Interest Rates

INTRO COST OF MONEY DETERMINANTS TERM STRUCTURE EST.
FUTURE RATES
Chapter 6
Interest Rates
Cost of Money and Interest Rate Levels

Determinants of Interest Rates
The Term Structure and Yield Curves
Using Yield Curves to Estimate Future
Interest Rates
6-1
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Sources of Capital
• Debt - creditors
• Equity - shareholders
6-2
INTRO COST OF MONEY DETERMINANTS TERM STRUCTURE EST. FUTURE RATES
What four factors affect the level of interest rates?
• Production opportunities
- the investment opportunities in productive
(cash-generating) assets.
• Time preferences for consumption
- save or consume now?
• Risk
- uncertainty; low or negative return
• Expected inflation
- price increase overtime
6-3
Exercises
• One of the four most fundamental factors that affect

the cost of money as discussed in the text is the
current state of the weather. If the weather is dark
and stormy, the cost of money will be higher than if it
is bright and sunny, other things held constant.
the cost of money as discussed in the text is the
expected rate of inflation. If inflation is expected to be
relatively high, then interest rates will tend to be
relatively low, other things held constant.
the cost of money as discussed in the text is the time
preference for consumption. The higher the time
preference, the lower the cost of money, other things
held constant. 6-4
Supply and Demand
• Price – interest rates

• Risk premium = expected earnings – initial risk
6-5
“Nominal” vs. “Real” Rates
r = represents any nominal rate

r* = represents the “real” risk-free rate of
interest. Like a T-bill rate, if there was no
inflation. Typically ranges from 1% to 4%
per year.
IP = inflation premium
rRF = represents the rate of interest on
Treasury securities.
6-6
Determinants of Interest Rates
r = r* + IP + DRP + LP + MRP
r = required return on a debt security

r* = real risk-free rate of interest
IP = inflation premium
DRP = default risk premium
LP = liquidity premium
MRP = maturity risk premium
6-7
Real Risk Free Rate = r*
• Default free
• No inflation expected
6-8
Nominal (Quoted) Risk Free Rate= rRF
• Free of all risk but includes inflation premium

– Examples are T-bill or T-bond
6-9
Inflation Premium
• A premium equal to expected inflation.
6-10
Exercises
• If investors expect a zero rate of inflation, then

the nominal rate of return on a very short-term
U.S. Treasury bond should be equal to the real
risk-free rate, r*.
6-11
Default Risk Premium
• Means the borrower will not make scheduled

interest or principal payment on due date.
6-12
Market Risk Premium
• Are designed to compensate investors for

taking on the risk of holding bonds over a
lengthy period of time.
6-13
Exercise
• The real risk-free rate is 3.05%, inflation is

expected to be 2.75% this year, and the
maturity risk premium is zero. Ignoring any
cross-product terms, what is the equilibrium
rate of return on a 1-year Treasury bond?
6-14
Reinvestment Rate Risk
• The risk that a decline in interest rates will lead

to lower income when bonds mature and funds
are reinvested.
6-15
Term Structure of Interest Rates
• The relationship between bond yields and

maturities.
• Short term or Long Term
6-16
What Is a Yield Curve
• A line that plots yields (interest rate) of bonds

having equal credit quality but differing maturity
dates.
 Normal Yield Curve- longer maturity bonds have a
higher yield compared to shorter-term bonds due
to the risks associated with time.
 Inverted Yield Curve- in which the shorter term
yields are higher than the longer-term yields, which
can be a sign of upcoming recession.
 Flat or Humped Yield Curve- the shorter and
longer term yields are very close to each other,
which is also a predictor of an economic transition .
6-17
T-Bonds
T-bond yield= r*t + IPt + MRPt
6-18
Corporate Bonds
Corp. Bond Yield= r*t + IPt + MRPt + DRPt + LPt
6-19
Pure Expectations Theory
• Attempts to predict what short-term interest

rates will be in the future based on current long
term interest rates.
Example:
Investor earns the same amount of interest by
investing in two consecutive one-year bond versus
investing in one two-year bond today.
6-20
Exercise
• Suppose the real risk-free rate is 3.00%, the

average expected future inflation rate is 2.25%,
and a maturity risk premium of 0.10% per year
to maturity applies, i.e., MRP = 0.10%(t), where
t is the number of years to maturity. What rate
of return would you expect on a 1-year
Treasury security, assuming the pure
expectations theory is NOT valid?
6-21
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    
6-22
Constructing the Yield Curve: Inflation
• Step 1: Find the average expected inflation

rate over Years 1 to N:
N
 INFL t
IPN  t 1
6-23
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).
6-24
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)
6-25
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.
6-26
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%,
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%
6-27
Exercises
• Suppose the real risk-free rate is 3.25%, the

average future inflation rate is 4.35%, and a
maturity risk premium of 0.07% per year to maturity
applies to both corporate and T-bonds, i.e., MRP =
0.07%(t), where t is the number of years to
maturity. Suppose also that a liquidity premium of
0.50% and a default risk premium of 0.90% apply
to A-rated corporate bonds but not to T-bonds. How
much higher would the rate of return be on a 10-
year A-rated corporate bond than on a 5-year
Treasury bond? Here we assume that the pure
expectations theory is NOT valid.
6-28
Hypothetical Yield Curve
Interest
Rate (%)
• An upward-sloping
yield curve.
15 Maturity risk premium
• Upward slope due to
an increase in
10 Inflation premium expected inflation
and increasing
maturity risk
5 premium.
Real risk-free rate
Years to
0 Maturity
1 10 20
6-29
Relationship Between Treasury Yield Curve and Yield

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

Treasury securities, though not necessarily
parallel to the Treasury curve.
• 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
6-30
Illustrating the Relationship Between Corporate and

Treasury Yield Curves
6-31
Pure Expectations Theory
• The pure expectations theory contends that the

shape of the yield curve depends on investors’
expectations about future interest rates.
• If interest rates are expected to increase, L-T
rates will be higher than S-T rates, and vice-
versa. Thus, the yield curve can slope up,
down, or even bow.
6-32
Assumptions of Pure Expectations
• Assumes that the maturity risk premium for

Treasury securities is zero.
• Long-term rates are an average of current and
future short-term rates.
• If the pure expectations theory is correct, you
can use the yield curve to “back out” expected
future interest rates.
6-33
An Example: Observed Treasury Rates and Pure

Expectations
Maturity Yield
1 year 6.0%
2 years 6.2
3 years 6.4
4 years 6.5
5 years 6.5
If the pure expectations theory holds, what does

the market expect will be the interest rate on one-
year securities, one year from now? Three-year
securities, two years from now?
6-34
One-Year Forward Rate

6.0% x%
0 1 2
6.2%
(1.062)2 = (1.060) (1 + X)
1.12784/1.060= (1 + X)
6.4004% = X
• The pure expectations theory says that one-year
securities will yield 6.4004%, one year from now.
• Notice, if an arithmetic average is used, the answer is
still very close. Solve: 6.2% = (6.0% + X)/2, and the
result will be 6.4%. 6-35
Three-Year Security, Two Years from Now

6.2% x%
0 1 2 3 4
5
6.5%
(1.065)5 = (1.062)2 (1 + X)3

1.37009/1.12784 = (1 + X)3
6.7005% = X
• The pure expectations theory says that three-year
securities will yield 6.7005%, two years from now.
6-36
Conclusions About Pure Expectations
• Some would argue that the MRP ≠ 0, and

hence the pure expectations theory is incorrect.
• Most evidence supports the general view that
lenders prefer S-T securities, and view L-T
securities as riskier.
– Thus, investors demand a premium to persuade
them to hold L-T securities (i.e., MRP > 0).
6-37
Macroeconomic Factors That Influence

Interest Rate Levels
• Federal reserve policy

• Federal budget deficits or surpluses
• International factors
• Level of business activity
6-38

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INTRO COST OF MONEY DETERMINANTS TERM STRUCTURE EST.

Cost of Money and Interest Rate Levels

What four factors affect the level of interest rates?

• One of the four most fundamental factors that affect

• Price – interest rates

“Nominal” vs. “Real” Rates

r = represents any nominal rate

Determinants of Interest Rates

r = required return on a debt security

• Free of all risk but includes inflation premium

• A premium equal to expected inflation.

• If investors expect a zero rate of inflation, then

• Means the borrower will not make scheduled

• Are designed to compensate investors for

• The real risk-free rate is 3.05%, inflation is

• The risk that a decline in interest rates will lead

• The relationship between bond yields and

• Short term or Long Term

• A line that plots yields (interest rate) of bonds

T-bond yield= r*t + IPt + MRPt

Corp. Bond Yield= r*t + IPt + MRPt + DRPt + LPt

• Attempts to predict what short-term interest

• Suppose the real risk-free rate is 3.00%, the

Premiums Added to r* for Different Types of

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

Constructing the Yield Curve:

Using the given equation:

MRP1  0.1%  (1  1)  0.0%

Notice that since the equation is linear, the

Add the IPs and MRPs to r* to Find the Appropriate

Step 3: Adding the premiums to r*.

rRF,1  3%  5%  0.0%  8.0%

• Suppose the real risk-free rate is 3.25%, the

Hypothetical Yield Curve

Relationship Between Treasury Yield Curve and Yield

• Corporate yield curves are higher than that of

Illustrating the Relationship Between Corporate and

Pure Expectations Theory

• The pure expectations theory contends that the

Assumptions of Pure Expectations

• Assumes that the maturity risk premium for

An Example: Observed Treasury Rates and Pure

If the pure expectations theory holds, what does

One-Year Forward Rate

Three-Year Security, Two Years from Now

(1.065)5 = (1.062)2 (1 + X)3

Conclusions About Pure Expectations

• Some would argue that the MRP ≠ 0, and

Macroeconomic Factors That Influence

• Federal reserve policy

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