EFM2e, CH 06, Interest Rates

Chapter 6
Interest Rates
 Cost of Money and Interest Rate

Levels
 Determinants of Interest Rates
 The Term Structure and Yield Curves
 Using Yield Curve to Estimate Future
Interest Rates
6-1
What four factors affect the level of
interest rates?
 Production
opportunities
 Time preferences
for consumption
 Risk
 Expected inflation
6-2
“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.
rRF= represents the rate of interest on
Treasury securities.
6-3
Determinants of Interest Rates
r = r* + IP + DRP + LP + MRP
r = required return on a debt security

r* = real risk-free rate of interest
IP = inflation premium
DRP = default risk premium
LP = liquidity premium
MRP = maturity risk premium
6-4
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    
6-5
Yield Curve and the Term Structure
of Interest Rates
 Term structure –
relationship between
interest rates (or yields)
and maturities.
 The yield curve is a
graph of the term
structure.
 The October 2008
Treasury yield curve is
shown at the right.
6-6
Constructing the Yield Curve:
Inflation
 Step 1 – Find the average expected inflation
rate over Years 1 to N:
 INFL t
IPN  t 1
N
6-7
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%
Must earn these IPs to break even vs. inflation;

these IPs would permit you to earn r* (before
taxes).
6-8
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)
6-9
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.
6-10
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%
6-11
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
6-12
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 spread between corporate and Treasury
yield curves widens as the corporate bond
rating decreases.
6-13
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
6-14
Pure Expectations Hypothesis
 The PEH contends that the shape of the yield

curve depends on investor’s expectations
about future interest rates.
 If interest rates are expected to increase, L-T
rates will be higher than S-T rates, and vice-
versa. Thus, the yield curve can slope up,
down, or even bow.
6-15
Assumptions of the PEH
 Assumes that the maturity risk premium for

Treasury securities is zero.
 Long-term rates are an average of current
and future short-term rates.
 If PEH is correct, you can use the yield curve
to “back out” expected future interest rates.
6-16
An Example:
Observed Treasury Rates and the PEH
Maturity Yield
1 year 6.0%
2 years 6.2%
3 years 6.4%
4 years 6.5%
5 years 6.5%
If PEH holds, what does the market expect will

be the interest rate on one-year securities, one
year from now? Three-year securities, two
years from now?
6-17
One-Year Forward Rate
6.0% x%
0 1 2
6.2%
(1.062)2 = (1.060) (1 + X)
1.12784/1.060 = (1 + X)
6.4004% = X
 PEH says that one-year securities will yield
6.4004%, one year from now.
 Notice, if an arithmetic average is used, the
answer is still very close. Solve: 6.2% =
(6.0% + X)/2, and the result will be 6.4%.
6-18
Three-Year Security, Two Years
from Now
6.2% x%
0 1 2 3 4 5
6.5%
(1.065)5 = (1.062)2 (1 + X)3

1.37009/1.12784 = (1 + X)3
6.7005% = X
 PEH says that three-year securities will yield

6.7005%, two years from now.
6-19
Conclusions about PEH
 Some would argue that the MRP ≠ 0, and

hence the PEH is incorrect.
 Most evidence supports the general view that
lenders prefer S-T securities, and view L-T
securities as riskier.
 Thus, investors demand a premium to persuade
them to hold L-T securities (i.e., MRP > 0).
6-20
Macroeconomic Factors That
Influence Interest Rate Levels
 Federal reserve policy
 Federal budget deficits or surpluses
 International factors
 Level of business activity
6-21

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Chapter 6

 Cost of Money and Interest Rate

r= represents any nominal rate

r = required return on a debt security

Must earn these IPs to break even vs. inflation;

MRP1  0.1%  (1  1)  0.0%

Notice that since the equation is linear, the

 Corporate yield curves are higher than that of

 The PEH contends that the shape of the yield

 Assumes that the maturity risk premium for

If PEH holds, what does the market expect will

(1.065)5 = (1.062)2 (1 + X)3

 PEH says that three-year securities will yield

 Some would argue that the MRP ≠ 0, and

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