Unformatted text preview: minal rate of interest – quoted rate of
interest, change in purchasing power, and
The ex ante nominal rate of interest includes
our desired real rate of return plus an
adjustment for expected inflation
adjustment 36 The Fisher Effect The Fisher Effect defines the relationship
between real rates, nominal rates, and inflation
(1 + R) = (1 + r)(1 + h), where R = nominal rate
r = real rate
h = expected inflation rate Approximation R=r+h 37 Example 7.5 If we require a 10% real return and we expect
inflation to be 8%, what is the nominal rate?
R = (1.1)(1.08) – 1 = .188 = 18.8%
Approximation: R = 10% + 8% = 18%
Because the real return and expected inflation
are relatively high, there is significant
difference between the actual Fisher Effect and
the 38 Term Structure of Interest Rates Term structure is the relationship between time to
maturity and yields, all else equal
It is important to recognize that we pull out the effect of
default risk, different coupons, etc.
Yield curve – graphical representation of the term
structure Normal – upward-sloping, long-term yields are higher than shortterm yields
Inverted – downward-sloping, long-term yields are lower than
short-term 39 Figure 7.6 – Upward-Sloping
Yield 40 Figure 7.6 – Downward-Sloping
Yield 41 Figure 7.7 42 Factors Affecting Bond Yields Default risk premium – remember bond ratings
Taxability premium – remember municipal
Liquidity premium – bonds that have more
frequent trading will generally have lower
Anything else that affects the risk of the cash
flows to the bondholders will affect the required
returns 43 Quick Quiz How do you find the value of a bond and why do bond
What is a bond indenture and what are some of the
What are bond ratings and why are they important?
How does inflation affect interest rates?
What is the term structure of interest rates?
What factors determine the required return on bonds?
What 44 7 End of Chapter 45
45 Comprehensive Problem What is the price of a $1,000 par value bond with
a 6% coupon rate paid semiannually, if the bond
is priced to yield 5% YTM, and it has 9 years to
What would be the price of the bond if the yield
rose to 7%.
What is the current yield on the bond if the YTM
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