Ch5 MARA 641

INTRO COST OF MONEY DETERMINANTS TERM STRUCTURE EST.
FUTURE RATES
Chapter 5
Interest Rates
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INTRO COST OF MONEY DETERMINANTS TERM STRUCTURE EST. FUTURE RATES
What factors affect the level of interest rates?
• Production
• Consumption
• Risk
Determinants of Interest Rates
r = r* + IP + DRP + LP + MRP
r = required return on a debt (bond) security

r* = real interest rate
IP = inflation premium
DRP = default risk premium
LP = liquidity premium
MRP = maturity risk premium
Premiums Added to r* for Different Types of Debt
IP MRP DRP LP
S-T Treasury 
L-T Treasury  
S-T Corporate   
L-T Corporate    
S-T = Short-Term; L-T = Long-Term.
Yield Curve and the Term Structure of Interest

Rates
•
Yield Curve for April 2014
Term structure: Interest
Rate (%)
16
relationship between Yield Curve for March
14
interest rates (or yields) 12
1980
and maturities. 10
• The yield curve is a 8 Yield Curve for

February 2000
graph of the term 6
structure. 4
•
2 Yield Curve for
The April 2014 Treasury 0

April 2014
0 10 20 30
yield curve is shown at Years to Maturity
the right.
Short Intermediate Long
Term Term Term
Determinants of Interest Rates
r = r* + IP + DRP + LP + MRP
r = required return on a debt (bond) security

r* = real interest rate
IP = inflation premium
DRP = default risk premium
LP = liquidity premium
MRP = maturity risk premium
Constructing the Yield Curve: Inflation
• Step 1: Find the average expected inflation

rate over Years 1 to N:
N
 INFL t
t 1
IPN 
N
Constructing the Yield Curve: Inflation
Assume inflation is expected to be 5% next year,

6% the following year, and 8% thereafter.
IP1  5% / 1  5.00%
IP10  [5%  6%  8%(8)] / 10  7.50%
IP20  [5%  6%  8%(18)] / 20  7.75%
Must earn these IPs to break even vs. inflation;

these IPs would permit you to earn r* (before
taxes).
Constructing the Yield Curve:

Maturity Risk
• Step 2: Find the appropriate maturity risk

premium (MRP). For this example, the
following equation will be used to find a
security’s appropriate maturity risk premium.
MRPt = 0.1% (t – 1)
T: Number of years (year-to-maturity)
Constructing the Yield Curve:

Maturity Risk
Using the given equation:
MRP1  0.1%  (1  1)  0.0%

MRP10  0.1%  (10  1)  0.9%
MRP20  0.1%  (20  1)  1.9%
Notice that since the equation is linear, the

maturity risk premium is increasing as the time to
maturity increases, as it should be.
“Nominal” vs. “Real” Rates
r = represents any nominal rate

r* = represents the “real” risk-free rate of
interest.
rRF = represents the rate of interest on Treasury
securities.
Add the IPs and MRPs to r* to Find the

Appropriate Nominal Rates
Step 3: Adding the premiums to r*.

rRF, t = r* + IPt + MRPt
Assume r* = 3%,
Treasury bond yield is:
rRF,1  3%  5%  0.0%  8.0%
rRF,10  3%  7.5%  0.9%  11.4%
rRF,20  3%  7.75%  1.9%  12.65%
Relationship Between Treasury Yield Curve and

Yield Curves for Corporate Issues
• Corporate yield curves are higher than that of

Treasury securities.
• The spread between corporate and Treasury
yield curves widens as the corporate bond
rating decreases.
• Since corporate yields include a default risk
premium (DRP) and a liquidity premium (LP),
the corporate bond yield spread can be
calculated as:
Corporate bond
 Corporate bond yield  Treasury bond yield
yield spread
 DRP  LP
Illustrating the Relationship Between Corporate

and Treasury Yield Curves
Pure Expectations Theory
• The pure expectations theory contends that the

shape of the yield curve depends on investors’
expectations.
Macroeconomic Factors That Influence

Interest Rate Levels
• Federal reserve policy

• Federal budget deficits or surpluses
• International factors
• Level of business activities
• Unemployment rate
• GDP and its growth
• Consumer confidence
• Real and expected inflation
Practice Questions
1. Which of the following factors would be most likely to lead to an

increase in nominal interest rates?
a. Households reduce their consumption and increase their savings.
b. A new technology like the Internet has just been introduced,
and it increases investment opportunities.
c. There is a decrease in expected inflation.
d. The economy falls into a recession.
e. The Federal Reserve decides to try to stimulate the economy.
Practice Questions
2. Which of the following would be most likely to lead to a higher level

of interest rates in the economy?
a. Households start saving a larger percentage of their income.
b. Corporations step up their expansion plans and thus increase
their demand for capital.
c. The level of inflation begins to decline.
d. The economy moves from a boom to a recession.
e. The Federal Reserve decides to try to stimulate the economy.
Practice Questions
3. Which of the following statements is CORRECT, other things held

constant?
a. If companies have fewer good investment opportunities, interest rates
are likely to increase.
b. If individuals increase their savings rate, interest rates are likely to
increase.
c. If expected inflation increases, interest rates are likely to increase.
d. Interest rates on all debt securities tend to rise during recessions
because recessions increase the possibility of bankruptcy, hence the
riskiness of all debt securities.
e. Interest rates on long-term bonds are more volatile than rates on short-
term debt securities like T-bills.
Practice Questions
4. Suppose the U.S. Treasury issued $50 billion of short-term securities

and sold them to the public. Other things held constant, what would be
the most likely effect on short-term securities' prices and interest rates?
a. Prices and interest rates would both rise.
b. Prices would rise and interest rates would decline.
c. Prices and interest rates would both decline.
d. Prices would decline and interest rates would rise.
e. There is no reason to expect a change in either prices or interest
rates.
Practice Questions
5. Assume the following: The real risk-free rate, r*, is expected to remain constant at
3%. Inflation is expected to be 3% next year and then to be constant at 2% a year
thereafter. The maturity risk premium is zero. Given this information, which of the
following statements is CORRECT?
a. The yield curve for U.S. Treasury securities will be upward sloping.
b. A 5-year corporate bond must have a lower yield than a 5-year Treasury security.
c. A 5-year corporate bond must have a lower yield than a 7-year Treasury security.
d. The real risk-free rate cannot be constant if inflation is not expected to remain
constant.
e. This problem assumed a zero maturity risk premium, but that is probably
not valid in the real world.
Practice Questions
6. Assume that interest rates on 20-year Treasury and corporate bonds

are as follows:
T-bond = 7.72% AAA = 8.72% A = 9.64% BBB = 10.18%
The differences in these rates were probably caused primarily by:
a. Tax effects.
b. Default and liquidity risk differences.
c. Maturity risk differences.
d. Inflation differences.
e. Real risk-free rate differences.
Practice Questions
7. Which of the following statements is CORRECT?

a. The yield on a 3-year Treasury bond cannot exceed the yield on a
10-year Treasury bond.
b. The yield on a 2-year corporate bond should always exceed the
yield on a 2-year Treasury bond.
c. The yield on a 3-year corporate bond should always exceed the
yield on a 2-year corporate bond.
d. The yield on a 10-year AAA-rated corporate bond should always
exceed the yield on a 5-year AAA-rated corporate bond.
e. The following represents a "possibly reasonable" formula for the
maturity risk premium on bonds: MRP = −0.1%(t), where t is the years
to maturity.
Practice Questions
8. The real risk-free rate of interest is expected to remain constant at 3% for the foreseeable
future. However, inflation is expected to increase steadily over the next 30 years, so the
Treasury yield curve has an upward slope. Assume that the pure expectations theory holds.
You are also considering two corporate bonds, one with a 5-year maturity and one with a 10-
year maturity. Both have the same default and liquidity risks. Given these assumptions, which
of these statements is CORRECT?
a. Since the pure expectations theory holds, the 10-year corporate bond must have the same
yield as the 5-year corporate bond.
b. Since the pure expectations theory holds, all 5-year Treasury bonds must have higher
yields than all 10-year Treasury bonds.
c. Since the pure expectations theory holds, all 10-year corporate bonds must have the same
yield as 10-year Treasury bonds.
d. The 10-year Treasury bond must have a higher yield than the 5-year corporate bond.
e. The 10-year corporate bond must have a higher yield than the 5-year corporate bond.
Practice Questions
9. The Federal Reserve tends to take actions to ______ interest rates

when the economy is very strong and to ______ rates when the
economy is weak.
a. Decrease; increase
b. Decrease; decrease
c. Increase; increase
d. Increase; decrease
Practice Questions
10. The "yield curve" shows the relationship between_____

a. Bonds' maturities and their yields
b. Equity prices and their risk
c. Long-term debt values and their correlations to equity prices
d. The price of options (call and put) that will be expired after one year
or more.

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INTRO COST OF MONEY DETERMINANTS TERM STRUCTURE EST.

What factors affect the level of interest rates?

Determinants of Interest Rates

r = required return on a debt (bond) security

Premiums Added to r* for Different Types of Debt

S-T = Short-Term; L-T = Long-Term.

Yield Curve and the Term Structure of Interest

• The yield curve is a 8 Yield Curve for

graph of the term 6

The April 2014 Treasury 0

Determinants of Interest Rates

r = required return on a debt (bond) security

Constructing the Yield Curve: Inflation

• Step 1: Find the average expected inflation

Constructing the Yield Curve: Inflation

Assume inflation is expected to be 5% next year,

Must earn these IPs to break even vs. inflation;

Constructing the Yield Curve:

• Step 2: Find the appropriate maturity risk

T: Number of years (year-to-maturity)

Constructing the Yield Curve:

Using the given equation:

MRP1  0.1%  (1  1)  0.0%

Notice that since the equation is linear, the

“Nominal” vs. “Real” Rates

r = represents any nominal rate

Add the IPs and MRPs to r* to Find the

Step 3: Adding the premiums to r*.

Relationship Between Treasury Yield Curve and

• Corporate yield curves are higher than that of

Illustrating the Relationship Between Corporate

Pure Expectations Theory

• The pure expectations theory contends that the

Macroeconomic Factors That Influence

• Federal reserve policy

1. Which of the following factors would be most likely to lead to an

2. Which of the following would be most likely to lead to a higher level

3. Which of the following statements is CORRECT, other things held

4. Suppose the U.S. Treasury issued $50 billion of short-term securities

6. Assume that interest rates on 20-year Treasury and corporate bonds

7. Which of the following statements is CORRECT?

9. The Federal Reserve tends to take actions to ______ interest rates

10. The "yield curve" shows the relationship between_____

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