CHAPTER 6

INTEREST RATES
 Realized Returns (Yields)

INVESTORS ( savers) determine rates of return

through their buying and selling actions
Regardless of the type of investment, the
DOLLAR return an investment earns is divided
into

1. Income paid by the ISSUER of the financial

assets
2. The change in the value of the asset in the
financial market ( capital gain) over some
time period
 Factors that affect the Cost of
Money

Four factors affect the cost of money

( which is the interest paid to SAVERS
= investors)
1. Production opportunities
2. Timer preferences for consumption
3. Risk
4. Inflation
 1. Production Opportunity

It is mainly about the RATE OF RETURN

that Producers ( Borrowers ) expect to
earn on their invested capital

In other words, the return available within an

economy from investment in productive
( cash generating ) assets
2. Time Preference for consumption

The preference of consumers for current

consumption as opposed to saving for future
consumption

So it is about SAVERS ( INVESTORS)

consumption preferences current VS future

High TFC  lend less  IR high

Low TFC  willing to lend more  IR low
3. Risk
It represent the riskiness of the loans made

 In a financial marker context, risk is the

chance that a financial asset will not earn
the return promised for the producers
( borrowers )

the higher the risk  the higher the

required rate of return asked by investors
( savers)  higher IR
4. Inflation

It is the tendency of prices to increase over

time

It usually affect the purchasing power of the $

and affect the returns on any investment

 The higher the expected rate of Inflation 

the higher the required rate of returns asked
by investors ( savers) in order to compensate
them for the loss on their purchasing power
caused by the inflation  higher IR
 Interest Rate Levels

Even with government interventions,

most capital in the U.S economy is
allocated through the PRICE SYSTEM
where IR is the price

SUPPLY & DEMAND interact to

determine the IR in capital markets
 Interest Rate Levels

The upward-sloping Supply curve indicates

that investors are willing to supply more
capital the higher the interest rate they
receive on their capital.

The downward-sloping demand curve indicates

that borrowers will borrow more if interest rate
are lower.

 The IR in each market is the point of

intersection between supply and demand.
 Interest Rate Levels

Take Market L : Low-Risk securities

Market H: high-Risk securities

 Once market forces changes assuming

moving toward a less riskier market thus
moving from H to L

 Moving money from H to L

 The supply of funds will ↑ in L  IR will ↓
 The supply of funds will ↓ in H  IR will ↑
 Determinants of Markets Interest
Rates
The required rate of return asked by investors is
computed as the following:

r = Risk-Free Rate + Risk

Premium
r= rf +
RP
r = (r* + IP) +
( DRP+LP+MRP)
 The variables are defined as follows
r = the nominal rate of interest on a given security

rf = risk-free rate of return. It is the return associated with an

investment that has a guaranteed outcome in the future ( has no
risk)

RP = Risk Premium, which is the portion of return that exceeds

the risk-free rate and thus represents payment for the risk
associated with an investment = DRP+LP+MRP

r* = Real risk-free rate of return

IP= Inflation premium

DRP = Default risk premium, which reflects the chance that the
borrower that is the issuer of the security will not pay the debt’s
interest or principal on time
( U.S treasury DRP = 0 )
The variables are defined as follows

LP = liquidity premium , which reflect that

some investments are more easily converted
into cash on short notice at a “ reasonable
price ” than other securities

MRP = maturity risk premium, which

accounts for the fact that longer-term bonds
experience greater price reactions to
interest changes than do short term bond
LT = higher MRP = IR ↑ = P ↓
 The nominal Risk-free rate (rf)

rf (nominal) = r* + IP

Whereby r* is the real risk-free rate of interest =

the rate of interest that would exist on default-free
U.S treasury securities if NO INFLATION were
expected

And IP is the inflation premium = a premium for

expected inflation that investors add to the real
risk-free rate of return = AVERAGE INFLATION RATE
EXPECTED IN THE FUTURE PERIOD
 Default Risk Premium (DRP)

The ↑ default risk  the ↑ the interest

rate that lenders charge ( demand )

Treasury securities have NO default risk

but corporate bonds have.

For corporate bonds, the better the bond’s

overall credit rating ( AAA is the best ), the
lower its default risk  the lower IR
 Liquidity Premium (LP)

A premium added to the rate on a

security if the security cannot be
converted to cash on short
notice at a price that is close to its
original cost
 Maturity Risk Premium (MRP)
Because interest rate can and do occasionally
rise, ALL long-term bonds even treasury bonds
have an element of risk called INTEREST
PRICE RISK

Which is the risk of capital losses to which

investors are exposed because of changing
interest rates

The higher or the longer the maturity  the ↑

IR
 Term Structure of Interest Rates
It is the relationship between the YIELDS and MATURITIES of
securities

Yield Curve: a graph showing the relationship between yields

and maturities of securities

In most instances, long-term interest rates are greater than

short-term interest rates – that is the yield curve is upward
sloping. (Normal yield curve)
( LT>ST)

However, there are rare instances when the yield curve is

inverted or downward sloping , which occur when long-term
interest rates are lower then short-term interest rates. This is
common during recession. (Inverted yield curve )
(LT<ST)
 WHY do yield curves differ?
Because changes in investors’ RISK attitudes
generally evolve over years, inflation
expectations represent the most important
factor in the determination of current interest
rates and thus the shape of the yield curve.

Investors generally prefer to hold on Short

term securities because they are less
sensitive to changes in IR and provide more
flexibility than Long-term one.
 WHY do yield curves differ?

Borrowers on the other hand prefer Long-

term debt, because Short term debt expose
them to the risk of having to refinance the
debt under conditions such as ( high interest
rates period).

MRP increases with years to maturity causing

the Yield curve to be UPWARD sloping
 Final Note
 Corporate Bond
Rate of return= r= rf + RP =[ r* + IP] + [ DRP + LP
+ MRP ]

 Treasury Security
Rate of return= r = rf + RP = [ r* + IP] + MRP
 Since DRP = 0 and LP = 0

 Thus RP corporate bond > RP treasury thus higher

Yield curve