Lecture 5 BH CH 6 Interest Rates

PRINCIPLES OF FINANCE
Chapter 6 (BH)
Interest Rates
1
Key Concepts
 Interest Rates
 Determinants of Interest Rates
 Risk Structure of Interest Rates
 Term Structure of Interest Rates
 Yield Curves
 Estimate the Future Interest Rates
2
The cost of money
 The price, or cost, of debt capital is the interest

rate.
 The price, or cost, of equity capital is the required
return. The required return investors expect is
composed of compensation in the form of dividends
and capital gains.
3
What factors affect the cost of money?
 Production opportunities
 Time preferences for
consumption
 Risk
 Expected inflation
4
“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.
rRF = represents the rate of interest on Treasury

securities. (RF = Risk Free) The premium for
expected inflation is include in rRF
5
Determinants of interest rates
r = r* + Inflation Premium + Default Risk Premium
+ Liquidity Premium + Maturity Risk Premium
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
If you invested money
 Not need now (willing to save for later)

 Certainty of repayment (credit or default)
 Maintain purchasing power
 Get paid for use of your money
 Get paid for not having access to money
 Get paid for volatility of rates
7
Premiums added to r* for different types of debt
Risk Premium: Infl Maty Default Liquid

S-T Treasury 
L-T Treasury  
S-T Corporate   
L-T Corporate    
8
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 February 2019 US

Treasury yield curve is
shown at the right.
9
Shape of Yield Curves
10
Constructing the yield curve: Inflation Premium(IP)
 Step1 – Find the average expected inflation rate over years

1 to N:
 INFL t
IPN  t 1
N
11
Constructing the yield curve:
Inflation Premium (IP)
Assume inflation is expected to be 5% next year, 6%
the following year, and 8% thereafter.
Inflation Premium
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; these

IPs would permit you to earn r* (before taxes).
12
Constructing the yield curve: Maturity Risk
 Step 2 – Find the appropriate Maturity Risk

Premium (MRP). For this example, the
following equation will be used find a
security’s appropriate maturity risk premium.
MRPt  0.1% ( t - 1 )
13
Constructing the yield curve:
Maturity Risk
Using the given equation:
MRP1 = 0.1% x (1-1) = 0.0%
MRP10 = 0.1% x (10-1) = 0.9%
MRP20 = 0.1% x (20-1) = 1.9%
Note:
 the equation is linear
 maturity risk premium increases as time to
maturity increases
14
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% + 0.0% = 8.0%
rRF, 10 = 3% + 7.5% + 0.9% = 11.4%
rRF, 20 = 3% + 7.75% + 1.9% = 12.65%
15
Hypothetical yield curve
Interest  An upward sloping

Rate (%)
yield curve.
15 Maturity risk premium
 Upward slope due
to an increase in
10 Inflation premium
expected inflation
and increasing
5 maturity risk
Real risk-free rate
premium.
0 Years to
1 10 20 Maturity 16
Relationship between Treasury yield
curve and corporate yield curves
 Corporate yield curves are higher than Treasuries
 Not necessarily parallel to the Treasury curve.
 Spread between corporate and Treasury yield
curves widens as the corporate bond rating
(credit) decreases
17
Illustrating the relationship between
corporate and Treasury yield curves
Interest
Rate (%)
15
BB-Rated
10
AAA-Rated
Treasury
6.0% Yield Curve
5 5.9%
5.2%
Years to
0 Maturity
0 1 5 10 15 20 18
Bond Ratings by Moody’s and S&P’s
19
20
Pure Expectations Hypothesis
 Yield curve depends on investor expectations about

future interest rates.
 Key Assumption: Bonds are different maturities are
perfect substitutes.
 Implication: expected return on bonds of different
maturities are equal.
21
Pure Expectations Hypothesis
 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, your expected wealth is the
same.
22
An example:
Observed Treasury rates and the Pure Expectation Hypothesis
(PEH)
Maturity Yield
1 year 6.0%
2 years 6.2%
3 years 6.4%
4 years 6.5%
5 years 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?
23
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
 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%.
24
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
 PEH says that three-year securities will yield
6.7005%, two years from now.
25
Conclusions about PEH
 Explains why yield curve has different slopes

1. When short rates are expected to rise in future,
average of future short rates is above today's short
rate; therefore yield curve is upward sloping.
2. When short rates expected to stay same in future,
average of future short rates same as today’s, and
yield curve is flat.
3. Only when short rates expected to fall will yield
curve be downward sloping.
26
Other factors that influence interest
rate levels
 Central Bank reserve policy

 Government budget surplus or deficit
 Level of business activity
 International factors
27
Summary
r = r* + IP +DRP +LP +MRP

 Yield Curve
 Bond Ratings
 Pure expectation Theory
28

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PRINCIPLES OF FINANCE

 The price, or cost, of debt capital is the interest

r* = represents the “real” risk-free rate of

rRF = represents the rate of interest on Treasury

r = Required Return on a debt security

r* = real risk-free rate of interest

 Not need now (willing to save for later)

Risk Premium: Infl Maty Default Liquid

 The February 2019 US

 Step1 – Find the average expected inflation rate over years

Must earn these IPs to break even vs. inflation; these

 Step 2 – Find the appropriate Maturity Risk

rRF, t = r* + IPt + MRPt

Interest  An upward sloping

 Yield curve depends on investor expectations about

 Assumes that the maturity risk premium for

(1.065)5 = (1.062)2 (1+x)3

 Explains why yield curve has different slopes

 Central Bank reserve policy

r = r* + IP +DRP +LP +MRP

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