STRUCTURE OF
INTEREST RATES
CHAPTER 6
Learning Objectives
To define interest rate
To discuss the determinants of interest rate
To discuss the components of interest rate
To explain the role of interest rate to finance
What is Interest rate?
An interest rate is the rate at which interest is paid by borrowers
(debtors) for the use of money that they borrow from lenders
(creditors).
Interest rate risk is a risk that an investment's value will change
due to a change in the absolute level of interest rates, in the
spread between two rates, in the shape of the yield curve or in
any other interest rate relationship.
6-3
Five Components of Interest Rates
Real Risk-Free Rate
Expected Inflation
Default-Risk Premium
Liquidity Premium
Maturity Premium
6-4
Determinants of Market
Interest Rates
nominal interest rate (or money interest rate) is the percentage
increase in money you pay the lender for the use of the money
you borrowed.
real interest rate measures the percentage increase in purchasing
power the lender receives when the borrower repays the loan with
interest
5
Real Rate of Interest
NOMINAL INTEREST RATE (R): Interest rate that is
observed in the marketplace
BASIC EQUATION: r = RR + IP + DRP
REAL RATE OF INTEREST (RR): Interest rate on a risk-
free debt instrument when no inflation is expected
6
Inflation Premium and Default Risk Premium
BASIC EQUATION: r = RR + IP + DRP
INFLATION PREMIUM (IP): Average inflation rate
expected over the life of the security
DEFAULT RISK PREMIUM (DRP): Compensation for
the possibility of the borrower’s failure to pay interest
and/or principal when due
7
Maturity Risk Premium
BASIC EQUATION EXPANDED: r = RR + IP + DRP + MRP
MATURITY RISK PREMIUM (MRP): Compensation
expected by investors due to interest rate risk on debt
instruments with longer maturities
8
Liquidity Premium
BASIC EQUATION EXPANDED: r = RR + IP + DRP + MRP +
LP
LIQUIDITY PREMIUM (LP): Compensation for securities that
cannot easily be converted to cash without major price discounts
Types of Treasury Debt
Obligations
TREASURY BILLS: Obligations that bear the shortest (up
to one year) original maturities
TREASURY NOTES: Obligations issued for maturities of
one to ten years
TREASURY BONDS: Obligations of any maturity but
usually over five years
10
Types of Inflation
COST-PUSH INFLATION: Occurs when prices are raised to
cover rising production costs, such as wages
DEMAND-PULL INFLATION: Occurs during economic
expansions when demand for goods and services is greater than
supply
11
Types of Inflation (Continued)
SPECULATIVE INFLATION: Caused by the expectation
that prices will continue to rise, resulting in increased
buying to avoid even higher future prices
12
Interest Rate and Its Role in Finance
Finance deals with funds which denote money
Money lent or money borrowed has a cost, that is, the interest
rate.
Changes in interest rates affect the level of investment spending,
level of consumer expenditures, redistribution of wealth between
borrowers and lenders, and prices of financial securities.
The interest rate on government securities like T-bills are used as
benchmark yield for all securities because these securities are
default-free
