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Chapter 6  Interest Rates
Interest rates
The determinants of interest rates
Term structure of interest rates and yield curves
What determines the shape of yield curves
Other factors
Interest rates
Cost of borrowing money
Factors that affect cost of money:
Production opportunities
Time preference for consumption
Risk
Inflation
Demand and supply for funds, see Figure 61
The determinants of interest rates
r = r* + IP + DRP + MRP + LP
where
r = the quoted, or nominal rate on a given security
r* = real riskfree rate
IP = inflation premium (the average of expected future inflation rates)
DRP = default risk premium
MRP = maturity risk premium
LP = liquidity premium
and
r* + IP = r
RF
= nominal riskfree rate (Tbill rate)
Examples
Term structure of interest rates and yield curves
Term structure of interest rates: the relationship between yields and maturities
Yield curve: a graph showing the relationship between yields and maturities
Normal yield curve (upward sloping)
Abnormal yield curve (downward sloping)
Humped yield curve (interest rates on mediumterm maturities are higher than
both shortterm and longterm maturities)
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What determines the shape of yield curves
Term structure theories
(1) Expectation theory: the shape of the yield curve depends on investor’s
expectations about future interest rates (inflation rates)
Forward rate: a future interest rate implied in the current interest rates
For example, a oneyear Tbond yields 5% and a twoyear Tbond yields 5.5%,
then the investors expect to yield 6% for the Tbond in the second year.
(1+5.5%)
2
= (1+5%)(1+X), solve for X(forward rate) = 6.00238%
Approximation: (5.5%)*2 – 5% = 6%
(2) Liquidity preference theory: other things constant, investors prefer to make
shortterm loans, therefore, they would like to lend shortterm funds at lower rates
Implication: keeping other things constant, we should observe normal yield
curves
Other factors
Fed policy; Government budget deficit; Business activity
International perspective: trade deficit, country risk, exchange rate risk
Exercise
ST1, ST2, and ST3
Problems: 2, 3, 5, 7, 10*, 11, and 12*
Problem 10: expected inflation this year = 3% and it will be a constant but above
3% in year 2 and thereafter; r* = 2%; If the yield on a 3year Tbond equals the 1
year Tbond yield plus 2%, what inflation rate is expected after year 1, assuming
MRP = 0 for both bonds?
Answer: yield on 1year bond, r
1
= 3% + 2% = 5%; yield on 3year bond,
r
3
= 5% + 2% = 7% = r* + IP
3
; IP
3
= 5%; IP
3
= (3% + x + x) / 3 = 5%, x = 6%
Problem 12: Given r* = 2.75%, inflation rates will be 2.5% in year 1, 3.2% in
year 2, and 3.6% thereafter. If a 3year Tbond yields 6.25% and a 5year Tbond
yields 6.8%, what is MRP
5
 MRP
3
(For Tbonds, DRP = 0 and LP = 0)?
Answer: IP
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This note was uploaded on 05/10/2011 for the course FIN 303 taught by Professor Philips during the Spring '08 term at CSU Northridge.
 Spring '08
 PHILIPS
 Interest, Interest Rate, Yield Curve

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