Determinants of Interest Rate

Interest Rates

Cost of Money and Interest Rate Levels

Determinants of Interest Rates
The Term Structure and Yield Curves
Using Yield Curves to Estimate Future
Interest Rates
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 What is interest rate?

It is the price the lenders receive and borrowers pay for

debt capital.

Interest rate varies based on the following:

1.Riskiness of the borrower
2.The use of the funds borrowed
3.The type of collateral used to support the loan
4.Length of time

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 What four factors affect the level of interest rates?

1. Production opportunities. The investment

opportunities in productive (cash-generating)
assets.
2. Time preferences for consumption. The
preferences of consumers for current consumption
as opposed to saving for future consumption.
3. Risk. The higher the risk, the higher the required
return.
4. Expected inflation. The higher the expected
inflation, the higher the required return.

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 Interest Rate Levels

1. Borrowers bid for the available supply of debt

capital using interest rates.
2. Government policy influence the allocation of
capital and the level of interest rates.

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 Interest Rate Levels

Market L: Low-Risk Securities Market H: High-Risk Securities

Interest Rate, r Interest Rate, r
% %
S2 S1
S1 S2
rH = 8
7
rL = 5
4

D
D
Peso Peso

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 Interest Rates Levels

Short-term interest rate

interest rate rise during boom market
• Need capital for an expanding economy

• Inflation rise

Interest rate decline during recession

• Slack business reduces the demand for credit

• Inflation falls

• Government supply capital to pump-prime the economy

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 Interest Rates Levels

Long-term interest rates primarily reflect long-run

expectations for inflation.

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 “Nominal” vs. “Real” Rates
r = represents any nominal rate

r* = represents the “real” risk-free rate of interest. It is a rate

that would exist on riskless security where no inflation is expected.

It is not static and it depends primarily on (1) the rate of

return that corporation and other borrower expect to earn on
productive assets; and (2) people’s time preferences for current
versus future compensation.

rRF = nominal risk-free rate. It represents the rate of interest on

Treasury securities. (r* + IP)

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 “Nominal” vs. “Real” Rates

IP = Inflation premium. (average expected rate of

inflation/life of the security)

DRP = Default risk premium. It reflects the possibility that the

issuer will not pay the promised interest or principal at the
stated time.

LP = Liquidity or marketability premium. It is charged by lenders

for some securities that cannot be converted to cash on short
notice.

MRP = Maturity risk premium. Charged by lenders due to

significant risk of price declines due to increase in inflation
and interest rates.
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 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

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 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 ✔ ✔ ✔ ✔

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 Constructing the Yield Curve: Inflation

• Step 1: Find the average expected inflation rate

over Years 1 to N:

6-12
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 Constructing the Yield Curve: Inflation

Assume inflation is expected to be 5% next year, 6% the

following year, and 8% thereafter.

Must earn these IPs to break even vs. inflation; these

IPs would permit you to earn r* (before taxes).

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 Constructing the Yield Curve:
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)

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 Constructing the Yield Curve:
Maturity Risk

Using the given equation:

Notice that since the equation is linear, the maturity

risk premium is increasing as the time to maturity
increases, as it should be.

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 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%,

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 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.
• Since corporate yields include a default risk
premium (DRP) and a liquidity premium (LP), the
corporate bond yield spread can be calculated as:

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 Representative Interest Rates on 5-Year Bonds in
May 2011

7-18
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 Pure Expectations Theory

• The pure expectations theory contends that the

shape of the yield curve depends on investors’
expectations about future interest rates. This
theory is indifferent when it comes to maturity.
• 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.

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 Assumptions of Pure Expectations

• 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 the pure expectations theory is correct, you can
use the yield curve to “back out” expected future
interest rates.

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 An Example: Observed Treasury Rates and Pure
Expectations

Maturity Yield
1 year 6.0%
2 years 6.2
3 years 6.4
4 years 6.5
5 years 6.5

If the pure expectations theory 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?
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 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
•The pure expectations theory 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
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result will be 6.4%.
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 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

• The pure expectations theory says that three-year

securities will yield 6.7005%, two years from now.
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 Macroeconomic Factors That Influence Interest Rate
Levels

• Federal reserve policy (Monetary Board Policy)

• Federal budget deficits or surpluses

• International factors including the foreign trade

balance and interest rates in other countries
• Level of business activity

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