INTRO COST OF MONEY DETERMINANTS TERM STRUCTURE EST.
FUTURE RATES
Chapter 6
Interest Rates
6-1
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INTRO COST OF MONEY DETERMINANTS TERM STRUCTURE EST. FUTURE RATES
What four factors affect the level of interest
rates?
• Production opportunities
• Time preferences for consumption
• Risk
• Expected inflation
6-2
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INTRO COST OF MONEY DETERMINANTS TERM STRUCTURE EST. FUTURE RATES
“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 4%
per year.
rRF = represents the rate of interest on Treasury
securities.
6-3
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INTRO COST OF MONEY DETERMINANTS TERM STRUCTURE EST. FUTURE RATES
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
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INTRO COST OF MONEY DETERMINANTS TERM STRUCTURE EST. FUTURE RATES
Determinants of Interest Rates
Inflation Premium (IP)—A premium equal to expected
inflation that investors add to the real risk-free rate of
return.
Default Risk Premium (DRP)—The difference between
the interest rate on a U.S. Treasury bond and a
corporate bond of equal maturity and marketability.
Maturity Risk Premium (MRP)—A premium that reflects
interest rate risk.
6-5
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INTRO COST OF MONEY DETERMINANTS TERM STRUCTURE EST. FUTURE RATES
Determinants of Interest Rates
Liquidity Premium (LP)—A premium added to the
equilibrium interest rate on a security if that security
cannot be converted to cash on short notice and at
close to its “fair market value.”
Reinvestment Rate Risk—Them risk that a decline in
interest rates will lead to lower income when bonds
mature and funds are reinvested.
6-6
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INTRO COST OF MONEY DETERMINANTS TERM STRUCTURE EST. FUTURE RATES
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
6-7
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INTRO COST OF MONEY DETERMINANTS TERM STRUCTURE EST. FUTURE RATES
PRACTICE
You read in The Wall Street Journal that 30-day T-bills
are currently yielding 5.5%. Your brother-in-law, a broker
at Safe and Sound Securities, has given you the
following estimates of current interest rate premiums:
Inflation premium 3.25%
Liquidity premium 0.6%
Maturity risk premium 1.8%
Default risk premium 2.15%
On the basis of these data, what is the real risk-
free rate of return?
6-8
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INTRO COST OF MONEY DETERMINANTS TERM STRUCTURE EST. FUTURE RATES
PRACTICE
A Treasury bond that matures in 10 years has a
yield of 6%. A 10-year corporate bond has a yield of
8%. Assume that the liquidity premium on the
corporate bond is 0.5%.
What is the default risk premium on the corporate
bond?
6-9
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INTRO COST OF MONEY DETERMINANTS TERM STRUCTURE EST. FUTURE RATES
PRACTICE
The real risk-free rate is 3%, and inflation is
expected to be 3% for the next 2 years. A 2-year
Treasury security yields 6.2%.
What is the maturity risk premium for the 2-year
security?
6-10
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INTRO COST OF MONEY DETERMINANTS TERM STRUCTURE EST. FUTURE RATES
Pure Expectations Theory
• A theory that asserts that forward rates
exclusively represent expected future
rates.
• In short, the entire term structure reflects
the markets expectations of future rates.
6-11
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INTRO COST OF MONEY DETERMINANTS TERM STRUCTURE EST. FUTURE RATES
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.
6-12
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INTRO COST OF MONEY DETERMINANTS TERM STRUCTURE EST. FUTURE RATES
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?
6-13
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INTRO COST OF MONEY DETERMINANTS TERM STRUCTURE EST. FUTURE RATES
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 result will be 6.4%. 6-14
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INTRO COST OF MONEY DETERMINANTS TERM STRUCTURE EST. FUTURE RATES
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.
6-15
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INTRO COST OF MONEY DETERMINANTS TERM STRUCTURE EST. FUTURE RATES
Conclusions About Pure Expectations
• Some would argue that the MRP ≠ 0, and
hence the pure expectations theory 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).
6-16
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INTRO COST OF MONEY DETERMINANTS TERM STRUCTURE EST. FUTURE RATES
PRACTICE
One-year Treasury securities yield 5%. The market
anticipates that 1 year from now, 1-year Treasury
securities will yield 6%.
If the pure expectations theory is correct, what is the
yield today for 2-year Treasury securities?
6-17
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INTRO COST OF MONEY DETERMINANTS TERM STRUCTURE EST. FUTURE RATES
Macroeconomic Factors That Influence
Interest Rate Levels
• Federal reserve policy
• Federal budget deficits or surpluses
• International factors
• Level of business activity
6-18
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