Interest Rates

Financial Management
Interest Rates

Costof Money and Interest Rate Levels

Determinants of Interest Rates
The Term Structure and Yield Curves
Equilibrium Rates
Interest rate levels are a factor of the
supply and demand of credit (or money)
The supply of credit is increased by an
increase in the amount of money made
available to borrowers
 For example, the more banks can lend, the
more credit there is available to the
economy:
 As the supply of credit increases, the price of
borrowing (interest) decreases
3
What four factors affect
the level of interest rates?

Productionopportunities
Time preferences for consumption
Risk
Expected inflation
“Nominal” vs. “Real” Rates
Suppose I deposited $930 in a bank
account for one year
 In one year, the balance will be $1,000
 What is the rate of return on this
“investment”?
Iinvest $930 and receive $1,000 in one
year, so if the nominal return is r then:
930 x (1 + r) = 1,000
Or r = (1000/930) – 1 = 7.5%
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“Nominal” vs. “Real” Rates
Suppose now that inflation is working
against me making my cost of living
increase by 3% over the same period
 Now, my $1,000 does not purchase as much in
real terms as it could compared to the
beginning of the period
Think about it in concrete terms
 Imagine all I consume is pizzas
 At the beginning they cost $8 each
 Their price increases at the rate of inflation
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“Nominal” vs. “Real” Rates
What is my return in pizzas?
Pizza prices in one year will be
$8 x (1 + inflation) = $8 x 1.03 = $8.24
So at the beginning my $930 would buy
930 / 8 = 116.25 pizzas
And at the end my $1,000 will buy
1,000 / 8.24 = 121.36 pizzas
 Effectively, I invest 116.25 pizzas and receive 121.36
pizzas in one year
 Define the real return as r* then:
116.25 x (1 + r*) = 121.36
So the real rate r*
r* = (121.36/ 116.25) – 1 = 4.4% 7
“Nominal” vs. “Real” Rates
Define:

r = Any nominal rate

r* = “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 = Rate of interest on Treasury
securities
“Real” vs. “Nominal” Rate

Algebraically, if we define i as the

inflation rate, r* as the real rate and r as
the nominal rate then:
1 + r* = (1 + r)/(1 + i), or restated
r* = (r – i)/(1 + i)
Approximately,

r* = r – i

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Components of Interest Rates

r = r* + IP + DRP + LP + MRP

IP= inflation premium

DRP = default risk premium
LP= liquidity premium
MRP = maturity risk premium
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    
Term Structure
The relationship between yield (interest rate) and time to maturity
The yield curve is a graph that displays the relationship between yield and
maturity
7

4
Yield %

1/3/17 1/4/10 1/2/07 8/1/00

0
3 Mo 6 Mo 1 Yr 2 Yr 3 Yr 5 Yr 7 Yr 10 Yr 20 Yr 30 Yr

12
Constructing the Yield Curve:
Inflation
N

INFL t
IPN  t 1
N

Step 1: Find the average expected

inflation rate over Years 1 to N:
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
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)
Constructing the Yield Curve:
Maturity Risk
Using the given equation:
MRP1  0.1%  (1  1)  0.0%
MRP10  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
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%  8.0%

rRF ,10  3%  7.5%  0.9%  11.4%

rRF ,20  3%  7.75%  1.9%  12.65%

 Hypothetical Yield Curve

Interest
Rate (%) Upward slope
15 Maturity risk premium
due to an
increase in
10 Inflation premium expected
inflation and
5
increasing
Real risk-free rate
Years to maturity risk
0
1 10 20
Maturity
premium
 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
Since corporate yields include a default risk premium
(DRP) and a liquidity premium (LP), the corporate bond
yield spread can be calculated as:

Corporate bond
 Corporate bond yield  Treasury bond yield
yield spread
 DRP  LP
Representative Interest Rates on Bonds
of Different Credit Rating, Jan 2018

Corporate Bond
Rate Yield Spread =
DRP + LP
U. S. Treasury 2.47% 
AAA 3.02 55bps (or
Corporate 0.55%)
BBB 3.63 116bps (or
Corporate 1.16%)
“Junk” 7.92 545bps (or
Corporate 5.45%)