Lecture Three – Integrative

Problems
The Cost of Money (Interest
Rates)

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Problem

 In an effort to better understand how his

investments are affected by market factors,
Mandla Tshabalala, the professional soccer
player introduced in the integrative problem in
Chapter 3, has posed some questions about
yields and interest rates that he wants
answered. Your boss at Cape Investors
Advisory has asked you to answer the
following questions for Mr. Tshabalala.

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A. What is the difference between the rand return and
the percentage return, or yield, on an investment?
Show how each return is computed.

 The rand return is the amount in Rands that an

investor would be paid if an investment is
liquidated at a particular period.
 The percentage return is simply the rand
return stated as a ratio of the original
purchase price of the investment.

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B. Mr. Tshabalala mentioned that he purchased shares
one year ago for R250 per share, and that the shares
have a current market value equal to R240. He knows
he received a dividend payment equal to R25, but he
doesn’t know what rate of return he earned on his
investment. Help Mr. Tshabalala by showing him how to
compute the rate of return on his investment.

 Total rand return = (R240 – R250) + R25 = R15

 Yield = R15/R250 = 0.06 = 6.0%

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C. What do you call the price that a borrower must pay
for debt capital? What is the price of equity capital?
What are the four most fundamental factors that affect
the cost of money, or the general level of interest rates,
in the economy?
 The interest rate is the price paid for borrowed
capital
 The return on equity capital equals dividends
plus capital gains.
 The return that investors require on capital
depends on:
1. Production opportunities
2. Time preferences for consumption
3. Risk
4. Inflation 5
D. What is the real risk‑free rate of interest (r*) And the
nominal risk‑free rate (rRF)? How are these two rates
measured?

 The real risk‑free rate, r*, is the rate that

would exist on default‑free securities in the
absence of inflation.
 The nominal risk‑free rate, rRF, is equal to the
real risk‑free rate plus an inflation premium
that is equal to the average rate of inflation
expected over the life of the security.

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E. Define the terms inflation premium (IP),
default risk premium (DRP), liquidity premium
(IP), and maturity risk premium (MRP). Which
of these premiums is included when
determining the interest rate on:

Short‑term SA Treasury securities

Long‑term SA Treasury securities
Short‑term corporate securities
Long‑term corporate securities?

Explain how the premiums would vary over

time and among the different securities listed
above.
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E. Define the terms inflation premium (IP), default risk
premium (DRP), liquidity premium (IP), and maturity
risk premium (MRP).
 The inflation premium (IP) is a premium added to
the real risk‑free rate of interest to compensate for
expected inflation.
 The default risk premium (DRP) is a premium based
on the probability that the issuer will default on the
loan, and it is measured by the difference between
the interest rate on a SA Treasury bond and a
corporate bond of equal maturity and marketability.
 A liquid asset is one that can be sold on short
notice without substantial loss of the original
principal (investment).

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E. Define the terms inflation premium (IP), default risk
premium (DRP), liquidity premium (IP), and maturity
risk premium (MRP).

 A liquidity premium is added to the rate of

interest on securities that are not liquid.
 The maturity risk premium (MRP) is a premium
which reflects interest rate risk; longer‑term
securities have more interest rate risk (the risk
of capital loss due to rising interest rates) than
do shorter‑term securities, and the MRP is
added to reflect this risk.

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E. Which premiums are included when determining the
interest rate?

1. Short‑term treasury securities include only an

inflation premium.
2. Long‑term treasury securities contain an inflation
premium plus a maturity risk premium.
3. The rate on short‑term corporate securities is equal
to the real risk‑free rate plus premiums for inflation,
default risk, and liquidity.
4. The rate for long‑term corporate securities is similar
to short-term corporate securities, but it also
includes a premium for maturity risk. Thus, long‑term
corporate securities generally carry the highest
yields of these four types of securities.

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F. What is the term structure of interest rates? What is
a yield curve?

 The term structure of interest rates is the

relationship between interest rates, or yields,
and the maturities of securities.
 When this relationship is graphed, the
resulting curve is called a yield curve.

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F. At any given time, how would the yield curve facing a
telecommunication company compare with the yield
curve for SA Treasury securities? Draw a graph to
illustrate your answer.

Telecommunication Company

SA Treasury Security

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G. Several theories have been advanced to explain the
shape of the yield curve. The three major ones are the
market segmentation theory, the liquidity preference
theory, and the expectations theory. Briefly describe
each of these theories.
 The market segmentation theory states that
each borrower and lender has a preferred
maturity, and that the slope of the yield curve
depends on the supply of and demand for
funds in the long‑term market relative to the
situation in the short‑term market.

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G. The three major ones are the market segmentation
theory, the liquidity preference theory, and the
expectations theory. Briefly describe each of these
theories.
 The liquidity preference theory states that
because:
1. Investors generally prefer to lend short‑term
2. Borrowers prefer to borrow long‑term,
long‑term rates generally will be higher than
short‑term rates. Borrowers are willing to
pay a premium for long‑term debt because it
exposes them to less risk of having to repay
the debt under adverse conditions, and
investors demand a higher return on
long‑term debt because it exposes them to
more interest rate risk. 14
G. The three major ones are the market segmentation
theory, the liquidity preference theory, and the
expectations theory. Briefly describe each of these
theories. Do economists regard one as being “true?”
 The expectations theory states that the yield
curve depends on investors’ expectations
about future interest rates: If inflation is
expected to increase, the yield curve will be
upward-sloping.
 All three theories have merit, and each of
these factors contribute to the shape of the
yield curve.

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H. Suppose most investors expect the rate of inflation
to be 2 percent next year, 4 percent the following year,
and 3 percent thereafter. The real risk-free rate is 3
percent. The maturity risk premium is zero for bonds
that mature in one year or less, 0.1 percent for two-
year bonds, and the MRP increases by 0.1 percent per
year thereafter for 20 years, after which it is stable.
What is the interest rate on one-, 10-, and 20-year
treasury bonds? Draw a yield curve with these data. Is
your yield curve consistent with the three term
structure theories?

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H. What is the interest rate on one-, 10-, and 20-year
treasury bonds?

 Step 1: find the average expected inflation rate over years 1

to 20:
 Year 1: IP = 1.0%
 Year 10: IP = (1 + 3 + 4 + 4 +...+ 4)/10 = 36/10 =
3.6%
 Year 20: IP = (1 + 3 + 4 + 4 +...+ 4)/20 = 76/20 =
3.8%
 Step 2: Find the maturity premium in each year:
 Year 1: MRP = 0.0%
 Year 10: MRP = 0.1 x 9 = 0.9%
 Year 20: MRP = 0.1 x 19 = 1.9%
 Step 3: Sum the IPs and MRPs, and add r* = 3%:
 Year 1: rRF = 3% + 1.0% + 0.0% = 4.0%
 Year 10: rRF = 3% + 3.6% + 0.9% = 7.5%
 Year 20: rRF = 3% + 3.8% + 1.9% = 8.7% 17
H. Draw a yield curve with these data. Is your yield
curve consistent with the three term structure theories?

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H. Is your yield curve consistent with the three term
structure theories?

 The yield curve is based directly on, hence is consistent

with, at least two of the theories: (1) expectation and
(2) liquidity preferences.
 It contains a maturity risk premium, which is the
essence of the liquidity preference theory, and it
reflects inflation, which is the essence of the
expectations theory.
 It could be consistent with the market segmentation
theory, but this would require that there be no excess
supply or demand in any maturity segment. If we added
a “kicker” which raised or lowered long- or short-term
rates, we could build in market segmentation.

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I. Suppose current interest rates on treasury securities
are as follows: Using the expectations theory, compute
the expected interest rates (yields) for each security
one year from now. What will the rates be three years
from today?
Maturity yield
1 year 4.4%
2 years 4.8
3 years 5.0
4 years 5.4
5 years 6.0

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I. What will the rates be three years from today?
 The yield to maturity represents the average of the
one-year rates that are expected during the life of the
bond. As a result the annual rates that are expected
for the next five years are computed as follows:
YTM1-year = 4.4% = rYear 1/1, so the expected interest rate next year is
4.4%

YTM2-years = 4.8% = (rYear 1 + rYear 2)/2 = (4.4% + rYear 2)/2

rYear 2 = 2(4.8%) – 4.4% = 5.2%

YTM3-years = 5.0% = (rYear 1 + rYear 2 + rYear 3)/3 = (4.4% + 5.2% + rYear

3 )/3
rYear 3 = 3(5.0%) – (4.4% + 5.2%) = 5.4%
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I. The annual rates that are expected for the next five
years are computed as follows:

YTM4-years = 5.4% = (rYear 1 + rYear 2 + rYear 3 + rYear 4)/4 = (4.4% + 5.2%

+ 5.4% + rYear 4)/4
rYear 4 = 4(5.4%) – (4.4% + 5.2% + 5.4%) = 6.6%

YTM5-years = 6.0% = (rYear 1 + rYear 2 + rYear 3 + rYear 4 + rYear 5)/5 = (4.4%

+ 5.2% + 5.4% + 6.6% + rYear 5)/5
rYear 5 = 5(6.0%) – (4.4% + 5.2% + 5.4% + 6.6%) = 8.4%

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I. According to the previous computations, the
expected rates each year for the next five years are:

Period One-Year Rate

Year 1 4.4%
Year 2 5.2
Year 3 5.4
Year 4 6.6
Year 5 8.4

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I. Because the yields on the bonds represent the
averages of the one-year rates, after one year has
passed, the yields on the bonds that remain
outstanding are as follows:
Original Remaining
Life Life Yield
1 Year matured
2 Years 1 Year 5.2% = (5.2%)/1
3 Years 2 Years 5.3 = (5.2% + 5.4%)/2
4 Years 3 Years 5.7 = (5.2% + 5.4% +
6.6%)/3
5 Years 4 Years 6.4 = (5.2% + 5.4% +
6.6% + 8.4%)/4

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I. After three years have passed, the yields on the
bonds that remain outstanding are as follows:

Original Remaining
Life Life Yield
1 Year matured
2 Years matured
3 Years matured
4 Years 1 Years 6.6 = (6.6%)/1
5 Years 2 Years 7.5 = (6.6% +
8.4%)/2

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END

 Thank You

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