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structure of interest
rates
Interest Rate Fundamentals
• Interest rate
• The compensation paid by the borrower of funds to the lender; from
the borrower’s point of view, the cost of borrowing funds.
• Required return
• The cost of funds obtained by selling an ownership interest; it reflects
the funds supplier’s level of expected return.
• Liquidity preferences
• General preferences of investors for shorter-term securities.
• The interest rate or required return represents the cost of money. It is
the compensation that a demander of funds must pay a supplier.
When funds are lent, the cost of borrowing the funds is the interest
rate. When funds are obtained by selling an ownership interest—as in
the sale of stock—the cost to the issuer (demander) is commonly
called the required return, which reflects the funds supplier’s level of
expected return. In both cases the supplier is compensated for
providing funds. Ignoring risk factors, the cost of funds results from
the real rate of interest adjusted for inflationary expectations and
liquidity preferences—general preferences of investors for shorter-
term securities.
The Real Rate of Interest