Interest Rates and Its
Determinants
Lecture 6
Videos to understand Interest Rates
• https://www.youtube.com/watch?v=R8VBRCs2jTU
Two forms of raising Capital
• Debt vs Equity
• Cost of Debt: Interest Rate
• Cost of Equity: Rate of Return
• The interest rate is the price that lenders receive and
borrowers pay for debt capital.
• Factors that affect the supply of and demand for capital, which
in turn affects the cost of money
Factors affecting Cost of Money
1. Production Opportunities: The investment opportunities in
productive (cash generating) assets.
2. Time Preferences for Consumption: The preferences of
consumers for current consumption as opposed to saving for
future consumption.
3. Risk: In a financial market context, the chance that an
investment will provide a low or negative return.
• The higher the perceived risk, the higher the required rate of return
4. Inflation: The amount by which prices increase over time.
• The higher the expected rate of inflation, the larger the required dollar
return.
Factors affecting Cost of Money
• Thus, we see that the interest rate paid to savers depends (1)
on the rate of return that producers expect to earn on
invested capital, (2) on savers’ time preferences for current
versus future consumption, (3) on the riskiness of the loan,
and (4) on the expected future rate of inflation.
Interest Rate Levels
• Supply and demand interact to determine interest rates in two
capital markets.
• The supply curve in each market is upward sloping, which
indicates that investors are willing to supply more capital the
higher the interest rate they receive on their capital. Likewise,
the downward-sloping demand curve indicates that borrowers
will borrow more if interest rates are lower.
• The interest rate in each market is the point where the
supply and demand curves intersect.
• There is a price for each type of capital, and these prices
change over time as supply and demand conditions change.
The Determinants of Market
Interest Rates
• In general, the quoted (or nominal) interest rate on a debt
security, r, is composed of a real risk-free rate, r* , plus several
premiums that reflect inflation, the security’s risk, its liquidity (or
marketability), and the years to its maturity.
• Quoted interest rate = r = r* + IP + DRP + LP + MRP
Real Risk-Free Rate (r*)
• The real risk-free rate of interest, r*, is the interest rate that
would exist on a riskless security if no inflation were
expected.
• This is the pure return a lender expects without any risks or
inflation.
• It may be thought of as the rate of interest on short-term U.S.
Treasury securities.
Nominal (Quoted) Risk-Free Rate, rRF
• The nominal, or quoted, risk-free rate, rRF, is the real risk-free
rate plus a premium for expected inflation: rRF = r* + IP.
• When we use the term risk-free rate, rRF, we mean the
nominal risk-free rate, which includes an inflation premium
equal to the average expected inflation rate over the remaining
life of the security.
Difference between r* and rRF
• Risk-Free Rate (rRF)
• This is the interest rate on an investment that has zero risk
of default (meaning the borrower will definitely pay back).
• It includes compensation for inflation because investors
want to maintain their purchasing power.
• Real Risk-Free Rate (r*)
• This is the pure return an investor earns without any risk or
inflation.
• Reflects the real growth of money after adjusting the
inflation.
• If the risk-free rate on government bonds is 8% and inflation is
5%, the real risk-free rate is:
•
r∗=8%−5%=3%
Nominal (Quoted) Risk-Free Rate, rRF
• T-bill rate to approximate the short-term risk-free rate
• T-bond rate to approximate the long-term risk-free rate.
• So, whenever you see the term risk-free rate, assume that we
are referring to the quoted U.S. T-bill rate or to the quoted Tbond rate.
• We will assume Treasury securities have no default risk.
Inflation Premium (IP)
• Inflation has a major impact on interest rates because it erodes
the real value of what you receive from the investment.
• Inflation premium (IP) equal to the average expected inflation
rate over the life of the security into the rate they charge.
• Inflation rate built into interest rates is the inflation rate
expected in the future.
Default Risk Premium (DRP)
• The risk that a borrower will default, which means the borrower
will not make scheduled interest or principal payments.
• The greater the bond’s risk of default, the higher the market
rate.
• The higher the bond’s rating, the lower its default risk and,
consequently, the lower its interest rate.
• The difference between the quoted interest rate on a T-bond
and that on a corporate bond with similar maturity, liquidity, and
other features is the default risk premium (DRP).
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.”
• A “liquid” asset can be converted to cash quickly at a “fair
market value.”
• The liquidity of real assets also varies over time. For example,
at the height of the housing boom, many homes in “hot” real
estate markets were often sold the first day they were listed.
After the bubble burst, homes in these same markets often sat
unsold for months.
Maturity Risk Premium (MRP) and
Interest Rate Risk
• The risk of capital losses to which investors are exposed
because of changing interest rates.
• The prices of long-term bonds decline whenever interest rates
rise, and because interest rates can and do occasionally rise, all
long-term bonds, even Treasury bonds, have an element of
risk called interest rate risk.
• The bonds of any organization have more interest rate risk the
longer the maturity of the bond.
• MRP: A premium that reflects interest rate risk.
Reinvestment Risk
• Short-term bills are heavily exposed to reinvestment rate risk.
• When short-term bills mature and the principal must be
reinvested, a decline in interest rates would necessitate
reinvestment at a lower rate, which would result in a decline in
interest income.
• Reinvestment Risk: The risk that a decline in interest rates
will lead to lower income when bonds mature and funds are
reinvested.
Practice Questions
1. Assume that the real risk-free rate is r* = 2% and the average
expected inflation rate is 3% for each future year. The DRP
and LP for Bond X are each 1%, and the applicable MRP is
2%. What is Bond X’s interest rate?
1. A Treasury bond that matures in 10 years has a yield of
5.75%. A 10-year corporate bond has a yield of 8.75%.
Assume that the liquidity premium on the corporate bond is
0.35%. What is the default risk premium on the corporate
bond?
The Term Structure of Interest Rates
• The term structure of interest rates describes the relationship
between long- and short-term rates.
• SIMPLY: How interest rates change depending on how long
you lend or borrow money?
• Both borrowers and lenders should understand (1) how longand short-term rates relate to each other and (2) what causes
shifts in their relative levels.
• Bond Yield: A bond's yield is the return an investor expects to
receive each year over its term to maturity.
• Term Structure of Interest Rates: The relationship between
bond yields and maturities.
Imagine This
You go to a bank to deposit money in a fixed deposit. The bank
offers:
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6% for 1 year
7% for 5 years
8% for 10 years
You notice that the longer you keep your money with the bank,
the higher the interest rate. This pattern of different interest
rates for different time periods is called the term structure of
interest rates.
Why Does This Happen?
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Time & Risk – The longer the period, the more uncertainty
(inflation, economy, etc.), so lenders demand a higher return.
Liquidity Preference – People prefer cash now rather than
later, so they need extra incentive to lock in their money.
Expectations of Future Rates – If people expect interest
rates to rise in the future, they will demand higher rates for
long-term loans.
Yield Curve
When we plot these different interest rates against time, we get a
yield curve. It can be:
• Upward Sloping (Normal) – Long-term rates are higher than
short-term rates (common when the economy is growing).
• Flat – Short- and long-term rates are similar (uncertainty in the
economy).
• Inverted – Short-term rates are higher than long-term rates
(often signals a recession).
Types of Yield Curves
• “Normal” Yield Curve: An upward-sloping yield curve,
• Longer-term securities have higher yields than short-term ones. This
reflects expectations of economic growth and inflation over time.
• Inverted (“Abnormal”) Yield Curve: A downward-sloping yield
curve.
• Short-term interest rates are higher than long-term rates. This can
indicate a future economic downturn, as investors expect lower growth
and inflation.
• Market interest rates also depend on expected inflation, default
risk, and liquidity, each of which can vary with maturity.
Inverted Yield Curve
• An inverted yield curve often indicates the lead-up to a
recession or economic slowdown.
• Under normal conditions, interest rates go up with an increase
in the time to maturity.
Pure Expectations Theory
• A theory that states that the interest rates on long-term
bonds are just an average of what people expect short-term
rates to be in the future.
Think of It Like This
Imagine you're deciding whether to:
Deposit money for 2 years straight.
You get 6% in Year 1.
The bank will offer a new rate in Year 2 (but you don’t know what it
is yet).
1. Deposit money for 2 years at once.
• The bank offers a fixed 7% for 2 years (meaning you lock in this
rate).
According to PET, the reason the 2-year rate is 7% is because
people expect the Year 2 rate to be higher than 6%, pushing the
average to 7%.
1.
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