Chapter 6

Interest Rates

6-1
 Interest Rate History

• For a long time in the history –charging interest has

been viewed as a “SIN”
– Aristotle considered money itself to be "barren", and
the charging of interest on loans "unfair".
– In Europe throughout the Middle Ages and beyond,
charging and paying interest are moral sins. The ban
of interest rate is rigorously enforced after the Black
Death in the 14th century.
– Medici family in Italy get around it by “lending in one
currency” and repay in another (or in commodities),
where interest rate is built in exchange rate.

6-2
 What four factors affect the level of
interest rates?
• Production opportunities
– The demand for money
• Time preferences for consumption
– The supply of money
• Risk
– The chances of getting a zero or negative return
• Expected inflation
– Will your money buy less in the future?
 Nominal versus Real Rate

rRF = represents the rate of interest on Treasury securities.

Also often referred to as “nominal risk free rate”
Example: US T-bill; US T-bond

r* represents “real risk free rate”

Inflation premium: average expected inflation over the life

of the security
rRF = r* + IP

6-4
 Example: Nominal versus Real Rate

• Real risk-free rate r*= 1.7%

• Expected inflation premium over the next year: IP =
1%
• Rate on one year risk free US T-bill ?
1.7% + 1% =2.7%

6-5
 Determinants of Interest Rates

r = r* + IP + DRP + LP + MRP

r = required return on a debt security, nominal interest rate

r* = real risk-free rate of interest; represents the “real” risk-
free rate of interest. Like a T-bill rate, if there was no
inflation.

rRF = represents the rate of interest on Treasury securities

rRF = r* + IP

IP = inflation premium
DRP = default risk premium
6-6
LP = liquidity premium
Inflation and Interest Rates

6-7
 Default Risk Premium

• How likely is the corporation default on the bond

(not paying back scheduled interest or principal
payments)?

• Default risk of bond: The difference between a US

Treasury bond and a corporate bond of equal
maturity and marketability.

6-8
 Default Risk Premium

• Rating companies
evaluate default risk of
bonds
– Moody’s Investor
Service
– Standard & Poor’s
– PACRA (The Pakistan
Credit Rating Agency)

6-9
 Liquidity Premium

• A premium added to the equilibrium interest rate

on a security if that security cannot be converted to
cash on short notice and at close to its “fair market
value”

6-10
 Maturity Risk Premium

• A premium that reflects interest rate risk—that is, a

bond obligation will be more sensitive to interest
rate fluctuations the longer to maturity it is.

6-11
 Premiums Added to r* for Different Types of Debt

IP MRP DRP LP
ury r = r* + IP S-T Treasury 

r = r* + IP + MRP L-T Treasury  

* + IP + DRP + LP S-T Corporate   

P + MRP + DRP + LP L-T Corporate    

6-12
 Example

• A company’s 5-year bonds are yielding 7.75% per year.

Treasury bonds with the same maturity are yielding
5.2% per year, and the real risk-free rate is 2.3%. The
average inflation premium is 2.5%; and the maturity
risk premium is estimated to be 0.1* (t-1)%, where
t=number of years to maturity. If the liquidity
premium is 1%, what is the default risk premium on
the corporate bonds?

6-13
 Solution

• MRP = 0.1%(5 – 1) = 0.4%

• T- bonds r = r* + IP + MRP = 5.2%

• r= r* + IP + MRP + LP + DRP
7.75% = 2.3% + 2.5% + 0.4% + 1.0% + DRP
7.75% = 5.2% + 1.0% + DRP
DRP = 1.55%.

6-14
 Example

• You read in The Wall Street Journal that 30-day T-

bills are currently yielding 5.5%. Your brother-in-
law, a broker at Safe and Sound Securities, has
given the following estimates of current interest
rate premiums:
– Inflation premium = 3.25%
– Liquidity premium =0.6%
– Maturity risk premium = 1.8%
– Default risk premium = 2.15%
What is the real risk-free rate of return?

6-15
 Solution

• T-bill rate = r* + IP
5.5% = r* + 3.25%
r* = 2.25%.

6-16
 What is “Risk-free Rates”

• Risk-free rate:
– Long term: long term government rate
– Short term: short term government security rate

• The conventional practice of estimating risk-free rates is

to use the government bond rate. In November 2013,
for instance, the rate on a ten-year US treasury bond
(2.75%) is used as the risk free rate in US dollars.

6-17
When the government is default free: Risk free
rates

6-18
 Term Structure

Term structure: relationship between interest rates

(or yields) and maturities.
Yield for US Treasury Bond

6-19
 Yield Curve and the Term Structure of Interest
Rates
Yield Curve for US Treasury Bond

• The yield curve is a graph Interest Rate

(%)

of the term structure.

16
Yield Curve for
14 March 1980

12

10

• The February 2013 8 Yield Curve for Feb-

ruary 2000

Treasury yield curve is 6

shown at the right.

4

2 Yield Curve for Feb-

ruary 2013
0
0 5 10 15 20 25 30
Years to Maturity

Short Intermediate Long

Term Term Term

6-20
 Hypothetical Yield Curve for US Treasury Bond
(With US T-bond: r = r* + IP + MRP)

Interest
Rate (%)
• An upward-sloping
yield curve.
15 Maturity risk premium
• Upward slope due to
an increase in expected
10 Inflation premium inflation and increasing
maturity risk premium.
5 • Any other shapes?

Real risk-free rate

Years to
0 Maturity
1 10 20

6-21
 Yield Curves

Yields
Upward Sloping

Flat

Downward Sloping

Maturity
6-22
Yield Curves and Inflation Expectations

23
Corporate and Treasury Yield Curves

Figure shows yield curves for two

hypothetical corporate bonds—an AA-
rated bond with minimal default risk and a
BBB-rated bond with more default risk—
along with the yield curve for Treasury
securities (zero default risk).

24