Chapter 6

Interest Rates
Learning Objectives
After reading this chapter, students should be able to:
List the various factors that influence the cost of money.
Discuss how market interest rates are affected by borrowers need for capital, expected
inflation, different securities risks, and securities liuidity.
!xplain what the yield curve is, what determi nes its shape, and how you can use the yield
curve to help forecast future interest rates.
Chapter 6: Interest Rates Learning Objectives 113
Lecture Suggestions
"hapter # is important because it lays the groundwork for the followi ng chapters.
Additionall y, students have a curiosity about interest rates, so this chapter stimulates their
interest in the course.
$hat we cover, and the way we cover it, can be seen by scanning the slides and
%ntegrated "ase solution for "hapter #, which appears at the end of this chapter solution. &or
other suggestions about the lecture, please see the 'Lecture (uggestions) in "hapter *, where
we describe how we conduct our classes.
DAYS ON CA!"#R: 1 O$ %& DAYS '%() *inute perio+s,
11- Lecture Suggestions Chapter 6: Interest Rates
Ans.ers to #n+) o/) Chapter 0uestions
6) 1 +egional mortgage rate differentials do exist, depending on supply,demand
conditions in the different regions. -owever, relativel y high rates in one region would
attract capital from other regions, and the end result would be a differenti al that was
.ust sufficient to cover the costs of effecting the transfer /perhaps 0 of one
percentage point1. Differentials are more likely in the residential mortgage market
than the business loan market, and not at all likely for the large, nationwi de firms,
which will do their borrowing in the lowest2 cost money centers and thereby uickl y
euali3e rates for large corporate loans. %nterest rates are more competi ti ve, making
it easier for small borrowers, and borrowers in rural areas, to obtain lower cost loans.
6) 1 (hort2 term interest rates are more volatile because /41 the &ed operates mainl y in the
short2 term sector, hence &ederal +eserve interventi on has its ma.or effect here, and
/*1 long2 term interest rates reflect the average expected inflation rate over the next
*5 to 65 years, and this average does not change as radically as year2 to2 year
expectations.
6) 3 %nterest rates will fall as the recession takes hold because /41 business borrowi ngs will
decrease and /*1 the &ed will increase the money supply to stimulate the economy.
7hus, it would be better to borrow short2 term now, and then to convert to long2 term
when rates have reached a cyclical low. 8ote, though, that this answer reuires
interest rate forecasting, which is extremel y difficult to do with better than 95:
accuracy.
6) - a2 %f transfers between the two markets are costly, interest rates would be different in
the two areas. Area ;, with the relativel y young population, would have less in
savings accumulati on and stronger loan demand. Area <, with the relati vel y old
population, would have more savings accumulati on and weaker loan demand as
the members of the older population have already purchased their houses and are
less consumption oriented. 7hus, supply,demand euilibri um would be at a higher
rate of interest in Area ;.
b2 ;es. 8ationwide branching, and so forth, would reduce the cost of financial
transfers between the areas. 7hus, funds would flow from Area < with excess
relati ve supply to Area ; with excess relati ve demand. 7his flow would increase
the interest rate in Area < and decrease the interest rate in ; until the rates were
roughl y eual, the difference being the transfer cost.
6) % A significant increase in producti vi ty would raise the rate of return on producers
investment, thus causing the investment curve /see &igure #24 in the textbook1 to
shift to the right. 7his would increase the amount of savings and investment in the
economy, thus causing all interest rates to rise.
6) 6 a2 7he immediate effect on the yield curve would be to lower interest rates in the
short2 term end of the market, since the &ed deals primaril y in that market
segment. -owever, people would expect higher future inflation, which would raise
long2 term rates. 7he result would be a much steeper yield curve.
b2 %f the policy is maintai ned, the expanded money supply will result in increased
Chapter 6: Interest Rates Answers and Solutions 11%
rates of inflation and increased inflationary expectations. 7his will cause investors
to increase the inflation premium on all debt securities, and the entire yield curve
would rise= that is, all rates would be higher.
6) 3 a2 (>Ls would have a higher level of net income with a 'normal ) yield curve. %n this
situation their liabilities /deposits1, which are short2 term, would have a lower cost
than the returns being generated by their assets /mortgages1, which are long2 term.
7hus, they would have a positive 'spread.)
b2 %t depends on the situation. A sharp increase in inflation would increase interest
rates along the entire yield curve. %f the increase were large, short2 term interest
rates might be boosted above the long2 term interest rates that prevailed prior to
the inflation increase. 7hen, since the bulk of the fixed2 rate mortgages were
initiated when interest rates were lower, the deposits /liabilities1 of the (>Ls would
cost more than the returns being provided on the assets. %f this situation continued
for any length of time, the euity /reserves1 of the (>Ls would be drained to the
point that only a 'bailout ) would prevent bankruptcy. 7his has indeed happened
in the ?nited (tates. 7hus, in this situation the (>L industry would be better off
selling their mortgages to federal agencies and collecting servicing fees rather
than holding the mortgages they originated.
6) & 7reasury bonds, along with all other bonds, are available to investors as an alternati ve
investment to common stocks. An increase in the return on 7reasury bonds would
increase the appeal of these bonds relative to common stocks, and some investors
would sell their stocks to buy 72bonds. 7his would cause stock prices, in general, to
fall. Another way to view this is that a relativel y riskless investment /72bonds1 has
increased its return by @ percentage points. 7he return demanded on riskier
investments /stocks1 would also increase, thus driving down stock prices. 7he exact
relationship will be discussed in "hapter A /with respect to risk1 and "hapters B and C
/with respect to price1.
6) 4 A trade deficit occurs when the ?.(. buys more than it sells. %n other words, a trade
deficit occurs when the ?.(. imports more than it exports. $hen trade deficits occur,
they must be financed, and the main source of financing is debt. 7herefore, the larger
the ?.(. trade deficit, the more the ?.(. must borrow, and as the ?.(. increases its
borrowi ng, this drives up interest rates.
116 Answers and Solutions Chapter 6: Interest Rates
So5utions to #n+) o/) Chapter !rob5e*s
6) 1 a2 7erm +ate
# months 9.4:
4 year 9.9
* years 9.#
6 years 9.B
@ years 9.A
9 years #.5
45 years #.4
*5 years #.9
65 years #.6
b2 7he yield curve shown is an upward sloping yield curve.
c2 7his yield curve tells us generall y that either inflation is expected to increase or
there is an increasing maturi ty risk premi um.
+2 !ven though the borrower reinvests in increasing short2 term rates, those rates are
still below the long2 term rate, but what makes the higher long2 term rate attracti ve
is the rollover risk that may possibly occur if the short2 term rates go even higher
than the long2 term rate /and that could be for a long timeD1. 7his exposes you to
rollover risk. %f you borrow for 65 years outright you have locked in a #.6: interest
rate each year.
6) 1 72bill rate E rF G %H
9.9: E rF G 6.*9:
rF E *.*9:.
6) 3 rF E 6:= %4 E *:= %* E @:= %6 E @:= I+H E 5= r7* E J= r76 E J
r E rF G %H G D+H G LH G I+H.
(ince these are 7reasury securities, D+H E LH E 5.
r7* E rF G %H*.
%H* E /*: G @:1,* E 6:.
r7* E 6: G 6: E #:.
r76 E rF G %H6.
%H6 E /*: G @: G @:1,6 E 6.66:.
r76 E 6: G 6.66: E #.66:.
6) - r745 E #:= r"45 E A:= LH E 5.9:= D+H E J
r E rF G %H G D+H G LH G I+H.
Chapter 6: Interest Rates Answers and Solutions 113
0
2
4
6
8
10
0 5 10 15 20 25 30
%nterest +ate
/:1
;ears to Iaturity
r745 E #: E rF G %H45 G I+H45= D+H E LH E 5.
r"45 E A: E rF G %H45 G D+H G 5.9: G I+H45.
Kecause both bonds are 452 year bonds the inflation premi um and maturi ty risk
premium on both bonds are eual. 7he only difference between them is the liuidi ty
and defaul t risk premiums.
r"45 E A: E rF G %H G I+H G 5.9: G D+H. Kut we know from above that rF G %H45 G
I+H45 E #:= therefore,
r"45 E A: E #: G 5.9: G D+H
4.9: E D+H.
6) % rF E 6:= %H* E 6:= r7* E #.*:= I+H* E J
r7* E rF G %H* G I+H* E #.*:
r7* E 6: G 6: G I+H* E #.*:
I+H* E 5.*:.
6) 6 rF E 9:= %42@ E 4#:= I+H E D+H E LH E 5= r@ E J
r@ E r+&.
r+& E /4 G rF1/4 G %1 L 4
E /4.591/4.4#1 L 4
E 5.*4A E *4.A:.
6) 3 r74 E 9:= 4r74 E #:= r7* E J
/4 G r7*1
*
E /4.591/4.5#1
/4 G r7*1
*
E 4.446
4 G r7* E 4.599
r7* E 9.9:.
6) & Let M eual the yield on *2year securities @ years from now:
/4.5B1
@
/4 G M1
*
E /4.5B91
#
/4.645A1/4 G M1
*
E 4.9@66
4 G M E
* , 4
645A . 4
9@66 . 4

M E A.9:.
6) 4 r E rF G %H G I+H G D+H G LH.
rF E 5.56.
%H E N5.56 G 5.5@ G /91/5.5691O,B E 5.569.
I+H E 5.5559/#1 E 5.556.
D+H E 5.
LH E 5.
r7B E 5.56 G 5.569 G 5.556 E 5.5#A E #.A:.
11& Answers and Solutions Chapter 6: Interest Rates
6) 1( Kasic relevant euations:
rt E rF G %Ht G D+Ht G I+Ht G %Ht .
Kut here %Ht is the only premium, so r t E rF G %Ht .
%Ht E Avg. inflation E /%4 G %* G . . .1,8.
$e know that %4 E %H4 E 6: and rF E *:. 7herefore,
r74 E *: G 6: E 9:. r76 E r74 G *: E 9: G *: E B:. Kut,
r76 E rF G %H6 E *: G %H6 E B:, so
%H6 E B: L *: E 9:.
$e also know that %t E "onstant after t E 4.
$e can set up this table:
rF % Avg. % E %Ht r E rF G %Ht
4 *: 6: 6:,4 E 6: 9:
* *: % /6: G %1,* E %H*
6 *: % /6: G % G %1,6 E %H6 r6 E B:, so %H6 E B: L *: E 9:.
%H6 E /6: G *%1,6 E 9:
*% E 4*:
% E #:.
6) 11 $ere given all the components to determi ne the yield on the bonds except the
default risk premium /D+H1 and I+H. "alculate the I+H as 5.4:/9 L 41 E 5.@:. 8ow,
we can solve for the D+H as follows:
B.B9: E *.6: G *.9: G 5.@: G 4.5: G D+H, or D+H E 4.99:.
6) 11 &irst, calculate the inflation premi ums for the next three and five years, respectivel y.
7hey are %H6 E /*.9: G 6.*: G 6.#:1,6 E 6.4: and %H9 E /*.9: G 6.*: G 6.#: G
6.#: G 6.#:1,9 E 6.6:. 7he real risk2 free rate is given as *.B9:. (ince the default
and liuidi ty premi ums are 3ero on 7reasury bonds, we can now solve for the maturi ty
risk premium. 7hus, #.*9: E *.B9: G 6.4: G I+H6, or I+H6 E 5.@:. (imilarly, #.A:
E *.B9: G 6.6: G I+H9, or I+H9 E 5.B9:. 7hus, I+H9 L I+H6 E 5.B9: L 5.@5: E
5.69:.
6) 13 r"A E rF G %HA G I+HA G D+HA G LHA
A.6: E *.9: G /*.A: @ G 6.B9: @1,A G 5.5: G D+HA G 5.B9:
A.6: E *.9: G 6.*B9: G 5.5: G D+HA G 5.B9:
A.6: E #.9*9: G D+HA
D+HA E 4.BB9:.
Chapter 6: Interest Rates Answers and Solutions 114
6) 1- a2 /4.5@91
*
E /4.561/4 G M1
4.5C*,4.56 E 4 G M
M E #:.
b2 &or riskless bonds under the expectations theory, the interest rate for a bond of
any maturi ty is
r8 E rF G average inflation over 8 years. %f rF E 4:, we can solve for %H8:
;ear 4: r4 E 4: G %4 E 6:=
%4 E expected inflation E 6: L 4: E *:.
;ear *: r4 E 4: G %* E #:=
%* E expected inflation E #: L 4: E 9:.
8ote also that the average inflation rate is /*: G 9:1,* E 6.9:, which, when
added to rF E 4:, produces the yield on a *2year bond, @.9:. 7herefore, all of our
results are consistent.
6) 1% rF E *:= I+H E 5:= r4 E 9:= r* E B:= M E J
M represents the one2 year rate on a bond one year from now /;ear *1.
/4.5B1
*
E /4.591/4 G M1
59 . 4
4@@C . 4
E 4 G M
M E C:.
C: E rF G %*
C: E *: G %*
B: E %*.
7he average interest rate during the *2year period differs from the 42year interest rate
expected for ;ear * because of the inflation rate reflected in the two interest rates.
7he inflation rate reflected in the interest rate on any security is the average rate of
inflation expected over the securitys life.
6) 16 r+& E r# E *5.A@:= I+H E D+H E LH E 5= rF E #:= % E J
*5.A@: E /4.5#1/4 G %1 L 4
4.*5A@ E /4.5#1/4 G %1
4.4@ E 4 G %
5.4@ E %.
6) 13 r79 E 9.*:= r745 E #.@:= r"45 E A.@:= %H45 E *.9:= I+H E 5. &or 7reasury securities, D+H
E LH E 5.
D+H9 G LH9 E D+H45 G LH45. r"9 E J
r745 E rF G %H45
#.@: E rF G *.9:
11( Answers and Solutions Chapter 6: Interest Rates
rF E 6.C:.
r79 E rF G %H9
9.*: E 6.C: G %H9
4.6: E %H9.
r"45 E rF G %H45 G D+H45 G LH45
A.@: E 6.C: G *.9: G D+H45 G LH45
*: E D+H45 G LH45.
r"9 E 6.C: G 4.6: G D+H9 G LH9, but D+H9 G LH9 E D+H45 G LH45 E *:. (o,
r"9 E 6.C: G 4.6: G *:
E B.*:.
6) 1& a2 ;ears to +eal +isk2&ree
Iaturi ty +ate /rF1 %HFF I+H r7 E rF G %H G I+H
4 *: B.55: 5.*: C.*5:
* * #.55 5.@ A.@5
6 * 9.55 5.# B.#5
@ * @.95 5.A B.65
9 * @.*5 4.5 B.*5
45 * 6.#5 4.5 #.#5
*5 * 6.65 4.5 #.65
FF7he computation of the inflation premium is as follows:
!xpected Average
;ear %nflation !xpected %nflation
4 B: B.55:
* 9 #.55
6 6 9.55
@ 6 @.95
9 6 @.*5
45 6 6.#5
*5 6 6.65
&or example, the calculation for 6 years is as follows:
3
% 3 % 5 % 7 + +
E 9.55:.
7hus, the yield curve would be as follows:
Chapter 6: Interest Rates Answers and Solutions 111
+isky "orprate Kond
AAA "orporate Kond
72bonds
44.5
45.9
45.5
C.9
C.5
A.9
A.5
B.9
B.5
5 * @ # A 45 4* 4@ 4# 4A *5
%nt erest
+at e /:1
#.9
;ears
t o
Iat urit
y
b2 7he interest rate on the AAA2rated corporate bonds has the same components as the
7reasury securities, except that the AAA2rated corporate bonds have default risk, so a
default risk premium must be included. 7herefore,
r E rF G %H G I+H G D+H.
&or a strong company, the default risk premium is virtuall y 3ero for short2 term
bonds. -owever, as time to maturi ty increases, the probabili ty of default,
although still small, is sufficient to warrant a default premi um. 7hus, the yield risk
curve for the AAA2rated corporate bonds will rise above the yield curve for the
7reasury securities. %n the graph, the default risk premium was assumed to be 4.5
percentage point on the *52 year AAA2rated corporate bonds. 7he return should
eual #.6: G 4: E B.6:.
c2 7he lower2 rated corporate bonds would have significantl y more default risk than
either 7reasury securities or AAA2rated corporate bonds, and the risk of default
would increase over time due to possible financial deterioration. %n this example,
the default risk premium was assumed to be 4.5 percentage point on the 42year
lower2 rated corporate bonds and *.5 percentage points on the *52 year lower2 rated
corporate bonds. 7he *52 year return should eual #.6: G *: E A.6:.
6) 14 a2 7he average rate of inflation for the 92year period is calculated as:
rate inflation
Average
E /5.46 G 5.5C G 5.5B G 5.5# G 5.5#1,9 E A.*5:.
b2 r E rF G %HAvg. E *: G A.*: E 45.*5:.
c2 -ere is the general situation:
;ea
r
42;ear
!xpected
%nflation
Arithmeti c
Average !xpected
%nflation
rF
Iaturity
+isk
Hremium
!stimated
%nterest +ates
4 46: 46.5: *: 5.4: 49.4:
* C 44.5 * 5.* 46.*
9 # A.* * 5.9 45.B
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
45 # B.4 * 4.5 45.4
*5 # #.# * *.5 45.#
111 Answers and Solutions Chapter 6: Interest Rates
/:1
%nterest +ate
49.5
4*.9
45.5
B.9
9.5
*.9
5 * @ # A 45 4* 4@ 4# 4A *5
;ears to Iaturity
+2 7he 'normal ) yield curve is upward sloping because, in 'normal ) times, inflation is
not expected to trend either up or down, so %H is the same for debt of all
maturi ti es, but the I+H increases with years, so the yield curve slopes up. During
a recession, the yield curve typicall y slopes up especially steeply, because
inflation and conseuentl y short2 term interest rates are currentl y low, yet people
expect inflation and interest rates to rise as the economy comes out of the
recession.
e2 %f inflation rates are expected to be constant, then the expectations theory holds that
the yield curve should be hori3ontal. -owever, in this event it is likely that maturity
risk premiums would be applied to long2 term bonds because of the greater risks of
holding long2 term rather than short2 term bonds:
%f maturi ty risk premi ums were added to the yield curve in Hart e above, then the
yield curve would be more nearly normal= that is, the long2 term end of the curve
would be raised. /7he yield curve shown in this answer is upward sloping= the
yield curve shown in Hart c is downward sloping.1
Chapter 6: Interest Rates Answers and Solutions 113
/:1
Hercent
Actual yield curve
Iaturity
premium
Hure expectations yield curve
;ears to Iaturity
risk
Co*prehensive6Sprea+sheet !rob5e*
Note to Instructors:
"he so5ution to this prob5e* is not provi+e+ to stu+ents at the bac7 o/ their te8t2
Instructors can access the Excel /i5e on the te8tboo79s .eb site or the Instructor9s
Resource CD2
6) 1( a2 4. 7his action will increase the supply of money= therefore, interest rates will
decline.
*. 7his action will cause interest rates to increase.
6. 7he larger the federal deficit, other things held constant, the higher the level of
interest rates.
@. 7his expectation will cause interest rates to increase.
b2
11- ComprehensiveSpreadsheet !roblem Chapter 6: Interest Rates
Treasury Bond
Real risk-free rate (r*) = 4.00%
Maturity: 12
!"e#ted inflation: for t$e ne!t 2 years = 2%
!"e#ted inflation: for t$e ne!t 4 years = %%
!"e#ted inflation: for t$e ne!t & years = 4%
12
'nflation "re(iu(: =(()2**+2*),()2-*+2-),()%0*+%0)).+%1 = %.%%%
Maturity risk "re(iu( == 0.1*(/20-1)% = 1.1%
12-year Treasury yield = r* , '1 , MR1 = *.4%%%
0-year #or"orate 2ond
Ratin3 : 4
Real risk-free rate (r*) = 4%
Maturity: 0
!"e#ted inflation: for t$e ne!t 2 years = 2%
!"e#ted inflation: for t$e ne!t 4 years = %%
!"e#ted inflation: for t$e ne!t 1 years = 4%
0
'nflation "re(iu(: =(()44*+44),()45*+45),()4&*+4&)).+40 = 2.*&%
Maturity risk "re(iu(: = 0.1*(/4%-1)% = 0.&0%
6i7uidity "re(iu(: )i8en in "ro2le( 0.00%
+efault risk "re(iu(: ='9(B%-=:4-;'4-;'9(B%-=:50;'50;'9(T/.) = 0.-0%
c2
+2 7he real risk2 free rate would be the same for the corporate and treasury bonds.
(imilarl y, without informati on to the contrary, we would assume that the maturi ty
and inflation premi ums would be the same for bonds with the same maturi ti es.
-owever, the corporate bond would have a liuidi ty premi um and a default
premium. %f we assume that these premiums are constant across maturi ties, then
we can use the LH and D+H as determi ned above and add them to the 72bond
yields to find the corporate yields. 7his procedure was used in the table below.
Chapter 6: Interest Rates ComprehensiveSpreadsheet !roblem 11%
0%
1%
2%
3%
4%
5%
6%
7%
0 5 10 15 20 25 30
<ield /ur8e
<ears Treasury 4-/or"orate ="read 61 +R1
1 5.%0% &.-0% 1.&0% 0.00% 0.-0%
2 5.40% 0.00% 1.&0% 0.00% 0.-0%
% 5.&5% 0.25% 1.&0% 0.00% 0.-0%
4 5.01% 0.%1% 1.&0% 0.00% 0.-0%
5 5.&4% 0.24% 1.&0% 0.00% 0.-0%
10 5.05% 0.%5% 1.&0% 0.00% 0.-0%
20 &.%%% 0.-%% 1.&0% 0.00% 0.-0%
%0 5.-4% 0.54% 1.&0% 0.00% 0.-0%
0 year /or"orate yield = r* , '1 , MR1 , 61 , +R1 = -.050%
<ield ="read = /or"orate - Treasury = 0.&24%
Re#on#iliation: +efault "re(iu( 0.-00%
6i7uidity "re(iu( 0.000%
'nflation "re(iu( -0.40&%
Maturity "re(iu( -0.500%
0.&24%
8ow we can graph the data in the first 6 columns of the above table to get the
7reasury and corporate /A2rated1 yield curves:
8ote that if we constructed yield curves for corporate bonds with other ratings, the
higher the rating, the lower the curves would be. 8ote too that the D+H for
different ratings can change over time as investorsP /41 risk aversion and /*1
perceptions of risk change, and this can lead to different yield spreads and curve
positions. !xpectations for inflation can also change, and this will lead to upward
or downward shifts in all the yield curves.
e2 (hort2 term rates are more volatile than longer2 term rates= therefore, the left side
of the yield curve would be most volatile over time.
/2 4. 7he 42year rate, one year from now.
(1 , r
2)
2
= (1 , r
1
) : (1,
1
r
1
)
1.1124 = 1.05%0 : (1,
1
r
1
)
5.50% =
1
r
1
*. 7he 92year rate, five years from now.
(1 , r
10
)
10
= (1 , r
5)
5
: (1 ,
5
r
5
)
5
1.04-1 = 1.%150 : (1 ,
5
r
5
)
5
1.%2-4 = (1 ,
5
r
5
)
5
5.*&% =
5
r
5
6. 7he 452 year rate, ten years from now.
(1 , r
20
)
20
= (1, r
10
)
10
: (1,
10
r
10
)
10
%.412* = 1.04-1 : (1,
10
r
10
)
10
1.-512 = (1,
10
r
10
)
10
&.-1% =
10
r
10
@. 7he 452 year rate, twenty years from now.
(1, r
%0
)
%0
= (1, r
20
)
20
: (1 ,
20
r
10
)
10
5.&4&* = %.412* : (1 ,
20
r
10
)
10
1.&54& = (1 ,
20
r
10
)
10
5.1&% =
20
r
10
116 ComprehensiveSpreadsheet !roblem Chapter 6: Interest Rates
0%
1%
2%
3%
4%
5%
6%
7%
8%
9%
0 5 10 15 20 25 30
Treasury and /or"orate <ield /ur8es
Treasury
A-Corporate
Chapter 6: Interest Rates ComprehensiveSpreadsheet !roblem 113
Integrat e+ Case
6) 11
;orton an+5e< = Co*pan<
Interest "ate #etermi nati on
;aria >uare? is a pro/essiona5 tennis p5a<er@ an+ <our /ir* *anages
her *one<2 She has as7e+ <ou to give her in/or*ati on about .hat
+eter*i nes the 5eve5 o/ various interest rates2 Your boss has
prepare+ so*e Auestions /or <ou to consi+er2
A2 Bhat are the /our *ost /un+a*ent a5 /actors that a//ect the
cost o/ *one<@ or the genera5 5eve5 o/ interest rates@ in the
econo*<C
Ans.er: DSho. S6) 1 an+ S6) 1 here2 E "he /our *ost /un+a*ent a5
/actors a//ecti ng the cost o/ *one< are '1, pro+uction
opportuni ti es@ '1, ti*e pre/erences /or consu*ption@ '3,
ris7@ an+ '-, in/5ation2
!ro+uction opportuni ti es are the invest *ent
opportuni ti es in pro+ucti ve 'cash) generati ng, assets2
"i*e pre/erences /or consu*ption are the pre/erences o/
consu*ers /or current consu*ption as oppose+ to saving
/or /uture consu*pti on2 Ris7@ in a /inancia5 *ar7et
conte8t@ is the chance that an invest*ent .i55 provi+e a
5o. or negati ve return2 In/5ation is the a*ount b< .hich
prices increase over ti*e2
"he interest rate pai+ to savers +epen+s '1, on the
rate o/ return pro+ucers e8pect to earn on investe+
capita5 @ '1, on savers9 ti*e pre/erences /or current versus
/uture consu*pti on@ '3, on the ris7iness o/ the 5oan@ an+
11& Integrated Case Chapter 6: Interest Rates
'-, on the e8pecte+ /uture rate o/ in/5ation2 !ro+ucers9
e8pecte+ returns on their business invest*ents set an
upper 5i*it to ho. *uch the< can pa< /or savings@ .hi5e
consu*ers9 ti*e pre/erences /or consu*ption estab5ish
ho. *uch consu*pti on the< are .i55ing to +e/er@ hence
ho. *uch the< .i55 save at +i//erent interest rates2 igher
ris7 an+ higher in/5ation a5so 5ea+ to higher interest rates2
F2 Bhat is the rea5 ris7) /ree rate o/ interest 'rG, an+ the
no*ina5 ris7) /ree rate 'r R$,C o. are these t.o rates
*easure+C
Ans.er: DSho. S6) 3 an+ S6) - here2 E Heep these eAuations in *in+
as .e +iscuss interest rates2 Be .i55 +e/ine the ter*s as
.e go a5ong:
r I rG J I! J DR! J L! J ;R!2
rR$ I rG J I!2
"he rea5 ris7) /ree rate@ rG@ is the rate that .ou5+ e8ist on
+e/au5 t) /ree securiti es in the absence o/ in/5ation2
"he no*ina5 ris7) /ree rate@ r R$@ is eAua5 to the rea5 ris7)
/ree rate p5us an in/5ation pre*i u* @ .hich is eAua5 to the
average rate o/ in/5ation e8pecte+ over the 5i/e o/ the
securit< 2
"here is no tru5< ris75ess securit<@ but the c5osest thing
is a short) ter* K2S2 "reasur< bi55 '") bi55,@ .hich is /ree o/
*ost ris7s2 "he rea5 ris7) /ree rate@ rG@ is esti*at e+ b<
subtracti ng the e8pecte+ rate o/ in/5ation /ro* the rate on
short) ter* treasur< securi ti es2 It is genera55 < assu*e+
that rG is in the range o/ 1 to - percent age points2 "he ")
bon+ rate is use+ as a pro8< /or the 5ong) ter* ris7) /ree
Chapter 6: Interest Rates Integrated Case 114
rate2 o.ever@ .e 7no. that a55 5ong) ter* bon+s contain
interest rate ris7 @ so the ") bon+ rate is not rea55< ris75ess2
It is@ ho.ever@ /ree o/ +e/au5 t ris7 2
13( Integrated Case Chapter 6: Interest Rates
C2 De/ine the ter*s in/5ation pre*i u* 'I!,@ +e/au5 t ris7
pre*i u* 'DR!,@ 5iAui+i t< pre*i u* 'L!,@ an+ *aturi t < ris7
pre*i u* ';R!,2 Bhich o/ these pre*i u*s is inc5u+e+
.hen +eter*i ni ng the interest rate on '1, short) ter* K2S2
"reasur< securi ti es@ '1, 5ong) ter* K2S2 "reasur< securi ti es@
'3, short) ter* corporat e securi ti es@ an+ '-, 5ong) ter*
corporat e securi ti esC #8p5ain ho. the pre*i u*s .ou5+
var< over ti*e an+ a*ong the +i//erent securiti es 5iste+2
Ans.er: DSho. S6) % here2 E "he in/5ation pre*i u* 'I!, is a pre*i u*
a++e+ to the rea5 ris7) /ree rate o/ interest to co*pensat e
/or e8pecte+ in/5ation2
"he +e/au5 t ris7 pre*i u* 'DR!, is a pre*i u* base+ on
the probabi5i t< that the issuer .i55 +e/au5 t on the 5oan@ an+
it is *easure+ b< the +i//erence bet.een the interest rate
on a K2S2 "reasur< bon+ an+ a corporat e bon+ o/ eAua5
*aturi t < an+ *ar7et abi 5i t<2
A 5iAui+ asset is one that can be so5+ at a pre+ictab5 e
price on short noticeL a 5iAui+i t< pre*i u* is a++e+ to the
rate o/ interest on securiti es that are not 5iAui+2
"he *aturi t < ris7 pre*i u* ';R!, is a pre*i u* that
re/5ects interest rate ris7 L 5onger) ter* securiti es have
*ore interest rate ris7 'the ris7 o/ capita5 5oss +ue to rising
interest rates, than +o shorter) ter* securi ti es@ an+ the
;R! is a++e+ to re/5ect this ris72
12 Short) ter* treasur< securiti es inc5u+e on5< an in/5ation
pre*i u*2
12 Long) ter* treasur< securi ti es contain an in/5ation
pre*i u* p5us a *aturi t < ris7 pre*i u*2 Note that the
Chapter 6: Interest Rates Integrated Case 131
in/5ation pre*i u* a++e+ to 5ong) ter* securi ti es .i55
+i//er /ro* that /or short) ter* securiti es un5ess the
rate o/ in/5ation is e8pecte+ to re*ai n constant2
32 "he rate on short) ter* corporat e securi ti es is eAua5 to
the rea5 ris7) /ree rate p5us pre*i u*s /or in/5ation@
+e/au5 t ris7@ an+ 5iAui+i t<2 "he si?e o/ the +e/au5 t an+
5iAui+i t< pre*i u*s .i55 var< +epen+i ng on the /inancia5
strengt h o/ the issuing corporati on an+ its +egree o/
5iAui+i t<@ .ith 5arger corporati ons genera55 < having
great er 5iAui+i t< because o/ *ore active tra+i ng2
-2 "he rate /or 5ong) ter* corporat e securi ti es a5so
inc5u+es a pre*i u* /or *aturi t < ris72 "hus@ 5ong) ter*
corporat e securiti es genera55 < carr< the highest <ie5+s
o/ these /our t<pes o/ securi ti es2
D2 Bhat is the ter* structure o/ interest ratesC Bhat is a
<ie5+ curveC
Ans.er: DSho. S6) 6 here2 S6) 6 sho.s a recent 'October 1((&,
"reasur< <ie5+ curve2 E "he ter* structure o/ interest rates
is the re5ationship bet.een interest rates@ or <ie5+s@ an+
*aturi ti es o/ securi ti es2 Bhen this re5ationship is
graphe+@ the resu5 ting curve is ca55e+ a <ie5+ curve2
'S7etch out a <ie5+ curve on the boar+2 ,
131 Integrated Case Chapter 6: Interest Rates
0%
2%
4%
6%
8%
10%
12%
14%
0 10 20 30
Interest
Years to Maturity
October 2008
Years to ;aturi t < Yie5+
12(( 123-M
%2(( 12%%
1( 2(( 3261
3( 2(( -2(4
#2 Suppose *ost investors e8pect the in/5ation rate to be %M
ne8t <ear@ 6M the /o55o.ing <ear@ an+ &M therea/ t er 2 "he
rea5 ris7) /ree rate is 3M2 "he *aturi t < ris7 pre*i u* is ?ero
/or bon+s that *ature in 1 <ear or 5ess an+ (21M /or 1) <ear
bon+sL then the ;R! increases b< (21M per <ear therea/ t er
/or 1( <ears@ a/ter .hich it is stab5e2 Bhat is the interest
rate on 1) @ 1() @ an+ 1() <ear "reasur< bon+sC Dra. a <ie5+
curve .ith these +ata2 Bhat /actors can e8p5ain .h< this
constructe+ <ie5+ curve is up.ar+ s5opingC
Chapter 6: Interest Rates Integrated Case 133
Ans.er: DSho. S6) 3 through S6) 11 here2 E
Step 1: $in+ the average e8pecte+ in/5ation rate over
Years 1 to 1(:
Yr 1: I! I %2(M2
Yr 1(: I! I '% J 6 J & J & J & J 2 2 2 J &,6 1( I 32%M2
Yr 1(: I! I '% J 6 J & J & J 2 2 2 J &,61( I 323%M2
Step 1: $in+ the *aturi t < ris7 pre*i u* in each <ear:
Yr 1: ;R! I (2(M2
Yr 1(: ;R! I (21M 4 I (24M2
Yr 1(: ;R! I (21M 14 I 124M2
Step 3: Su* the I!s an+ ;R!s@ an+ a++ rG I 3M:
Yr 1: r R$ I 3M J %2(M J (2(M I &2(M2
Yr 1(: r R$ I 3M J 32%M J (24M I 112 -M2
Yr 1(: r R$ I 3M J 323%M J 124M I 112 6%M2
"he shape o/ the <ie5+ curve +epen+s pri*ari5 < on t.o
/actors: '1, e8pectati ons about /uture in/5ation an+ '1, the
re5ati ve ris7iness o/ securi ti es .ith +i//erent *aturi ti es2
"he constructe+ <ie5+ curve is up.ar+ s5oping2 "his is
13- Integrated Case Chapter 6: Interest Rates
+ue to increasing e8pecte+ in/5ation an+ an increasing
*aturi t < ris7 pre*i u*2
$2 At an< given ti*e@ ho. .ou5+ the <ie5+ curve /acing a AAA)
rate+ co*pan< co*pare .ith the <ie5+ curve /or K2S2
"reasur< securi ti esC At an< given ti*e@ ho. .ou5+ the
<ie5+ curve /acing a FF)rate+ co*pan< co*pare .ith the
<ie5+ curve /or K2S2 "reasur< securiti esC Dra. a graph to
i55ustrat e <our ans.er2
Ans.er: DSho. S6) 13 an+ S6) 1- here2 E 'Curves /or AAA) rate+ an+
FF) rate+ securiti es have been a++e+ to +e*onstrat e that
ris7ier securi ti es reAuire higher returns2 , "he <ie5+ curve
nor*a55 < s5opes up.ar+@ in+icati ng that short) ter*
interest rates are 5o.er than 5ong) ter* interest rates2
Yie5+ curves can be +ra.n /or govern*ent securiti es or /or
the securi ti es o/ an< corporati on@ but corporat e <ie5+
curves .i55 a5.a<s 5ie above govern*ent <ie5+ curves@ an+
the ris7ier the corporation@ the higher its <ie5+ curve2 "he
sprea+ bet.een a corporat e <ie5+ curve an+ the "reasur<
curve .i+ens as the corporat e bon+ rating +ecreases2
(
%
1(
1%
( 1 % 1( 1% 1(
Years to
;aturit<
Interest
Rate 'M,
%21M
%24M
62(M
"reasur<
Yie5+ Curve
FF)Rate+
AAA)Rate+
Chapter 6: Interest Rates Integrated Case 13%
N2 Bhat is the pure e8pectati ons theor<C Bhat +oes the pure
e8pectati ons theor< i*p5< about the ter* structure o/
interest ratesC
Ans.er: DSho. S6) 1% an+ S6) 16 here2 E "he pure e8pectati ons
theor< assu*es that investors estab5ish bon+ prices an+
interest rates strict5< on the basis o/ e8pectati ons /or
interest rates2 "his *eans that the< are in+i//erent .ith
respect to *aturi t < in the sense that the< +o not vie.
5ong) ter* bon+s as being ris7ier than short) ter* bon+s2 I/
this .ere true@ then the *aturi t < ris7 pre*i u* .ou5+ be
?ero@ an+ 5ong) ter* interest rates .ou5+ si*p5< be a
.eighte+ average o/ current an+ e8pecte+ /uture short)
ter* interest rates2 I/ the pure e8pectati ons theor< is
correct@ <ou can use the <ie5+ curve to Obac7 outP
e8pecte+ /uture interest rates2
2 Suppose that <ou observe the /o55o.ing ter* structure /or
"reasur< securi ti es:
;aturi t < Yie5+
1 <ear 62(M
1 <ears 621
3 <ears 62-
- <ears 62%
% <ears 62%
Assu*e that the pure e8pectati ons theor< o/ the ter*
structure is correct2 '"his i*p5ies that <ou can use the
<ie5+ curve provi+e+ to Obac7 outP the *ar7et9 s
e8pectati ons about /uture interest rates2 , Bhat +oes the
*ar7et e8pect .i55 be the interest rate on 1) <ear securiti es
1 <ear /ro* no.C Bhat +oes the *ar7et e8pect .i55 be the
136 Integrated Case Chapter 6: Interest Rates
interest rate on 3) <ear securi ti es 1 <ears /ro* no.C
Ans.er: DSho. S6) 13 through S6) 11 here2 E Ca5cu5ation /or r on 1)
<ear securi ti es one <ear /ro* no.:
'12 (61,
1
I '12 (6, ' 1 J Q,
12113& I '12 (6, ' 1 J Q,
(6 2 1
113& 2 1
I 1 J Q
62-M I Q2
One <ear /ro* no.@ 1) <ear securi ti es .i55 <ie5+ 62-M2
Ca5cu5ation /or r on 3) <ear securiti es t.o <ears /ro* no.:
'12 (6%,
%
I '12 (61,
1
'1 J Q,
3
1
%
, (61 2 1 '
, (6% 2 1 '
I '1 J Q,
3
113& 2 1
33(1 2 1
I '1 J Q,
3
'12 11-&,
163
R 1 I Q
623M I Q2
".o <ears /ro* no.@ 3) <ear securi ti es .i55 <ie5+ 623M2
Chapter 6: Interest Rates Integrated Case 133