Finance Management

Interest Rates
 The Cost of Money
• Factors Affecting Money
1- Production opportunities
2- Time preferences for consumption
3- Risk
4- Inflation
 Interest rates paid to savers depends
on:
1- the rate of return that producers expect to
earn on invested capital,
2- savers’ time preferences for current versus
future consumption,
3- the riskiness of loan, and
4- the expected future inflation rates.
Expectations of Borrowers & Savers
• Producers’ (or borrowers’) expected return on
their business investments set an upper limit
to how much they can pay for savings,
• While consumers’ (or savers’) time
preferences for consumption establish how
much consumption they are willing to defer
and, hence, how much will they save at
different interest rates.
 Interest rate levels
• Borrowers bid for the available supply of debt
capital using interest rates.
• The firms with the most profitable investment
opportunities are willing and able to pay the
most for capital.
• They tend to attract it from inefficient firms
and firms whose products are not in demand.
 Interest rate levels
• At the same time government policies can also
influence the allocation of capital and the
level of interest rates.
• The figure below shows how supply and
demand interact to determine interest rates in
two capital markets.
Interest rate levels-figure
 Interest rate levels
• Market L and Market H represent two of the many capital
markets in existence.
• The supply curve in each market is upward-sloping, which
indicates that investors are willing to supply more capital
the higher interest rates they want to receive on their
capital.
• Likewise the downward-sloping demand curve indicates
that borrowers will borrow more if the interest rates are
lower.
• The interest rates in each market is the point where the
supply and demand curves intersect.
• The going interest rate, designed as r, is initially 5% for the
low-risk securities in Market L.
 Interest rate levels
• Borrowers whose credit is strong enough to participate
in this market can obtain funds at a cost of 5%, and
investors who want to put their money to work
without much risk can obtain a 5% return.
• Riskier borrowers must obtain higher-cost funds in
Market H, where investors who are more willing to take
risks expect to earn a 7% return but also realize that
they might receive much less.
• In this scenario investors are willing to accept the
higher risk in Market H in exchange for a risk premium
of 7% - 5% = 2%.
 Interest rate levels
• Assume that because of changing market forces,
investors perceive that Market H becomes
relatively more risky.
• This changing perception will induce many
investors to shift toward safer investments.
• Investors move their money from Market H to
Market L.
• The supply of funds is increased in Market L from
S1 to S2 ;
• and increased availability of capital will push down
interest rates in Market L from 5% to 4%.
 Interest rate levels
• At the same time, as investors move their
money out of Market H, there will be a
decreased supply of funds in that market;
• and tighter credit in Market H will force
interest rates up from 7% to 8%.
• In this new environment, money is transferred
from Market H to Market L,
• and risk premium rises from (7% - 5%) 2% to
8% - 4% = 4%.
 Interest rate levels

• Short-term interest rates are especially volatile,

rising rapidly during booms and falling equally
during recessions.
• In particular, see the dramatic drop in short-term
interest rates during recent recession.
Interest rate levels
 Interest rate levels
• When the economy is expanding, firms need
capital, and this demand pushes rates up.
• Inflationary pressures are strongest during
business booms, also exerting pressure on rates.
• Conditions are reversed during recessions: slack
business reduces the demand for credit, inflation
falls, and the central banks increases the supply
of funds to help stimulate the economy.
• The result is decline in interest rates.
 Interest rate levels

• The relationship between inflation and long-term

interest rates is highlighted figure below.
• It reflects the inflation over time goes along with
long-term interest rates.
The relationship between inflation and long-term
interest rates is highlighted in figure below.
 Real rates of interest
• The current interest rates minus the current
inflation rate is defined as
the «current real rate of interest».
• It is called a «real rate» because it shows how
much investors really earned after the effect of
inflation are removed.
• According to figure above, the real rate was
extremely high during the mid-1980s, but it has
generally been in the range of 1% to 4% since
1987.
 Real rates of interest
• However, long term interest rates have been
volatile in recent years because investors are
not sure if inflation is truly under control or it
is about to jump to higher levels of 1980s.
• Then we sure that in the years ahead:
1- the interest rates will vary, and
2- if inflation is higher the interest rates
will increase and if the inflation is expected to
decline, then the interest rates will decrease.
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 (or time) to its maturity.
 The Determinants of Market Interest Rates

𝐫 = the quoted, or nominal, rate of interest on a given

security.
𝐫 ∗ ="r-star“ the real risk free rate of interest.
it is the rate that would exist on a riskless security in a world
where no inflation was expected.
𝐫𝐑𝐅 = 𝐫 ∗ + 𝐈𝐏.
It is the quoted rate on risk-free security such as T-bills,
which is very liquid and is free of most types of risk.
Premium for expected inflation, IP, is included in rRF .
The Determinants of Market Interest Rates
𝐈𝐏 = inflation premium.
IP is equal to the average expected rate of inflation
over the life of the security.
The expected future inflation rate is not necessarily
equal to current inflation rate, so IP is not necessarily
equal to current inflation as shown figure above.
𝐃𝐑𝐏 = default risk premium.
This premium reflects the possibility that the issuer will
not pay the promised interest or principal at the stated
time.
DRP is zero for the Treasury or the States, but it rises as
the riskiness of the issuer’ risk increases.
The Determinants of Market Interest Rates
𝐋𝐏 = liquidity (or marketability) premium.
This is a premium charged by lenders to reflect the fact that
some securities cannot be converted to cash on short time at
a «reasonable» price.
LP is very low for Treasury securities and for securities by
large, strong firms;
but it is relatively high on securities issued by small, privately
held firms.
𝐌𝐑𝐏 = maturity risk premium.
Longer term bonds, even Treasury bonds, are exposed to a
significant risk of price declines due to increases in inflation
and interest rates; and the maturity risk premium is charged
by lenders to reflect this risk.
The Determinants of Market Interest Rates

𝐐𝐮𝐨𝐭𝐞𝐝 𝐨𝐫 𝐧𝐨𝐦𝐢𝐧𝐚𝐥 𝐢𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐫𝐚𝐭𝐞 =

𝐫 = 𝐫 ∗ + 𝐈𝐏 + 𝐃𝐑𝐏 + 𝐋𝐏 + 𝐌𝐑𝐏

Because 𝐫𝐑𝐅 = 𝐫 ∗ + 𝐈𝐏

we can rewrite the equation as follows:

𝐐𝐮𝐨𝐭𝐞𝐝, 𝐨𝐫 𝐧𝐨𝐦𝐢𝐧𝐚𝐥, 𝐫𝐚𝐭𝐞 =

𝐫 = 𝐫𝐑𝐅 + 𝐃𝐑𝐏 + 𝐋𝐏 + 𝐌𝐑𝐏

 ∗
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.
• It may be thought of as the rate of interest on
short-term Treasury securities in an inflation-free
world.
• The real risk-free rate is not static.
• It changes over time depending on economic
conditions.
 ∗
𝐫 , The Real Risk-Free Rate of Interest
• Especially;
1) on the rate of return that corporations and other
borrowers expect to earn on productive assets, and
2) on people’s time preferences for current versus future
consumption.
• Borrowers’ expected returns on real assets set an
upper limit on how much borrowers can afford to pay
for funds, while savers’ time preferences for
consumption establish how much consumption savers
will defer.
• Hence, the amount of money they will lend at different
interest rates.
 ∗
𝐫 , The Real Risk-Free Rate of Interest
• It is difficult to measure the risk-free rate
precisely, but most experts think that 𝐫 ∗ has
typically fluctuated in the range of 1% to 3% in
recent years in developed countries.
• The best estimate of 𝐫 ∗ is the rate of return on
indexed Treasury-bonds, which will be
discussed later.
 𝐫𝐑𝐅 = 𝐫 ∗ + 𝐈𝐏
The Nominal, or Quoted, Risk-Free Rate of Interest Rate
• 𝐫𝐑𝐅 is the real risk-free rate plus a premium for expected
inflation:
𝐫𝐑𝐅 = 𝐫 ∗ + 𝐈𝐏

• The risk free rate should be the interest rate on a totally

risk-free security-one that has no default risk, no maturity
risk, no liquidity risk, no risk of loss if inflation increases,
and no risk of any other type.
• There is no such security, and there is no observable truly
risk-free rate.
• Except one security, in the USA in recent downgrade,
named Treasury Inflation Protected Security (TIPS), whose
value increases with inflation was free of most risks.
 ∗
𝐫𝐑𝐅 = 𝐫 + 𝐈𝐏
• If the risk-free rate is used without the modifiers,
like real or nominal, then people generally mean
the quoted (or nominal) rate.
• 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.
 ∗
𝐫𝐑𝐅 = 𝐫 + 𝐈𝐏
• In general we use the T-bill rate to approximate
the short-term risk-free rate and T-bond rate to
approximately the long-term risk-free rate.
• So whenever you see the term risk-free rate,
assume that it is referring to the quoted T-bill
rate or to the quoted T-bond rate.
• The definition of the risk-free rate assumes that,
despite some exceptions, treasury securities have
no meaningful default risk.
 Inflation Premium (IP)
• Inflation has a major impact on interest rates.
• It erodes the real value of what you receive
from your investments.
• Suppose you have saved $10,000 to purchase
a car.
• Rather than buying a car today.
• You could invest the money with the hope of
buying a better car one year from now.
 Inflation Premium (IP)
• If you decide to invest in a one-year T-bill that pays a 1%
interest rate, you will have a little bit more money (10,000 x
1.01 = 10,100) at the end of the year.
• Suppose that overall inflation rate increased by 3% that
year.
• In this case, a similar version of the $10,000 car that you
would have purchased at the beginning of the year would
cost 3% more (10,300) at the end of that year.
• In this case, the additional interest that you earn on the T-
bill is not enough to compensate for the expected increase
in the price of the car.
• In real terms you are worse off because the nominal
interest rate is less than the expected inflation rate.
 Inflation Premium (IP)
• Investors are well aware of all this.
• So when they lend money, they build an inflation
premium (IP) equal to the average expected
inflation rate over the life of the security into the
rate they charge.
• So, the actual interest rate on a short-term default-
free T-bill, rT−bill , would be the real risk-free rate,
r ∗ , plus inflation premium (IP):

𝐫𝐓−𝐛𝐢𝐥𝐥 = 𝐫𝐑𝐅 = 𝐫 ∗ + 𝐈𝐏
 Inflation Premium (IP)
• If the real risk-free rate was r ∗ = 1.7%,
• and the inflation was expected to be 1.5% (IP =
1.5%) during the next year, the quoted rate of
interest on one-year T-bills would be 1.7% +
1.5% = 3.2%.
 Expected rate of inflation
• The inflation rate built into interest rates is the
«inflation rate expected in the future», is not the rate
experienced in the past.
• Thus the latest reported figures might show an annual
inflation rate 3% over the past 12 months, but that is
for the past year!
• If people on average expect a 4% inflation rate in the
future, 4% would be built into the current interest rate.
• Note also that the inflation rate reflected in the quoted
interest rate on any security is the «average inflation
rate expected over the security’s life».
 Expected rate of inflation
• So, the inflation rate built into a 1-year bond is
the expected inflation rate for the next year,
but the inflation rate built into a 30-year bond
is the average inflation rate expected over the
next 30 years.
• Expectations for the future inflation are
closely, but not perfectly, correlated with past
inflation rates.
 Expectations
• Therefore, if the inflation rate reported for last month
increased, people would tend to raise their
expectations for future inflation.
• This changes in expectations would increase current
rates.
• Also consumer prices change with a lag following
changes at the producer level.
• Also, if the price of oil increases this month, gasoline
prices are likely to increase in the coming months.
• This lagged situation between final product and
producer goods prices exists throughout the economy.
 Default Risk Premium (DRP)
• The risk that a borrower will default.
• Which means the borrower will not make
scheduled interest or principal payments.
• DRP also affects the market interest rate on a
bond.
• The greater the bond’s risk of default, the
higher the market rate for it.
 Default Risk Premium (DRP)
• Also that we are assuming Treasury securities
have no default risk, they carry the lowest
interest rates.
• For corporate bonds, bond ratings are often
used to measure default risk.
• The higher the bond’s rating, the lower its
default risk and the lower its interest rate.
 Default Risk Premium (DRP)
• 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».
• The average default risk premiums vary over
time, and tend to get larger when the
economy is weaker and borrowers are more
likely to have a hard time paying off their
debts.
 Liquidity Premium (LP)
• A liquid asset can be converted to cash
«quickly» at a «fair market value».
• Real assets generally the less liquid than
financial assets.
• Different financial assets vary in their liquidity.
• Because investors prefer assets that are more
liquid, they include a liquidity premium (LP) in
the rates charged on different debt securities.
 Liquidity Premium (LP)
• Although it is difficult to measure liquidity premium
accurately, we can get some sense of an asset’s
liquidity by looking its trading volume.
• Assets with higher trading volume are generally
easier to sell, and are therefore more liquid.
• The average liquidity premiums also vary over time.
• During the financial crisis, the liquidity premiums
on many assets soared.
 Liquidity premium
• The markets for many assets that were once
highly liquid suddenly dried up as everyone
rushed to sell them at the same time.
• The liquidity of real assets also varies over time.
• For example at the height of housing boom in the
USA, many homes in hot real asset markets were
often sold the first day they were listed.
• After the bubble burst, homes in these same
markets sat unsold for months.
Interest Rate Risk and The Maturity Risk Premium
(MRP)
• Despite a few recent concerns about the Treasury’s
long-run ability to service its growing debt, we
generally assume that Treasury securities are free of
default risk.
• In the sense that one can be certain that the
government will pay interest on its bonds and pay
them off when they mature.
• Therefore we assume that the default risk premium on
Treasury securities is zero.
• Further, active markets exist for Treasury securities, so
we assume that their liquidity premium is also zero.
Interest Rate Risk and The Maturity Risk Premium
(MRP)
• Thus, the rate of interest on a Treasury security
should be the risk-free rate, rRF , which is the real
risk-free rate plus an inflation premium.
rRF = r ∗ + IP
• However 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.
Interest Rate Risk and The Maturity Risk Premium
(MRP)
• As a general rule, the bonds of any organization
have more interest rate risk the longer maturity
of the bond.
• Therefore, a maturity risk premium (MRP),
which is higher the greater the years to maturity,
is included in the required interest rate.
 MRP
• The effect of maturity risk premiums is to raise
interest rates on long-term bonds relative to
those on short-term bonds.
• This premium like the others is difficult to
measure; but
(1)it varies somewhat over time, rising when
interest rates are more volatile and uncertain, and
then falling when interest rates are more stable and
(2)in recent years, the maturity risk premium on 20-
year T-bonds has generally been in the range of one
to two percentage points.
 Reinvestment rate risk
• Although long-term bonds heavily exposed to
interest rate risk, short-term bills are heavily
exposed to reinvestment rate risk.
• When short-term bills mature and the principal
must be reinvested, or «rolled over», a decline
in interest rates would necessitate
reinvestment at a lower rate, which would
result in a decline in interest income.
 Interest rate risk and reinvestment rate risk
• Suppose you had $100,000 invested in T-bills and you lived
on the income.
• In 1981 for example, short-term rates for T-bills were about
15%, so your income would have been about $15,000.
• However your income would have declined to about $9,000
by 1983 and to just $70 by February 2013.
• Had you invested your money in long-term bonds, your
income (but not the value of the principal) would have
been stable.
• Although ‘investing short’ preserves one’s principal, the
interest income provided by short-term T-bills is less stable
than that on long-term bonds.
 Example
• The real rate of interest is 2% and is expected to remain constant
for the next 3 years.
• Inflation is expected to be 3% next year, 3.5% for the following
year, and 4% the third year.
• The maturity risk premium is estimated to be 0.1 x t − 1 %,
where t =number of years to maturity.
• The liquidity premium on relevant 3-year securities is 0.25% and
the default risk premium on relevant 3-year securities is 0.6%.

• a. What is the yield on a 1-year T-bill?

• b. What is the yield on a 3-year T-bond?
• c. What is the yield on a 3-year corporate bond?
 Answer
a. A Treasury security has no default risk premium or liquidity risk premium. Therefore,
rT1 = r ∗ + IP1 + MRP1
rT1 = 2% + 3% + 0.1 1 − 1 % = 5%.

b. A Treasury security has no default risk premium or liquidity risk premium. Therefore,
rT3 = r ∗ + IP3 + MRP3
rT3 = 2% + (3% + 3.5% + 4%)/3 + 0.1 3 − 1 %
rT3 = 2% + 3.5% + 0.2% = 5.7%

c. Unlike Treasury securities, corporate bonds have both a default risk premium and a
liquidity risk premium
rC3 = r ∗ + IP3 + MRP3 + DRP + LP

Realize that the first three terms in this equation are identical to the terms in the Part b
equation.
So we can rewrite this equation as follows:
rC3 = rT3 + DRP + LP
rC3 = 5.7% + 0.6% + 0.25% = 6.55%.