STRUCTURE OF

INTEREST RATES
CHAPTER 6
Learning Objectives

 To define interest rate

 To discuss the determinants of interest rate
 To discuss the components of interest rate
 To explain the role of interest rate to finance
What is Interest rate?

 An interest rate is the rate at which interest is paid by borrowers

(debtors) for the use of money that they borrow from lenders
(creditors).
 Interest rate risk is a risk that an investment's value will change
due to a change in the absolute level of interest rates, in the
spread between two rates, in the shape of the yield curve or in
any other interest rate relationship.

6-3
Five Components of Interest Rates

 Real Risk-Free Rate

 Expected Inflation
 Default-Risk Premium
 Liquidity Premium
 Maturity Premium

6-4
Determinants of Market
Interest Rates
 nominal interest rate (or money interest rate) is the percentage
increase in money you pay the lender for the use of the money
you borrowed.
 real interest rate measures the percentage increase in purchasing
power the lender receives when the borrower repays the loan with
interest

5
Real Rate of Interest

 NOMINAL INTEREST RATE (R): Interest rate that is

observed in the marketplace
 BASIC EQUATION: r = RR + IP + DRP
 REAL RATE OF INTEREST (RR): Interest rate on a risk-
free debt instrument when no inflation is expected

6
Inflation Premium and Default Risk Premium

 BASIC EQUATION: r = RR + IP + DRP

 INFLATION PREMIUM (IP): Average inflation rate
expected over the life of the security
 DEFAULT RISK PREMIUM (DRP): Compensation for
the possibility of the borrower’s failure to pay interest
and/or principal when due

7
Maturity Risk Premium

 BASIC EQUATION EXPANDED: r = RR + IP + DRP + MRP

 MATURITY RISK PREMIUM (MRP): Compensation
expected by investors due to interest rate risk on debt
instruments with longer maturities

8
Liquidity Premium

 BASIC EQUATION EXPANDED: r = RR + IP + DRP + MRP +

LP
 LIQUIDITY PREMIUM (LP): Compensation for securities that
cannot easily be converted to cash without major price discounts
Types of Treasury Debt
Obligations
 TREASURY BILLS: Obligations that bear the shortest (up
to one year) original maturities
 TREASURY NOTES: Obligations issued for maturities of
one to ten years
 TREASURY BONDS: Obligations of any maturity but
usually over five years

10
Types of Inflation

 COST-PUSH INFLATION: Occurs when prices are raised to

cover rising production costs, such as wages
 DEMAND-PULL INFLATION: Occurs during economic
expansions when demand for goods and services is greater than
supply

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Types of Inflation (Continued)
 SPECULATIVE INFLATION: Caused by the expectation
that prices will continue to rise, resulting in increased
buying to avoid even higher future prices

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Interest Rate and Its Role in Finance
 Finance deals with funds which denote money
 Money lent or money borrowed has a cost, that is, the interest
rate.
 Changes in interest rates affect the level of investment spending,
level of consumer expenditures, redistribution of wealth between
borrowers and lenders, and prices of financial securities.
 The interest rate on government securities like T-bills are used as
benchmark yield for all securities because these securities are
default-free