Fisher Effect
Nominal interest rates observed in FM must
compensate investors for:
1. Reduced purchasing power on funds lent due to
inflationary price
2. Additional premium above the expected rate of
inflation for forgoing present consumption
 RIR= 0, nominal interest = expected inflation
rate
Default or Credit Risk
- The higher the default risk, the higher the
interest rate that will be demanded by the
buyer of the security (supplier of the fund) to
compensate him or her for this default
exposure
- Not all securities exhibit default
(Government issued securities)
- Difference between a quoted interest rate on a
security and a Treasury security with similar
features
Liquidity Risk
- Interest rate on a security reflects its relative
liquidity, with highly liquid assets carrying the
lowest interest rates
- Investors demand a liquidity premium on top of
all other premiums to compensate for the
bond’s lack of liquidity and the potential price
discount of selling it early.
- A liquidity risk premium may also be added to a
security with a longer maturity because of its
exposure to price risk
Special Provisions or Covenants
- May either benefit or adversely affect investors
 Treasury bond, is taxable at the federal level
but not the state or local levels
 Corporate bond, taxable in both local and
federal level
 Special provisions that provide benefits to the
security holder are associated with lower
interest rates
 Special provisions that provide benefits to the
security issuer are associated with higher
interest rates
Unbiased Expectations Hypothesis
- Shape of the yield of the curve is determined by
the market’s current expectations of future
short-term interest rates
- Geometric averages of current and future short-
term interest rates
First subscript
risk - Period in which the security is bought
Second subscript
- Maturity of the security
 Return to holding a four-year bond to maturity
= the return of investing in four successive one-
year bonds (if not, it will result to arbitrage
opportunity)
Liquidity Premium Theory
- Extension of the unbiased expectations theory
- Geometric averages of current and expected
short-term rates plus liquidity risk premiums
Idea: investors will only hold long-term maturities only
if they are offered at a premium to compensate for
future uncertainty in a security’s value
 Short-term securities provide greater
marketability and have less price risk than long-
term securities due to an active secondary
market and smaller price fluctuations
 Long-term securities are sensitive to interest
rate changes
  The longer the maturity the greater the risk Assumption: any interest or other return earned on a
 Liquidity premium increases as maturity dollar invested over any given period of time is
increases immediately reinvested
Market Segmentation Theory - TVM can be used to convert cash flows over an
- Individual investors and FIs have specific investment horizon into a value at the end of
maturity preferences the investment horizon
- In order for them to hold long-term securities Simple Interest
would require a higher interest rate (maturity - The interest earned in year 1 is not carried out
premium to year thus, it does not earn interest
 Determined by distinct supply and demand Compound Interest
conditions within a particular maturity - Interest earned in year 1 is carried out to year 2
segment and earns interest (interest on interest on year)
Forecasting Interest Rates - By compounding interest using the time value
 as the interest rates change, so do the value of of money, investor increases his or her return
financial securities compared to the simple interest

 If interest rates rise, the value of investment Present Value of a Lump Sum

portfolios of FIs and individuals will fall, - Discounting future cash flows back to the

resulting in a loss of wealth present using the current market rate of

Forward rate interest

- By using the equation representing the Effect of interest on the PV of securities:

unbiased expectations theory, market’s - as interest rate increases, the PV of the security

expectation of forward rates can be derived investment decreases at a decreasing rate

directly from existing or actual rates on - the greater the number of compounding

securities currently traded in the spot market. periods per year, the smaller the present value

- f= forward rate of a future value

Time Value of Money Reason: as interest increase, fewer funds need to be

- A dollar received today is worth more than a invested at the beginning of an investment horizon to

dollar received at some future date receive a stated amount at the end of the investment

Reason: a dollar received today can be invested and its horizon

value enhanced by an interest rate or return - the inverse relationship

- The interest rate or return reflects the fact that - the inverse relationship between interest rates

people generally prefer to consume now rather and the present value of security investments is

than wait until later neither linear nor proportional

Future Value
- future value of an investment increases as
interest rates increases
 - as interest rates increase, future value increase
at an increasing rate
Reason: the stated amount of funds invested at the beg.
of an investment horizon accumulates to a larger
amount at the end of the investment horizon
- as the number of compounding periods per year
increases, the future value of a present amount
increases

Future Value of an Annuity

- last annuity payment occurs on the last day of
the investment horizon
- it earns no interest
- First annuity payment earns only 5 years of
interest
Effective Annual Return
- If interest is paid or compounded more than
once per year, the true annual rate earned or
paid will differ from the simple annual rate
- EAR provides a more accurate measure of
annual returns in TVM calculations