Corporate Finance –FIN 622 VU

Lesson 06

TERM STRUCTURE OF INTEREST RATES

The relationship between long tem & short-term rates is known as Term Structure.

Interest rates in short & long terms are different. Term structure tells us nominal interest rate on default
free securities. When long-term rate is greater than short term then the term structure will be upward
sloping and when short-term rate is greater than the long term, the term structure will be downward
sloping.
The term structure of interest rates, also known as the yield curve, is a very common bond valuation
method.
There are three main patterns created by the term structure of interest rates:

1) Normal Yield Curve:

As its name indicates, this is the yield curve shape that forms during normal market conditions, wherein
investors generally believe that there will be no significant changes in the economy, such as in inflation
rates, and that the economy will continue to grow at a normal rate. During such conditions, investors
expect higher yields for fixed income instruments with long-term maturities that occur farther into the
future. In other words, the market expects long-term fixed income securities to offer higher yields than
short-term fixed income securities. This is a normal expectation of the market because short-term
instruments generally hold less risk than long-term instruments; the farther into the future the bond's
maturity, the more time and, therefore, uncertainty the bondholder faces before being paid back the
principal. To invest in one instrument for a longer period of time, an investor needs to be compensated
for undertaking the additional risk.
Remember that as general current interest rates increase, the price of a bond will decrease and its yield
will increase.

2) Flat Yield Curve:

These curves indicate that the market environment is sending mixed signals to investors, who are
interpreting interest rate movements in various ways. During such an environment, it is difficult for the
market to determine whether interest rates will move significantly in either direction farther into the future.
A flat yield curve usually occurs when the market is making a transition that emits different but
simultaneous indications of what interest rates will do. In other words, there may be some signals that
short-term interest rates will raise and other signals that long-term interest rates will fall. This condition will
create a curve that is flatter than its normal positive slope. When the yield curve is flat, investors can
maximize their risk/return tradeoff by choosing fixed-income securities with the least risk, or highest credit
quality. In the rare instances wherein long-term interest rates decline, a flat curve can sometimes lead to an
inverted curve.

3) Inverted Yield Curve:

These yield curves are rare, and they form during extraordinary market conditions wherein the
expectations of investors are completely the inverse of those demonstrated by the normal yield curve.
In such abnormal market environments, bonds with maturity dates further into the future are expected
to offer lower yields than bonds with shorter maturities. The inverted yield curve indicates that the
market currently expects interest rates to decline as time moves farther into the future, which in turn
means the market expects yields of long-term bonds to decline. Remember, also, that as interest rates
decrease, bond prices increase and yields decline.

You may be wondering why investors would choose to purchase long-term fixed-income investments
when there is an inverted yield curve, which indicates that investors expect to receive less compensation
for taking on more risk. Some investors, however, interpret an inverted curve as an indication that the
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Corporate Finance –FIN 622 VU
economy will soon experience a slowdown, which causes future interest rates to give even lower yields.
Before a slowdown, it is better to lock money into long-term investments at present prevailing yields,
because future yields will be even lower.

REAL VS NOMINAL INTEREST RATES:

The nominal interest rate is the amount, in money terms, of interest payable.
For example, suppose household deposits $100 with a bank for 1 year and they receive interest of $10.
At the end of the year their balance is $110. In this case, the nominal interest rate is 10% per annum.
The real interest rate, which measures the purchasing power of interest receipts, is calculated by
adjusting the nominal rate charged to take inflation into account.
If inflation in the economy has been 10% in the year, then the $110 in the account at the end of the
year buys the same amount as the $100 did a year ago. The real interest rate, in this case, is zero.
After the fact, the 'realized' real interest rate, which has actually occurred, is:
ir = in — p
where p = the actual inflation rate over the year.
The expected real returns on an investment, before it is made, are:
ir = in — pe
where:
in = nominal interest rate
ir = real interest rate
pe = expected or projected inflation over the year.

Market interest rates

There is a market for investments which ultimately includes the money market, bond market, stock
market and currency market as well as retail financial institutions like banks.
Exactly how these markets function is a complex question. However, economists generally agree that
the interest rates yielded by any investment take into account:

The risk-free cost of capital

Inflationary expectations
The level of risk in the investment
The costs of the transaction

Risk-free cost of capital

The risk-free cost of capital is the real interest on a risk-free loan. While no loan is ever entirely risk-
free, bills issued by major nations are generally regarded as risk-free benchmarks.
This rate incorporates the deferred consumption and alternative investments elements of interest.

Inflationary expectations
According to the theory of rational expectations, people form an expectation of what will happen to
inflation in the future. They then ensure that they offer or ask a nominal interest rate that means they
have the appropriate real interest rate on their investment.
This is given by the formula:
in = ir + pe
Where:
in = offered nominal interest rate
ir = desired real interest rate
pe = inflationary expectations

Risk
The level of risk in investments is taken into consideration. This is why very volatile investments like
shares and junk bonds have higher returns than safer ones like government bonds.
The extra interest charged on a risky investment is the risk premium. The required risk premium is
dependent on the risk preferences of the lender.

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Corporate Finance –FIN 622 VU
If an investment is 50% likely to go bankrupt, a risk-neutral lender will require their returns to double.
So for an investment normally returning $100 they would require $200 back. A risk-averse lender would
require more than $200 back and a risk-loving lender less than $200. Evidence suggests that most
lenders are in fact risk-averse.
Generally speaking a longer-term investment carries a maturity risk premium, because long-term loans
are exposed to more risk of default during their duration.

Liquidity preference
Most investors prefer their money to be in cash than in less fungible investments. Cash is on hand to be
spent immediately if the need arises, but some investments require time or effort to transfer into spend
able form. This is known as liquidity preference. A 10-year loan, for instance, is very illiquid compared
to a 1-year loan. A 10-year US Treasury bond, however, is liquid because it can easily be sold on the
market.

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