CHAPTER 3 - STRUCTURE OF

INTEREST RATES, RISKS,

AND RATES OF RETURN
 Learning Objectives:

1. Describe the nature of interest and how they affect investments

2. Explain the factors in determining interest rates
3. Describe the concept of risks
4. Identify the various investment risks
5. Explain how risks can affect the rates of return on investments

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 1 Nature of Interest
Rates

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 Cost of Money
Companies raise capital in two main forms: debt and equity.

Cost of Capital or Cost of money is the amount you are paying or receiving
for the use of money. (Cost of Debt and Cost of Equity).

Interest Rate differs from one debt security to another. This is caused by
several factors such as:
1. Borrower’s risk.
2. The use of the borrowed funds.
3. The type of collateral used to back the loan.
4. The length of time the money is needed.
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 Factors Affecting Cost of Money
1. Production opportunities - This refers to the investment opportunities in
productive assets. The higher the expected return on investment, the more the
investor can afford to pay the interest or cost of money.

2. Time preference for consumption -This is dependent on the need of the

investor (lender) to use his excess money in the short-term or long-term period.
If the need for the money is to accumulate funds for future needs, that investor
may accept a low interest rate for his money since the consumption of such will
take place in the future. On the other hand if the investor (lender) who needs
consumption is in a short-period, he may not be able to lend the money unless
the borrower pays a high return.

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 Factors Affecting Cost of Money
3. Risk – Risk refers to the uncertainty of not achieving what has been set to
attain or to achieve. If someone borrows money, there is a risk that the
promised rate of return will not materialize or be delivered. It has something to
do with the degree of risk perceived by the investors before lending their
money. Risk and rates of return have a direct relationship.

4. Inflation – It refers to the tendency of prices to go up over periods. Inflation

and interest rates have a direct relationship. This is because inflation tends to
affect the purchasing power of the lender.

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 Self Test Questions
1. What is the price paid to borrow debt capital called?
2. What are the two items whose sum is the cost of equity?
3. What four fundamental factors affect the cost of money?
4. Which factor sets an upper limit on how much can be paid for savings?
5. Which factor determines how much will be saved at different interest rates?
6. How do risk and inflation impact interest rates in the economy?

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 Interest Rate Levels
Borrowers bid for the available supply of debt capital using interest rates.
Moreover, riskiness of securities is also a determining factor for investors.
Assuming an investment in Low-Risk and High-Risk Securities.

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 2 Determinants of
Interest Rates

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 Determinants of Interest Rate
In general, the quoted (or nominal) interest rate on a debt security, r, is composed of a real risk-free rate, r*,
plus several premiums that reflect inflation, the security’s risk, its liquidity (or marketability), and the years
to its maturity. This relationship can be expressed as follows:

Quoted interest rate (r) = r*+IP +DRP+LP+MRP

Where:
r= the quoted, or nominal, rate of interest on a given security
r*= the real risk-free rate of interest, and it is the rate that would exist on a riskless security in a world
where no inflation was expected.

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 Determinants of Interest Rate
rRF= r* + IP. It is quoted rate on a risk-free security such as a Treasury bill, which is very liquid and is
free of most types of risk. Note that the premium of expected inflation, IP, is included in rRF

IP= inflation premium. IP is equal to the average expected rate of inflation over the life of the security.
The expected future inflation rate is not necessarily equal to the current inflation rate, so IP is not
necessarily equal to current inflation.

DRP= default risk premium. This premium reflects the possibility that the issuer will not pay the
promised interest or principal at the stated time. DRP is zero for Treasury securities, but it rises as the
riskiness of the issuer increases.

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 Determinants of Interest Rate
LP= liquidity (or marketability) premium. This is a premium charged by lenders to reflect the fact that
some securities cannot be converted to cash on short notice at a “reasonable” price. LP is very low for
Treasury securities and for securities issued by large, strong firms; but it is relatively high on securities
issued by small, privately held firms.

MRP= maturity risk premium. Longer-term bonds, even Treasury bonds, are exposed to a significant risk
of price declines due to increases in inflation and interest rates; and a maturity risk premium is charged by
lenders to reflect the risk.

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 Determinants of Interest Rate
Example 1. Short-Term Government Security. (Treasury Bills)
Government Securities are considered to be default-free and always available in the market in terms of
trading.

How do we compute for the nominal interest rate of a Short-term government security?

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 Determinants of Interest Rate
Example 2. Long-Term Government Security. (Treasury Notes and Treasury Bonds)
These Government Securities are considered to be default-free and always available in the market in terms
of trading.

How do we compute for the nominal interest rate of a Long-term government security?

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 Determinants of Interest Rate
Example 3. Short-Term Corporate Security. (Notes Payable and Commercial Papers)
Corporate Securities are considered to be subject to default and are not always available in the market in
terms of trading.

How do we compute for the nominal interest rate of a Short-term corporate security?

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 Determinants of Interest Rate
Example 4. Long-Term Corporate Security. (Loans and Bonds Payable)
These corporate Securities are considered to be subject to default and are not always available in the market
in terms of trading.

How do we compute for the nominal interest rate of a long-term corporate security?

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 Determinants of Interest Rate – Real Risk
Free Rate
The Philippine Government issued a 5-year Treasury bonds that yield 6.5% interest. The inflation premium
is 1.5%, and the maturity risk premium is computed based on 0.1% of the (maturity period less 1).

Compute for the real risk free rate and the risk free rate.

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 Determinants of Interest Rate – Inflation
Premium
Mr. ABC is thinking of investing in a 5-year treasury note. He is expecting that the real risk-free rate of
interest is 2% on the treasury note. The average default risk premium and maturity risk premium in the
market is 1% and 0.5%, respectively. Based on his forecast, the expected inflation rate is as follows:
2021 – 1.3%
2022 – 2.9%
2023 – 5.2%
2024 – 2.5%
2025 – 2.7%
Compute for the average nominal interest rate for the 5-year treasury note.

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 Determinants of Interest Rate – Default
Risk Premium
A treasury bond that matures in 20 years has a yield of 6%. A 20-year corporate bond has a yield of 8%.
Assume that the liquidity premium on the corporate bond is 0.8%. What is the default risk premium on the
corporate bond?

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 Determinants of Interest Rate – Liquidity
Premium
ABC Corporation’s 5-year bonds yield 6.50% and 5-year T-bonds yield 4.90%. The real risk free rate is
3.00%, the inflation premium for 5-year bonds is 1.50%, the default risk premium for ABC Corporation’s
bonds is 1.30%, and the maturity risk premium for all bonds is 0.1% of (t-1). What is the liquidity premium
on ABC Corporation’s bonds?

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 Determinants of Interest Rate – Maturity
Risk Premium
A 5-year treasury security currently yields 2.50%. Over the next five years, the real risk-free rate is
expected to be 1.00% per year and the expected inflation premium for the 1 st year and 2nd year is 1.20% and
1.25%, respectively. From the 3rd year to the 5th year, the expected inflation rate is 1.30%. Calculate the
maturity risk premium on the five-year treasury security.

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 Determinants of Interest Rate
The real risk-free rate of interest, r*, is 3%, and it is expected to remain constant over time. Inflation is
expected to be 2% per year for the next 3 years and 4% per year for the next 5 years. The maturity risk
premium is equal to 0.1 X (t-1)%, where t = the bond’s maturity. The default risk premium for a BBB-rated
bond is 1.3%.
1. What is the average expected inflation rate over the next 4 years?
2. What is the yield on a 4-year Treasury Bond?
3. What is the yield on a 4-year BBB-rated corporate bond with a liquidity premium of 0.5%?
4. What is the yield on an 8-year Treasury Bond?
5. What is the yield on an 8-year BBB rated corporate bond with a liquidity premium of 0.5%?
6. If the yield on a 9-year Treasury bond is 7.3%, what does that imply about expected inflation in 9
years?

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 3 Term Structure of
Interest Rates

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 Term Structure of Interest Rates
The term structure of Interest Rate describes the relationship between long-term and short-term
rates based on its term to maturity. The term structure of interest rate is important to both
borrowers and investors.

Yield Curve is a graph showing the relationship between bond yields and term to maturity.
Assume the following data:
INTEREST RATE
TERM TO MATURITY
MARCH 1980 FEBRUARY 2000 APRIL 2014

1 YEAR 14.0% 6.2% 0.1%

5 YEARS 13.5% 6.7% 1.7%
10 YEARS 12.8% 6.7% 2.7%
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30 YEARS 12.3% 6.3% 3.5%
 Term Structure of Interest Rates
YIELD CURVE (in Million of Pesos)
March 1980 February 2000 April 2014
16.00%

14.00%

12.00%

10.00%

8.00%

6.00%

4.00%

2.00%

0.00%
0 5 10 15 20 25 30 35

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 Yield Curves
Yield Curves can either be:
1. Upward Sloping (Normal Yield Curve) – The longer the maturity of the security the higher
the interest rate. %LTS > %STS
2. Downward Sloping (Abnormal Yield Curve) – The longer the maturity of the security the
lower the interest rate. %LTS > %STS
3. Humped Yield Curve – The interest rates go up for the immediately succeeding years then it
will go down as the maturity of the security goes longer. %ITS > %LTS and %STS
4. Flat Yield Curve – The interest rate is similar regardless of the maturity of the security.
%LTS = %STS

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 Yield Curves
On March 15, 2024, the BTr. issued a 1-year Treasury Bill with a quoted interest rate of 6.09%
while when it issued a 10 year Treasury Bond on the same date, the quoted interest rate is 6.25%.

Why is the quoted interest rate different for the 1-year treasury bill and the 10-year treasury bond?

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 Yield Curves
Assume the following Yield Rates:
MATURITY r* IP MRP YIELD
1 YEAR 2.50% 3.00% 0.00% 5.50%
5 YEARS 2.50% 3.40% 0.18% 6.08%
10 YEARS 2.50% 4.00% 0.28% 6.78%
20 YEARS 2.50% 4.50% 0.42% 7.42%
30 YEARS 2.50% 4.67% 0.53% 7.70%

MATURITY r* IP MRP YIELD

1 YEAR 2.50% 5.00% 0.00% 7.50%
5 YEARS 2.50% 4.60% 0.18% 7.28%
10 YEARS 2.50% 4.00% 0.28% 6.78%
20 YEARS 2.50% 3.50% 0.42% 6.42%
30 YEARS 2.50% 3.33% 0.53% 6.36%
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 Yield Curves
SUPPLY CURVE (in Million of Pesos)
Panel A Panel B

9.00%

8.00%

7.00%

6.00%

5.00%

4.00%

3.00%

2.00%

1.00%

0.00%
0 5 10 15 20 25 30 35
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 Yield Curves
On March 15, 2024, the ABC Co. issued a 1-year Bonds with a quoted interest rate of 6.09%
while when it issued a 10 year Bonds on the same date, the quoted interest rate is 6.25%.

Why is the quoted interest rate different for the 1-year and the 10-year bonds?

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 Yield Curves
Assume the following Yield Rates:
MATURITY TREASURY BOND AA-RATED BOND BBB-RATED BOND
1 YEAR 5.5% 6.7% 7.4%
5 YEARS 6.1% 7.4% 8.1%
10 YEARS 6.8% 8.2% 9.1%
20 YEARS 7.4% 9.2% 10.2%
30 YEARS 7.7% 9.8% 11.1%

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 Yield Curves
SUPPLY CURVE (in Million of Pesos)
Treasury Bond BBB-Rated Bond AA-Rated Bond

12.00%

10.00%

8.00%

6.00%

4.00%

2.00%

0.00%
0 5 10 15 20 25 30 35
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 4
PURE
EXPECTATIONS
THEORY

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 Pure Expectations Theory
The slope of the yield curve depends primarily on two factors: (1) expectations about future
inflation and (2) effects of maturity on bond’s risks.

Suppose a company is in the midst of a 5-year expansion program and the Chief Financial Officer
knows that he will need to borrow a sort-term funds a year from now. If an interest rate for a one-
year bond today is 5% and an interest for a 2-year bond today is 8%. How much should the firm
pay as interest if it will issue a 1-year bond one year from now?

This can be answered through

1. Pure Expectations Theory – (a) Focuses on Treasury Bonds; and (b) The treasury bond
contains no maturity risk premium.

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 Pure Expectations Theory
ABC Co. is planning to invest in a 1-year treasury security or a 2-year treasury security which
currently yields 6.00% and 7.50%, respectively. ABC Co. is deciding whether to:
1. Buy a 2-year treasury security and hold it for 2 years, or
2. Buy a 1-year security; hold it for 1 year; and then at the end of the year, reinvest the proceeds
in another 1-year security.

Under Pure Expectations Theory, The yield from either option 1 or 2 will be similar. Hence, how
much should be the yield rate when the proceeds from the 1-year treasury security was reinvested?

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 ILLUSTRATIVE EXAMPLE 1 – PURE
EXPECTATIONS THEORY
The yield on 1-year treasury securities is 6%, 2-year securities yield 6.2%, 3-
year securities yield 6.3%, and 4-year securities yield 6.5%. There is no
maturity risk premium. Using expectations theory, forecast the yields on the
following securities:
1. A 1-year security, 1 year from now.
2. A 1-year security, 2 years from now.
3. A 2-year security, 1 year from now.
4. A 3-year security, 1 year from now.
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 ILLUSTRATIVE EXAMPLE 2 – PURE
EXPECTATIONS THEORY
One year treasury securities yield 5%. The market anticipates that 1 year
from now, 1 year treasury securities will yield 6%. If the pure expectations
theory is correct, what is the yield today for 2-year treasury securities?

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 ILLUSTRATIVE EXAMPLE 3 – PURE
EXPECTATIONS THEORY
Interest rates on 4-year treasury securities are currently 7%, while 6-year
treasury securities yield 7.5%. If the pure expectations theory is correct, what
does the market believe that 2-year treasury securities will be yielding 4
years from now?

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 4 Concepts of Risk

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 Risk and Rates of Return
After investing money in a project, a firm expects to get some outcomes from the project.
The outcomes or the benefits that the investment generates are called returns. Wealth
maximization approach is based on the concept of future value of expected cash flows
from a prospective project. So, cash flows are the earnings generated by the project that
we refer to as returns. Since future is uncertain, so returns are associated with some
degree of uncertainty. In other words, there will be some variability in generating cash
flows, which we call as risk.

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 Concept of Risk
A person making an investment expects to get some returns from the investment in the future.
However, as future is uncertain, the future expected returns too are uncertain. It is the uncertainty
associated with the returns from an investment that introduces a risk into a project. The expected
return is the uncertain future return that a firm expects to get from its project. The realized return,
on the contrary, is the certain return that a firm has actually earned.
The realized return from the project may not correspond to the expected return. This possibility of
variation of the actual return from the expected return is termed as risk. Risk is the variability in
the expected return from a project. In other words, it is the degree of deviation from expected
return. Risk is associated with the possibility that realized returns will be less than the returns that
were expected. So, when realizations correspond to expectations exactly, there would be no risk.

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 Elements of Risk
Systematic Risk:
Business organizations are part of society that is dynamic. Various changes occur in a society like economic,
political and social systems that have influence on the performance of companies and thereby on their expected
returns. These changes affect all organizations to varying degrees. Hence the impact of these changes is system-
wide and the portion of total variability in returns caused by such across the board factors is referred to as
systematic risk. These risks are further subdivided into interest rate risk, market risk, and purchasing power risk.

Unsystematic Risk:
The returns of a company may vary due to certain factors that affect only that company. Examples of such
factors are raw material scarcity, labour strike, management ineffi­ciency, etc. When the variability in returns
occurs due to such firm-specific factors it is known as unsystematic risk. This risk is unique or peculiar to a
specific organization and affects it in addition to the systematic risk. These risks are subdivided into business risk
and financial risk.

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 4 Investment Risk

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 Kinds of Investment Risk
a. Market risk
The risk of investments declining in value because of economic developments or other events that affect the entire
market. The main types of market risk are equity risk, interest rate risk and currency risk.

Equity risk – applies to an investment in shares. The market price of shares varies all the time depending on demand
and supply. Equity risk is the risk of loss because of a drop in the market price of shares.

Interest rate risk – applies to debt investments such as bonds. It is the risk of losing money because of a change in
the interest rate. For example, if the interest rate goes up, the market value of bonds will drop.

Currency risk – applies when you own foreign investments. It is the risk of losing money because of a movement in
the exchange rate. For example, if the U.S. dollar becomes less valuable relative to the Canadian dollar, your U.S.
stocks will be worth less in Canadian dollars.

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 Kinds of Investment Risk
b. Liquidity risk
The risk of being unable to sell your investment at a fair price and get your money out when you want to. To sell
the investment, you may need to accept a lower price. In some cases, such as exempt market investments, it may
not be possible to sell the investment at all.

c. Concentration risk
The risk of loss because your money is concentrated in 1 investment or type of investment. When you diversify
your investments, you spread the risk over different types of investments, industries and geographic locations.

d. Credit risk
The risk that the government entity or company that issued the bond will run into financial difficulties and won’t
be able to pay the interest or repay the principal at maturity. Credit risk applies to debt investments such as bonds.
You can evaluate credit risk by looking at the credit rating of the bond. For example, long-term Canadian
government bonds have a credit rating of AAA, which indicates the lowest possible credit risk.

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 Kinds of Investment Risk
e. Reinvestment risk
The risk of loss from reinvesting principal or income at a lower interest rate. Suppose you buy a bond paying 5%.
Reinvestment risk will affect you if interest rates drop and you have to reinvest the regular interest payments at
4%. Reinvestment risk will also apply if the bond matures and you have to reinvest the principal at less than 5%.
Reinvestment risk will not apply if you intend to spend the regular interest payments or the principal at maturity.

f. Inflation risk
The risk of a loss in your purchasing power because the value of your investments does not keep up with inflation.
Inflation erodes the purchasing power of money over time – the same amount of money will buy fewer goods and
services. Inflation risk is particularly relevant if you own cash or debt investments like bonds. Shares offer some
protection against inflation because most companies can increase the prices they charge to their customers. Share
prices should therefore rise in line with inflation. Real estate also offers some protection because landlords can
increase rents over time.

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 Kinds of Investment Risk
g. Horizon risk
The risk that your investment horizon may be shortened because of an unforeseen event, for example, the loss of
your job. This may force you to sell investments that you were expecting to hold for the long term. If you must sell
at a time when the markets are down, you may lose money.

h. Longevity risk
The risk of outliving your savings. This risk is particularly relevant for people who are retired, or are nearing
retirement.

i. Foreign investment risk

The risk of loss when investing in foreign countries. When you buy foreign investments, for example, the shares of
companies in emerging markets, you face risks that do not exist in Canada, for example, the risk of nationalization.

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 Concept of Return
Return can be defined as the actual income from a project as well as appreciation in the value of
capital. Thus, there are two components in return—the basic component or the periodic cash flows
from the investment, either in the form of interest or dividends; and the change in the price of the asset,
com­monly called as the capital gain or loss.
The term yield is often used in connection to return, which refers to the income component in relation
to some price for the asset. The total return of an asset for the holding period relates to all the cash
flows received by an investor during any designated time period to the amount of money invested in
the asset.
It is measured as:
Total Return = Cash payments received + Price change in assets over the period /Purchase price
of the asset. In connection with return, we use two terms—realized return and expected or predicted
return. Realized return is the return that was earned by the firm, so it is historic. Expected or predicted
return is the return the firm anticipates to earn from an asset over some future period.

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 5 Risk – Return
Tradeoff

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 Risk-Return Tradeoffs
Investors like returns and they dislike risk. This premise suggests that there is a fundamental trade-off between risk and
return: to entice investors to take on more risk, you have to provide them with higher expected returns.

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 Stand-Alone Risk
Risk is defined by Webster's Dictionary as "a hazard; a peril; exposure to loss or injury. In investments there
is a risk of not receiving your expected returns or even not recovering your investment. Individuals and
firms invest funds today with the expectation of receiving additional funds in the future. Bonds offer
relatively low returns, but with relatively little risk-at least if you stick to Treasury and high-grade corporate
bonds. Stocks offer the chance of higher returns, but stocks are generally riskier than bonds. If you invest in
speculative stocks (or, really, any stock), you are taking a significant risk in the hope of making an
appreciable return.
An asset's risk can be analyzed in two ways: (1) on a stand-alone basis, where the asset is considered by
itself, and (2) on a portfolio basis, where the asset is held as one of a number of assets in a portfolio. Thus,
an asset's stand-alone risk is the risk an investor would face if he or she held only this one asset. Most
financial assets, and stocks in particular, are held in portfolios; but it is necessary to understand stand-alone
risk to understand risk in a portfolio context.

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 Stand-Alone Risk
To illustrate stand-alone risk, suppose an investor buys $100,000 of short-term Treasury bills with an
expected return of 5% In this case, the investment's return, 5%, can be estimated quite precisely; and the
investment is defined as being essentially risk-free. This same investor could also invest the $100,000 in the
stock of a company just being organized to prospect for oil in the mid-Atlantic. Returns on the stock would
be much harder to predict. In the worst case, the company would go bankrupt, and the investor would lose
all of his or her money, in which case the return would be -100%. In the best-case scenario, the company
would discover huge amounts of oil, and the investor would receive a 1,000% return. When evaluating this
investment, the investor might analyze the situation and conclude that the expected rate of return, in a
statistical sense, is 20%; but the actual rate of return could range from, say, +1,000% to -100%. Because
there is a significant danger of earning much less than the expected return, such a stock would be relatively
risky.

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 Risk Aversion and Required Returns
Suppose you inherited $1 million dollar. Which you plan to invest and then retire on the income. You can
buy a 5% U.S. Treasury bill, and you will be sure of earning $50,000 interest. Alternatively, you can buy a
stock in R & D Enterprises. If R & D research programs are successful, your stock will increase to $2.1
million. However, if the research is a failure, the value of your stock will be zero, and you will be penniless.

You regard R&D's chances of success or failure as 50-50, so the expected value of the stock a year from
now is 0.5($0) + 0.5($2,100,000) = $1,050,000.

Expected rate of return = (Expected ending value – Current Cost)/Current Cost

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 Comments, Questions,
Concerns or Clarifications
“Do not be wise in your own eyes; fear the LORD
and shun evil. “
-(Proverbs 3:7)
End. Thank You!