treasuries
are similar but the yield on intermediate-term Treasuries are much lower than
Forward interest rates - are rates for periods commencing at points of time in the future. They
are implied by current rates for differing maturities
Forward yield curve - relates forward interest rates to the points of time to which they relate
Expectations theory - assumes that investors are indifferent between investing for a long period
on the one hand and investing for a shorter period with a view to reinvesting the principal plus
interest on the other hand
Liquidity premium theory - short-term securities are usually considered to be more liquid
because they are more likely to be converted to cash without a loss in value
Market segmentation theory - interest rates for different maturities are determined
independently of one another. The interest rate for short maturities is determined by the supply of
and demand for short-term funds
Preferred habitat theory - is a variation on the market segmentation theory. The preferred
habitat theory allows for some substitutability between maturities