CHAPTER 11

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Content
Interest rate structure
Yield curve
Determination of interest rates
The relationship between interest rate
and foreign exchange rate

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Introduction
An interest rate is the rate at which
interest is paid by a borrower for the use
of money that they borrow from a lender.
Nominal interest rates are the interest
rates actually observed in financial
markets.
These rates affect the price or value of
most securities traded in the money and
capital markets.
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Overnight Policy Rate (OPR) is an overnight
interest rate set by BNM used for monetary
policy direction. OPR is the interest rate at
which a depository institution lends
immediately available funds (balances within
the central bank) to another depository
institution overnight.
This is an efficient method for banks around
the world to practice 'Accessing short-term
financing' from the central bank depositories.
The interest rate of the OPR is influenced by
the central bank, where it is a good predictor
for the movement of short-term interest rates.

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Introduction
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Term Structure of Interest Rates
In finance, the term yield describes the amount in
cash that returns to the owners of a security. Yield
applies to various stated rates of return on stocks
(common and preferred, and convertible), fixed
income instruments (bonds, notes, bills, strips, zero
coupon), and some other investment type insurance
products (e.g. annuities).
The term structure of interest rates, also known as
the yield curve, is a very common bond valuation
method. The yield curve is a measure of the
market's expectations of future interest rates given
the current market conditions.
As general current interest rates increase, the price
of a bond will decrease and its yield will increase.


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Yield Curve
A plot of the yields on bonds with
differing terms to maturity but the same
risk, liquidity and tax considerations is
called a yield curve, and it describes the
term structure of interest rates for
particular types of bonds.
Yield curves can be classified as
upward-sloping, flat or downward-
sloping
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Term Structure of Interest Rates
Upward sloping
Flat
Downward sloping
Upward-sloping
The most usual case
Long-terms interest rates are above short-
term interest rates
Flat
Short-term and long-term interest rates are
the same
Downward-sloping (inverted yield curve)
Long-term interest rates are below short-
term interest rates
Yield Curve
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Theories to explain term structure of
interest rates
The expectations theory
The market segmentation theory
The liquidity premium theory
Yield Curve
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The Expectations Theory
the interest rate on a long-term bond
will equal an average of the short-term
interest rates that people expect to
occur over the life of the long-term
bond.

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Example: the current interest rate on a
one-year bond is 9% and you expect the
interest rate on the one-year bond next
year to be 11%. What is the expected
return over the two years? What
interest rate must a two-year bond (long-
term bond) have to equal to the two one-
year bonds (short-term bonds)?
Bonds of different maturities are perfect
substitutes.
The Expectations Theory
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When the yield curve is upward-sloping,
the expectation theory suggests that short-
term interest rates are expected to rise in
the future
When the yield curve is inverted, the
average of future short-term interest rates
is expected to be lower than the current
short-term rate.
Flat yield curve indicates short-term
interest rates are not expected to change.
The Expectations Theory
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The Market Segmentation
Theory
Sees markets for different maturity
bonds as completely separate and
segmented
The interest rate is determined by
supply and demand for that bond, not by
expected returns of other bonds with
other maturities
Bonds of different maturities are not
substitutes at all
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Yield curves typically slope upward.
Normally, the demand for long-term
bonds is relatively lower than short-term
bonds, long-term bonds will have lower
prices and higher interest rates, hence
the yield curve will typically slope
upward.
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The Market Segmentation
Theory
The Liquidity Premium
Theory
This theory states that the interest rate on
a long-term bond will equal an average of
short-term interest rates expected to occur
over the life of the long-term bond plus a
liquidity premium that responds to supply
and demand conditions for that bond.
It combines features of the expectations
theory and market segmentation theory.
Bonds of different maturities are assumed
to be substitutes, but not perfect
substitutes.
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Investors tend to prefer shorter-term bonds
because these bonds bear less interest-
rate risk.
To induce investors to hold longer-term
bonds, they must be offered a positive
liquidity premium which is always positive
and rises with the term to maturity.
The yield curve implied by the liquidity
premium theory is always above the yield
curve implied by the expectations theory
and generally has a steeper slope.
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The Liquidity Premium
Theory
Even though the theory indicates that
the yield curve usually slope upward, the
yield curve can also be inverted and flat.
The theory helps predicting the
movement of short-term interest rates in
the future by observing the slope of yield
curves.
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The Liquidity Premium
Theory
Determinants of Interest Rates
For Individual Securities
Inflation
Real interest rate
Default risk
Liquidity risk
Special provisions or covenants
Term to maturity
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Inflation
The higher the level of actual or expected
inflation rate, the higher will be the level of
interest rates
An investor who buys a financial asset must
earn a higher interest rate when inflation
increases to compensate for the increased
cost of foregoing consumption of real goods
and services today and buying them at a
higher price in the future
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Determinants of Interest Rates
For Individual Securities
Real interest rates
It is the interest rate that would exist on a
default free security if no inflation were
expected
Fisher Effect
Nominal interest rates =
real interest rates + expected inflation
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Determinants of Interest Rates
For Individual Securities
Default or credit risk
The risk that a security issuer will default on
that security by being late on or missing an
interest or principal payment
The higher the default risk, the higher
interest rate that will be demanded by the
buyer
What about Government bonds? Do they
have default risks?
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Determinants of Interest Rates
For Individual Securities
Liquidity Risk
The risk that a security can be sold at a
predictable price with low transaction costs
on short notice
Highly liquid assets carry low interest rates
For illiquid security, investors add a liquidity
risk premium to the interest rate on the
security
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Determinants of Interest Rates
For Individual Securities
Special provisions or covenants
Special provisions or covenants that may be
written into the contracts underlying the
issuance of a security
Securitys taxability free tax low interest
rate
Convertibility low interest rate
Callability higher interest rate
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Determinants of Interest Rates
For Individual Securities
Term to Maturity
Term structure of interest rates or the yield
curve
The change in required interest rates as the
maturity of a security changes is called the
maturity premium
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Determinants of Interest Rates
For Individual Securities
Determinants of Interest Rates
For Individual Securities
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ij = f (IP, RIR, DRPj, LRPj, SCPj, MPj)


Where

IP = Inflation premium
RIR = Real interest rate
DRPj = Default risk premium on the jth security
LRPj = Liquidity risk premium on the jth security
SCPj = Special feature premium on the jth security
MPj = Maturity premium on the jth security



The Relationship between Interest
Rate and Foreign Exchange Rate
Interest rate parity
Interest rate parity is a no-arbitrage condition
representing an equilibrium state under which
investors will be indifferent to interest rates
available on bank deposits in two countries.
The fact that this condition does not always hold
allows for potential opportunities to earn riskless
profits from covered interest arbitrage.
Two assumptions central to interest rate parity
are capital mobility and perfect substitutability of
domestic and foreign assets.
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Given foreign exchange market equilibrium, the
interest rate parity condition implies that the
expected return on domestic assets will equal the
exchange rate-adjusted expected return on foreign
currency assets.

Investors cannot then earn arbitrage profits by
borrowing in a country with a lower interest rate,
exchanging for foreign currency, and investing in a
foreign country with a higher interest rate, due to
gains or losses from exchanging back to their
domestic currency at maturity.

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The Relationship between Interest
Rate and Foreign Exchange Rate