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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 6-1
The determinants of interest rates
r = r* + IP + DRP + MRP + LP
where
r = the quoted, or nominal rate on a given security
r* = real risk-free 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 risk-free rate (T-bill 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 medium-term maturities are higher than
both short-term and long-term maturities)

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