Chapter 8

Level & Structure of Interest

Rates
Md. Mahbubul Alam
Assistant Professor, Finance & Banking
Department of Business Administration
 Questions
Define interest rate.
Define interest rate risk with example.
What do you mean by “Risk structure of Interest
Rate”?
Show the differences between Nominal interest and
real Interest rate.
Explain the Fisher`s Law.
Explain Fisher`s loan-able fund theory.
What is YTM & YTC?
Interest Rate
Interest rate is the price paid by a borrower (or debtor) to a lender (or
creditor) for the use of resources during some interval. The amount of
the loan is the principal, and the price paid is typically expressed as a
percentage of the principal per unit of time.

Interest rate can be seen by the following way-

Real rate: the rate that would prevail in the economy is the average
prices for goods and services were expected to remain constant during
the loan`s life.

Risk free rate: the rate on a loan whose borrower will not default on any
obligation.

Short term rate: The rate on a loan that has one year maturity.
 Explain Fisher`s theory of interest
Irving Fisher analyzed the determination of the level of the
interest rate in an economy by inquiring why people save (that is
why they do not consume all their resources) and why other
borrow.

Fisher`s theory of interest analyzes the equilibrium level of the

interest rate as the result of the interaction of savers` willingness
to save and borrowers` demand for investment funds.

In fisher`s terms, the interest rate reflects the interaction of the

savers` marginal rate of time preference and borrowers`
marginal productivity of capital.
Fisher`s law state that the observable nominal rate of interest is
composed of two unobservable variables: the real rate of interest
and the premium for expected inflation

The Fisher Effect is an economic theory created by economist

Irving Fisher that describes the relationship between inflation
and both real and nominal interest rates. The Fisher Effect states
that the real interest equals the nominal interest rate minus the
expected inflation rate. Therefore, real interest rates fall as
inflation increases, unless nominal rates increase at the same
rate as inflation.
 Nominal interest rate vs. Real interest rate
 
Nominal rate of interest is the number of monetary units
to be paid per unit borrowed and is the observable market
rate on a loan.

Real rate of interest is the inflation adjusted nominal rate

of interest.

In the absence of inflation, the nominal rate equals the real

rate.

The relationship between inflation and interest rates is the

well known Fisher`s Law.
Here,
i = nominal rate
r= real rate
p = expected % change in the price level of goods and
services over the loan life/ inflation premium
Keynes`s theory of Liquidity
Keynes`s theory emphasizes the role of liquidity balance or
money in transaction, and state that the interest rate is
determined in the money market.

Demand for money reflects income and the level of prices

for goods and services, and it is negatively related to the level
of interest rates.

The supply of money, in this theory, is controlled by the

central bank, which can affect the rate of interest by
changing the money supply.
Changes in the money supply can have three possible
effects on the level of the interest rate, depending on the
economy`s level of output and employment.

Those are:

i) Liquidity effect

ii) Income effect

iii) Price expectation effect

 Bond and its features
A bond is a type of security instrument used to raise debt
capital by an issuing party like government or corporation.

A bond typically has the following features /characteristics:

A principal amount to be repaid on a specific date in future

– the principal amount is also known as the face value or

par value

– the payment date is known as the maturity date

Many bonds have regular coupon payments which are paid

out annually, semi annually or quarterly

 - The coupon rate is the interest rate used to
calculate the coupon amount and is a percentage of the
principal amount

– coupon payment = Face value × coupon rate

A bond is legal debt obligation. Failure to make

payment as required can result in legal recourse by the

holders of the bonds.
YTM vs. YTC
YTM is the rate of return receive for holding a long term
security or bond till its maturity
YTC is the rate of return receive for holding a long term
security or bond till its call (before maturity).

Problem 1:
Suppose that a four year bond that pays interest
annually has par value of $ 1000, coupon rate of 5%, and
is selling in the market for $900. calculate yield to
maturity.
  𝑅𝑉 − 𝑁𝑆𝑉
𝐼+
𝑛
𝑌𝑇𝑀 =
𝑅𝑉 + 𝑁𝑆𝑉
2