Ch6 Interest Rates For CLASS

Interest Rates
 Cost of Money and Interest Rate

Levels
 Determinants of Interest Rates
 The Term Structure and Yield Curves
6-1
What four factors affect the level of
interest rates (cost of money)?*
 Production opportunities >

chance in productive activities
 Time preferences for
consumption > current need
instead of saving
 Risk > chance of lower return;
credit rating, long vs. short term
 Expected inflation > price
increase; erosion of purchasing
power of money
6-2
Determinants of Interest Rates
r = r* + IP + DRP + LP + MRP
r = required return on a debt security;
nominal or quoted interest rate
r* = real risk-free rate of interest (t-bill; no
inflation
IP = inflation premium
= expected (not past);
= average over the life (not for 1 year)
6-3
Determinants of Interest Rates
DRP = default risk premium (borrower cannot
pay on time when debt is due)
LP = liquidity premium (investor cannot
convert security to cash quickly, close to
it fair value, at low cost)
MRP = market risk premium (interest rate risk,
long-term debt, decrease in price if
interest rates increase (e.g. P1,000, 1 year,
10% vs. 12%; 1 year vs. 5 years)
6-4
“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 5%
per year; real rRF
rRF = represents the rate of interest on Treasury
securities; includes inflation; nominal risk-
free rate of interest (nominal rRF)
= formula (simple; e.g. r%=5%, IP=3%)
6-5
“Nominal” vs. “Real” Rates
rRF = formula (cross-term/cross-
product/exact/effective)
= if inflation is high or significant;
= a) first method (add cross term),
b) second method (multiply, deduct 1);
= e.g. r*=5%, IP=3%;
= cross-term is low when inflation is low
that’s why ignored
Reminder: Expected and average inflation
SW: 6-6
6-6
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    
SW: Problem 6-2 6-7

Yield Curve and the Term Structure
of Interest Rates
 Term structure – Interest
relationship between 14%

March 1980
interest rates (or yields) 12%
and maturities. 10%
 The yield curve is a graph

8%
February 2000
of the term structure. 6%

4%
The October 2008 2%

October 2008
Treasury yield curve is 0%

shown at the right. 0 10 20 30

Years to Maturity
Draw yield curve showing

the premiums
6-8
Types of Yield Curve
 Normal – upward sloping; Interest
longer maturity, higher 14%

March 1980
interest rates; LT rates are 12%
higher due to maturity risk 10%

premium

8%
February 2000
Abnormal/inverted – 6%
downward-sloping; ST rates
are higher (expected
4%
October 2008
decrease in inflation) 2%
 Humped yield curve –

0%
0 10 20 30
medium term rates are Years to Maturity
higher than LT and ST rates
6-9
Constructing the Yield Curve:
Inflation
 Step 1 – Find the average expected inflation
rate over Years 1 to N:
 INFL t
IPN  t 1
N
6-10
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%
6-11
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)
6-12
Maturity Risk
Using the given equation:
MRP1  0.1%  (1  1)  0.0%
MPP10  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.
6-13
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%  0.0%  8.0%
rRF , 10  3%  7.5%  0.9%  11.4%
rRF , 20  3%  7.75%  1.9%  12.65%
SW: Problems 6-3, 6-4, 6-5
6-14
Hypothetical Yield Curve
 An upward sloping
Interest yield curve.
Rate (%)
15 Maturity risk premium  Upward slope due
to an increase in
expected inflation
10 Inflation premium and increasing
maturity risk
5 premium.
Real risk-free rate
Years to
0 Maturity
1 10 20
6-15
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 corporate bond yield spread (DRP + LP)
between corporate and Treasury yield curves
widens as the corporate bond rating
decreases.
 SW 6-1
6-16
Illustrating the Relationship Between
Corporate and Treasury Yield Curves
Interest
Rate (%)
15
BB-Rated
10
AAA-Rated
Treasury
6.0% Yield Curve
5 5.9%
5.2%
Years to
0 Maturity
0 1 5 10 15 20
6-17
ASSIGNMENT
 Theory 6-10
 Problems 6-9, 6-10, 6-11, 6-12, 6-13, 6-16,
6-17
6-18

Ch6 Interest Rates For CLASS

Uploaded by

Copyright:

Available Formats

Ch6 Interest Rates For CLASS

Uploaded by

Document Information

Original Description:

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Ch6 Interest Rates For CLASS

Uploaded by

Copyright:

Available Formats

Interest Rates

 Cost of Money and Interest Rate

 Production opportunities >

r = represents any nominal rate

SW: Problem 6-2 6-7

relationship between 14%

interest rates (or yields) 12%

and maturities. 10%

 The yield curve is a graph

of the term structure. 6%

The October 2008 2%

Treasury yield curve is 0%

Draw yield curve showing

longer maturity, higher 14%

higher due to maturity risk 10%

 Humped yield curve –

medium term rates are Years to Maturity

higher than LT and ST rates

 Corporate yield curves are higher than that of

You might also like