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    Module 2

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    Ghillian Mae Guiang
    The document discusses interest rates, defining them as the rate paid by borrowers to lenders for borrowing money. It identifies five components that make up interest rates: the real risk-free rate, expected inflation, default risk premium, liquidity premium, and maturity premium. It also examines the determinants of market interest rates and different types of inflation and treasury debt obligations.

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    © All Rights Reserved
    Download as PPTX, PDF, TXT or read online from Scribd

    Module 2

    Uploaded by

    Ghillian Mae Guiang
    40 views13 pages
    The document discusses interest rates, defining them as the rate paid by borrowers to lenders for borrowing money. It identifies five components that make up interest rates: the real risk-free rate, expected inflation, default risk premium, liquidity premium, and maturity premium. It also examines the determinants of market interest rates and different types of inflation and treasury debt obligations.

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    The document discusses interest rates, defining them as the rate paid by borrowers to lenders for borrowing money. It identifies five components that make up interest rates: the real risk-free rate, expected inflation, default risk premium, liquidity premium, and maturity premium. It also examines the determinants of market interest rates and different types of inflation and treasury debt obligations.

    Copyright:

    © All Rights Reserved
    Download as PPTX, PDF, TXT or read online from Scribd
    Download as pptx, pdf, or txt
    40 views13 pages

    Module 2

    Uploaded by

    Ghillian Mae Guiang
    The document discusses interest rates, defining them as the rate paid by borrowers to lenders for borrowing money. It identifies five components that make up interest rates: the real risk-free rate, expected inflation, default risk premium, liquidity premium, and maturity premium. It also examines the determinants of market interest rates and different types of inflation and treasury debt obligations.

    Copyright:

    © All Rights Reserved
    Download as PPTX, PDF, TXT or read online from Scribd
    Download as pptx, pdf, or txt
    of 13

    STRUCTURE OF

    INTEREST RATES
    CHAPTER 6
    Learning Objectives

     To define interest rate


     To discuss the determinants of interest rate
     To discuss the components of interest rate
     To explain the role of interest rate to finance
    What is Interest rate?

     An interest rate is the rate at which interest is paid by borrowers


    (debtors) for the use of money that they borrow from lenders
    (creditors).
     Interest rate risk is a risk that an investment's value will change
    due to a change in the absolute level of interest rates, in the
    spread between two rates, in the shape of the yield curve or in
    any other interest rate relationship.

    6-3
    Five Components of Interest Rates

     Real Risk-Free Rate


     Expected Inflation
     Default-Risk Premium
     Liquidity Premium
     Maturity Premium

    6-4
    Determinants of Market
    Interest Rates
     nominal interest rate (or money interest rate) is the percentage
    increase in money you pay the lender for the use of the money
    you borrowed.
     real interest rate measures the percentage increase in purchasing
    power the lender receives when the borrower repays the loan with
    interest

    5
    Real Rate of Interest

     NOMINAL INTEREST RATE (R): Interest rate that is


    observed in the marketplace
     BASIC EQUATION: r = RR + IP + DRP
     REAL RATE OF INTEREST (RR): Interest rate on a risk-
    free debt instrument when no inflation is expected

    6
    Inflation Premium and Default Risk Premium

     BASIC EQUATION: r = RR + IP + DRP


     INFLATION PREMIUM (IP): Average inflation rate
    expected over the life of the security
     DEFAULT RISK PREMIUM (DRP): Compensation for
    the possibility of the borrower’s failure to pay interest
    and/or principal when due

    7
    Maturity Risk Premium

     BASIC EQUATION EXPANDED: r = RR + IP + DRP + MRP


     MATURITY RISK PREMIUM (MRP): Compensation
    expected by investors due to interest rate risk on debt
    instruments with longer maturities

    8
    Liquidity Premium

     BASIC EQUATION EXPANDED: r = RR + IP + DRP + MRP +


    LP
     LIQUIDITY PREMIUM (LP): Compensation for securities that
    cannot easily be converted to cash without major price discounts
    Types of Treasury Debt
    Obligations
     TREASURY BILLS: Obligations that bear the shortest (up
    to one year) original maturities
     TREASURY NOTES: Obligations issued for maturities of
    one to ten years
     TREASURY BONDS: Obligations of any maturity but
    usually over five years

    10
    Types of Inflation

     COST-PUSH INFLATION: Occurs when prices are raised to


    cover rising production costs, such as wages
     DEMAND-PULL INFLATION: Occurs during economic
    expansions when demand for goods and services is greater than
    supply

    11
    Types of Inflation (Continued)
     SPECULATIVE INFLATION: Caused by the expectation
    that prices will continue to rise, resulting in increased
    buying to avoid even higher future prices

    12
    Interest Rate and Its Role in Finance
     Finance deals with funds which denote money
     Money lent or money borrowed has a cost, that is, the interest
    rate.
     Changes in interest rates affect the level of investment spending,
    level of consumer expenditures, redistribution of wealth between
    borrowers and lenders, and prices of financial securities.
     The interest rate on government securities like T-bills are used as
    benchmark yield for all securities because these securities are
    default-free

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