CHAPTER 6
Interest Rates
Determinants of interest rates
The term structure and yield curves
Investing overseas
6-1
Why are these rates different?
3-month Treasury Bill
 5-year Treasury Note
 5-year A Corporate Bond
 10-year Treasury bond
 10-year A Corporate Bond
 30-year Treasury bond

5.15%
4.71%
5.33%
4.83%
5.78%
4.92%
6-2
What four factors affect the level of
interest rates?

Production
opportunities
 Time preferences for
consumption
 Risk
 Expected inflation
6-3
“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.
6-4
Determinants of interest rates
r = r* + IP + DRP + LP + MRP
r
=
r* =
IP =
DRP
LP =
MRP
required return on a debt security
real risk-free rate of interest
inflation premium
= default risk premium
liquidity premium
= maturity risk premium
6-5
Premiums added to r* for different
types of debt
IP
S-T Treasury

L-T Treasury

S-T Corporate

L-T Corporate

MR
P
DR
P
LP






6-6
Yield curve and the term structure of
interest rates



Term structure –
relationship between
interest rates (or
yields) and maturities.
The yield curve is a
graph of the term
structure.
The November 2005
Treasury yield curve
is shown at the right.
Yield
(%)
6
5
4
3
2
1
0
0.25
0.5
2
5
10
30
Maturity (years)
6-7
Recent Yield Curve (T-sec’s)
6-8
Hypothetical yield curve
Interest
Rate (%)
15

Maturity risk premium

10
Inflation premium
5
Real risk-free rate
0
1
10
An upward sloping
yield curve.
Upward slope due
to an increase in
expected inflation
and increasing
maturity risk
premium.
Years to
20 Maturity
6-9
Treasury yield curves vs. corporate bond yield
curves
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.

6-10
Illustrating the relationship between
corporate and Treasury yield curves
Interest
Rate (%)
15
BB-Rated
10
AAA-Rated
5
Treasury
6.0% Yield Curve
5.9%
5.2%
Years to
0
Maturity
0
1
5
10
15
20
6-11
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.

6-12
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.

6-13
An example:
Observed Treasury rates and the PEH
Maturity
1 year
2 years
3 years
4 years
5 years
Yield
6.0%
6.2%
6.4%
6.5%
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?
6-14
One-year forward rate
6.0%
0
x%
1
2
6.2%
(1.062)2
1.12784/1.060
6.4004%


= (1.060) (1+x)
= (1+x)
=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%.
6-15
Three-year security, two years from
now
6.2%
0
1
x%
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.
6-16
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).
6-17
Other factors that influence interest
rate levels
Federal reserve policy
 Federal budget surplus or deficit
 Level of business activity
 International factors

6-18
Risks associated with investing
overseas


Exchange rate risk – If an
investment is denominated in
a currency other than U.S.
dollars, the investment’s value
will depend on what happens
to exchange rates.
Country risk – Arises from
investing or doing business in
a particular country and
depends on the country’s
economic, political, and social
environment.
6-19
Country risk rankings
Top 5 countries (least risk)
Ran Country
k
Score
1
Switzerland
95.2
2
Luxembourg
93.9
3
United States
93.7
4
Norway
93.7
5
United Kingdom
93.6
Bottom 5 countries (most risk)
Ran Country
k
Score
169
Afghanistan
11.0
170
Liberia
9.4
171
Sierra Leone
9.3
172
North Korea
8.9
173
Somalia
8.2
Source: “Country Ratings by Region,” Institutional Investor,
www.institutionalinvestor.com, September 2004.
6-20