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
Interest

▪ Term structure – 14%

March 1980

relationship between 12%

interest rates (or yields) 10%

and maturities. 8%
February 2000

▪ The yield curve is a

6%

graph of the term

4%
October 2008

structure.
2%

▪
0%

The October 2008 0 10 20 30

Years to Maturity

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
Constructing the Yield Curve:
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
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)

6-9
Constructing the Yield Curve:
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