Week 2

Chapter 4
The Meaning of
Interest Rates
20-1 © 2016 Pearson Education Ltd. All rights reserved.

Preview
• Before we can go on with the study of

money, banking, and financial markets, we
must understand exactly what the phrase
interest rates means. In this chapter, we
see that a concept known as the yield to
maturity is the most accurate measure of
interest rate.

Learning Objectives
• Calculate the present value of future cash

flows and the yield to maturity on the four
types of credit market instruments.
• Recognize the distinctions among yield to
maturity, current yield, rate of return, and
rate of capital gain.
• Interpret the distinction between real and
nominal interest rates.

Measuring Interest Rates
• Present value: a dollar paid to you one

year from now is less valuable than a dollar
paid to you today.
– Why: a dollar deposited today can earn interest
and become $1 x (1+i) one year from today.

Present Value
Let i = .10
In one year: $100 X (1+ 0.10) = $110
In two years: $110 X (1 + 0.10) = $121
or $100 X (1 + 0.10)2
In three years: $121 X (1 + 0.10) = $133
3
or $100 X (1 + 0.10)
In n years
n
$100 X (1 + i)

Simple Present Value
PV = today's (present) value

CF = future cash flow (payment)
i = the interest rate
CF
PV = n
(1 + i )

Simple Present Value
•Cannot directly compare payments scheduled in different points in the

time line
$100 $100 $100 $100
Year 0 1 2 n
PV 100 100/(1+i) 100/(1+i)2 100/(1+i)n

Four Types of Credit Market
Instruments
• Simple Loan
• Fixed Payment Loan
• Coupon Bond
• Discount Bond

Yield to Maturity
• Yield to maturity: the interest rate that

equates the present value of cash flow
payments received from a debt
instrument with its value today

Yield to Maturity on a Simple Loan
PV = amount borrowed = $100

CF = cash flow in one year = $110
n = number of years = 1
$110
$100 =
(1 + i )1
(1 + i ) $100 = $110
$110
(1 + i ) =
$100
i = 0.10 = 10%
For simple loans, the simple interest rate equals the
yield to maturity

Fixed-Payment Loan
The same cash flow payment every period throughout

the life of the loan
LV = loan value
FP = fixed yearly payment
n = number of years until maturity
FP FP FP FP
LV =  2
 3
 ...+
1 + i (1 + i ) (1 + i ) (1 + i ) n

Fixed-Payment Loan
Example:
You decided to purchase a new home and
need a RM100,000 mortgage. You take out a
loan from a bank that has an interest rate of
7%. What is the yearly payment to the bank
to pay off the loan in 20 years?

Fixed-Payment Loan
Solution:
PV = - RM100,000
I/Y = 7%
N= 20
FV = 0
CPT PMT = RM9,439.29

Coupon Bond
Using the same strategy used for the fixed-payment loan:

P = price of coupon bond
C = yearly coupon payment
F = face value of the bond
n = years to maturity date
C C C C F
P=  2
 3
. . . + 
1+i (1+i ) (1+i ) n
(1+i ) (1+i ) n

Coupon Bond
Example:
Find the price of a 10% coupon bond with a
face value of RM1000, a 12.25% yield to
maturity and 8 years to maturity.

Coupon Bond
Solution:
Coupon Payment = 10% x 1000 = 100
Face value = RM1000
I/Y = 12.25%
N=8
CPT PV = -RM889.20

Coupon Bond
• When the coupon bond is priced at its face value,
the yield to maturity equals the coupon rate.
• The price of a coupon bond and the yield to
maturity are negatively related.
• The yield to maturity is greater than the coupon
rate when the bond price is below its face value.

Coupon Bond
• Consol or perpetuity: a bond with no maturity
date that does not repay principal but pays fixed
coupon payments forever
P  C / ic
Pc  price of the consol
C  yearly interest payment
ic  yield to maturity of the consol
can rewrite above equation as this : ic  C / Pc

For coupon bonds, this equation gives the current
yield, an easy to calculate approximation to the yield
to maturity
Discount Bond
For any one year discount bond

F-P
i=
P
F = Face value of the discount bond
P = current price of the discount bond
The yield to maturity equals the increase
in price over the year divided by the initial price.
As with a coupon bond, the yield to maturity is
negatively related to the current bond price.

The Distinction Between Interest
Rates and Returns
• Rate of Return:
The payments to the owner plus the change in value

expressed as a fraction of the purchase price
C P -P
RET = + t1 t
Pt Pt
RET = return from holding the bond from time t to time t + 1
Pt = price of bond at time t
Pt1 = price of the bond at time t + 1
C = coupon payment
C
= current yield = ic
Pt
Pt1 - Pt
= rate of capital gain = g
Pt

Rates and Returns

Rates and Returns
• The return equals the yield to maturity only
if the holding period equals the time to
maturity.
• A rise in interest rates is associated with a fall
in bond prices, resulting in a capital loss if
time to maturity is longer than the holding
period.
• The more distant a bond’s maturity, the
greater the size of the percentage price
change associated with an interest-rate change.

Rates and Returns
• The more distant a bond’s maturity, the

lower the rate of return the occurs as a
result of an increase in the interest rate.
• Even if a bond has a substantial initial
interest rate, its return can be negative if
interest rates rise.

Maturity and the Volatility of Bond
Returns: Interest-Rate Risk
• Prices and returns for long-term bonds

are more volatile than those for shorter-
term bonds.
• There is no interest-rate risk for any bond
whose time to maturity matches the holding
period.

The Distinction Between Real and
Nominal Interest Rates
• Nominal interest rate makes no

allowance for inflation.
• Real interest rate is adjusted for changes in
price level so it more accurately reflects the
cost of borrowing.
– Ex ante real interest rate is adjusted for
expected changes in the price level
– Ex post real interest rate is adjusted for actual
changes in the price level

Fisher Equation
i  ir   e
i = nominal interest rate
ir = real interest rate
 e = expected inflation rate
When the real interest rate is low,
there are greater incentives to borrow and fewer incentives to lend.
The real interest rate is a better indicator of the incentives to
borrow and lend.

Fisher Equation
Example:
Let’s consider a situation in which you have
made a one-year simple loan with a 5%
interest rate (i=5%) and you expect the price
level to rise by 3% over the course of the year
(∏e=3%). As a result of making the loan, at
the end of the year you expect to have 2%
more in real terms.
r=5% - 3% = 2%

Fisher Equation
Example:
Let’s consider a situation in which you have
made a one-year simple loan with a 8%
interest rate (i=8%) and you expect the price
level to rise by 10% over the course of the
year (∏e=10%). As a result of making the
loan, at the end of the year you expect to
have 2% more in real terms.
r=8% - 10% = -2%

Fisher Equation
• Lender:
– Less eager to make loan when i < ∏e.
– Earned negative interest rate.
• Borrower:
– More eager to make loan when i < ∏e.
– The amounts that the borrower need to pay back
will be ahead by in real terms.
When the real interest rate is low, there are

greater incentives to borrow and fewer
incentives to lend

Figure 1 Real and Nominal Interest Rates
(Three-Month Treasury Bill), 1953–2014
Sources: Nominal rates from Federal Reserve Bank of St. Louis FRED database: http://research.stlouisfed.org/fred2/. The real rate is
constructed using the procedure outlined in Frederic S. Mishkin, “The Real Interest Rate: An Empirical Investigation,” Carnegie-
Rochester Conference Series on Public Policy 15 (1981): 151–200. This procedure involves estimating expected inflation as a function
of past interest rates, inflation, and time trends, and then subtracting the expected inflation measure from the nominal interest rate.

Chapter 5
The Behavior of
Interest Rates

Preview
• In this chapter, we examine how the overall

level of nominal interest rates is determined
and which factors influence their behavior.

Learning Objectives
• Identify the factors that affect the demand

for assets.
• Draw the demand and supply curves for the
bond market, and identify the equilibrium
interest rate.
• List and describe the factors that affect the
equilibrium interest rate in the bond market.

Learning Objectives
• Describe the connection between the bond

market and the money market through the
liquidity preference framework.
• List and describe the factors that affect the
money market and the equilibrium interest
rate.
• Identify and illustrate the effects on the
interest rate of changes in money growth
over time.

Determinants of Asset Demand
• Wealth: the total resources owned by the

individual, including all assets
• Expected Return: the return expected over the
next period on one asset relative to alternative
assets
• Risk: the degree of uncertainty associated with
the return on one asset relative to alternative
assets
• Liquidity: the ease and speed with which an asset
can be turned into cash relative to alternative
assets

Theory of Portfolio Choice
Holding all other factors constant:

1. The quantity demanded of an asset is positively related
to wealth
to its expected return relative to alternative assets
3. The quantity demanded of an asset is negatively related
to the risk of its returns relative to alternative assets
to its liquidity relative to alternative assets

Theory of Portfolio Choice

Supply and Demand in the Bond
Market
• At lower prices (higher interest rates),

ceteris paribus, the quantity demanded of
bonds is higher: an inverse relationship
• At lower prices (higher interest rates),
ceteris paribus, the quantity supplied of
bonds is lower: a positive relationship

Figure 1 Supply and Demand for
Bonds
Price of Bonds, P ($)
1,000
(i = 0%) Bs
With excess supply, the
950 bond price falls to P *
(i = 5.3%) A I
900
(i = 11.1%) B H
C
P * = 850
(i * = 17.6%)
800 D
G
(i = 25.0%)
With excess demand, the

750
F E bond price rises to P *
(i = 33.0%)
Bd
100 200 300 400 500
Quantity of Bonds, B
($ billions)

Market Equilibrium
• Occurs when the amount that people are

willing to buy (demand) equals the
amount that people are willing to sell
(supply) at a given price
• Bd = Bs defines the equilibrium (or market
clearing) price and interest rate.
• When Bd > Bs , there is excess demand,
price will rise and interest rate will fall
• When Bd < Bs , there is excess supply,
price will fall and interest rate will rise

Changes in Equilibrium Interest
Rates
• Shifts in the demand for bonds:
– Wealth: in an expansion with growing wealth, the
demand curve for bonds shifts to the right
– Expected Returns: higher expected interest rates in
the future lower the expected return for long-term bonds,
shifting the demand curve to the left
– Expected Inflation: an increase in the expected rate of
inflations lowers the expected return for bonds, causing
the demand curve to shift to the left
– Risk: an increase in the riskiness of bonds causes the
demand curve to shift to the left
– Liquidity: increased liquidity of bonds results in the
demand curve shifting right

Figure 2 Shift in the Demand Curve
for Bonds
Price of Bonds, P
A′
An increase in the demand for
A bonds shifts the bond demand
curve rightward.
B′
C′
C
D′
D
E′
E
d B2d
B 1

Shifts in the Demand for Bonds

Shifts in the Supply of Bonds
• Shifts in the supply for bonds:

– Expected profitability of investment
opportunities: in an expansion, the supply
curve shifts to the right
– Expected inflation: an increase in expected
inflation shifts the supply curve for bonds to
the right
– Government budget: increased budget
deficits shift the supply curve to the right

Shifts in the Supply of Bonds

Figure 3 Shift in the Supply Curve
for Bonds
Price of Bonds, P
B s1 B 2s
I
I′
H
H′
C
An increase in the supply of
C′ bonds shifts the bond supply
curve rightward.
G
G′
F′

Figure 4 Response to a Change in
Expected Inflation
Price of Bonds, P
B1s
B2s
Step 1. A rise in expected inflation shifts

the bond demand curve leftward . . .
1
P1 Step 2. and shifts the bond supply
curve rightward . . .
Step 3. causing the price of bonds to
fall and the equilibrium interest rate to
2
rise.
P2
d B1d
B 2

Figure 5 Expected Inflation and Interest Rates
(Three-Month Treasury Bills), 1953–2014
Sources: Federal Reserve Bank of St. Louis FRE D database: http://research.stlouisfed.org/fred2. Expected inflation calculated
using procedures outlined in Frederic S. Mishkin, “The Real Interest Rate: An Empirical Investigation,” Carnegie-Rochester
Conference Series on Public Policy 15 (1981): 151–200. These procedures involve estimating expected inflation as a function of
past interest rates, inflation, and time trends.

Figure 6 Response to a Business
Cycle Expansion
Price of Bonds, P
B1s
Step 1. A business cycle expansion
shifts the bond supply curve
B2s rightward . . .
Step 2. and shifts the bond demand
curve rightward, but by a lesser
amount . . .
1 Step 3. so the price of bonds falls
P1 and the equilibrium interest rate
2 rises.
P2
B d B2d
1

Figure 7 Business Cycle and Interest Rates
(Three-Month Treasury Bills), 1951–2014
Source: Federal Reserve Bank of St. Louis FRE D database: http://research.stlouisfed.org/fred2

Supply and Demand in the Market for Money:
The Liquidity Preference Framework
Keynesian model that determines the equilibrium interest rate

in terms of the supply of and demand for money.
There are two main categories of assets that people use to store
their wealth: money and bonds.
Total wealth in the economy = Bs + M s = Bd + M d
Rearranging: Bs - Bd = M s - M d
If the market for money is in equilibrium (M s = M d ),
then the bond market is also in equilibrium (Bs = Bd ).

Figure 8 Equilibrium in the Market for Money
Interest Rate, i
(%)
30 Ms
A With excess supply, the interest

25
rate falls to i *.
B
20
C
i * =15
10 D
E With excess demand,

5 the interest rate rises
to i *.
Md
0 100 200 300 400 500 600

Quantity of Money, M
($ billions)

Supply and Demand in the Market for Money:
The Liquidity Preference Framework
• Demand for money in the liquidity

preference framework:
– As the interest rate increases:
• The opportunity cost of holding money increases…
• The relative expected return of money decreases…
– …and therefore the quantity demanded of
money decreases.

Changes in Equilibrium Interest Rates in
the Liquidity Preference Framework
• Shifts in the demand for money:

– Income Effect: a higher level of income
causes the demand for money at each interest
rate to increase and the demand curve to shift
to the right
– Price-Level Effect: a rise in the price level
causes the demand for money at each interest
rate to increase and the demand curve to shift
to the right

• Shifts in the supply of money:

– Assume that the supply of money is controlled
by the central bank.
– An increase in the money supply engineered by
the Federal Reserve will shift the supply curve
for money to the right.


Income or the Price Level
Interest Rate, i Ms
Step 1. A rise in income or the price

level shifts the money demand curve
rightward . . .
2
i2 Step 2. and the equilibrium interest
rate rises.
i1 1
M2d
M1d
M Quantity of Money, M

the Money Supply
M1s M2s
Interest rates, i
1
i1 Step 2. and the equilibrium
interest rate falls.
2
i2
Md
Quantity of Money, M

Money and Interest Rates
• A one time increase in the money supply will cause prices
to rise to a permanently higher level by the end of the year.
The interest rate will rise via the increased prices.
• Price-level effect remains even after prices have stopped
rising.
• A rising price level will raise interest rates because
people will expect inflation to be higher over the course of the
year. When the price level stops rising, expectations of
inflation will return to zero.
• Expected-inflation effect persists only as long as the price
level continues to rise.

Does a Higher Rate of Growth of the
Money Supply Lower Interest Rates?
• Liquidity preference framework leads to

the conclusion that an increase in the
money supply will lower interest rates:
the liquidity effect.
• Income effect finds interest rates rising
because increasing the money supply is an
expansionary influence on the economy
(the demand curve shifts to the right).

Does a Higher Rate of Growth of the
Money Supply Lower Interest Rates?
• Price-Level effect predicts an increase in the

money supply leads to a rise in interest
rates in response to the rise in the price
level (the demand curve shifts to the right).
• Expected-Inflation effect shows an increase
in interest rates because an increase in the
money supply may lead people to expect a
higher price level in the future (the demand
curve shifts to the right).

Interest Rate, i
i1
i2
(a) Liquidity effect larger than
T
other effects
Time
Figure 11
Liquidity Income, Price-Level,
Effect and Expected-
Interest Rate, i inflation Effects
Response
over Time i2
i1
to an (b) Liquidity effect smaller than
Increase in T other effects and slow adjustment

of expected inflation
Time
Money Liquidity Income, Price-Level,
Effect and Expected-
Supply Interest Rate, i

inflation Effects
Growth i2
i1
(c) Liquidity effect smaller than
expected-inflation effect and fast
T
adjustment of expected inflation
Time
Liquidity and Income and Price-
expected- Level Effects
inflation Effect

Figure 12 Money Growth (M2, Annual Rate) and Interest
Rates (Three-Month Treasury Bills), 1950–2014
Price level and income effect > Liquidity effect
Source: Federal Reserve Bank of St. Louis FRE D database: http://research.stlouisfed.org/fred2

Chapter 6
The Risk and
Term Structure
of Interest Rates

Preview
• In this chapter, we examine the sources and

causes of fluctuations in interest rates
relative to one another, and look at a
number of theories that explain these
fluctuations.

Learning Objectives
• Identify and explain three factors explaining

the risk structure of interest rates.
• List and explain the three theories of why
interest rates vary across maturities.

Risk Structure of Interest Rates
• Bonds with the same maturity have

different interest rates due to:
– Default risk
– Liquidity
– Tax considerations

Figure 1 Long-Term Bond Yields,
1919–2014
Sources: Board of Governors of the Federal Reserve System, Banking and Monetary Statistics,
1941–1970; Federal Reserve Bank of St. Louis FRED database: http://research.stlouisfed.org/fred2

• Default risk: probability that the issuer of

the bond is unable or unwilling to make
interest payments or pay off the face value
– U.S. Treasury bonds are considered default free
(government can raise taxes).
– Risk premium: the spread between the interest
rates on bonds with default risk and the interest
rates on (same maturity) Treasury bonds

Figure 2 Response to an Increase in
Default Risk on Corporate Bonds
Price of Bonds, P Price of Bonds, P
ST
Sc i2
T
P2T
Risk
P c1 T
Premium P1
P 2c
i 2c D2T
c c D1T
D2 D1
Quantity of Corporate Bonds Quantity of Treasury Bonds
(a) Corporate bond market (b) Default-free (U.S. Treasury) bond market
Step 1. An increase in default risk shifts the demand

curve for corporate bonds left . . .
Step 2. and shifts the demand curve for Treasury bonds

to the right . . .
Step 3. which raises the price of Treasury bonds and lowers

the price of corporate bonds, and therefore lowers the interest
rate on Treasury bonds and raises the rate on corporate bonds,
thereby increasing the spread between the interest rates on
corporate versus Treasury bonds.

Table 1 Bond
Ratings by
Moody’s,
Standard and
Poor’s, and
Fitch

• Liquidity: the relative ease with which an

asset can be converted into cash
– Cost of selling a bond
– Number of buyers/sellers in a bond market
• Income tax considerations
– Interest payments on municipal bonds are
exempt from federal income taxes.

Figure 3 Interest Rates on Municipal
and Treasury Bonds
Price of Bonds, P
Price of Bonds, P
ST
Sm
P m2
P 1m P 1T
P 2T
D m2
D m1
D1T
D2T
Quantity of Municipal Bonds Quantity of Treasury Bonds

(a) Market for municipal bonds (b) Market for Treasury bonds
Step 1. Tax-free status shifts the demand for municipal

bonds to the right . . .
Step 2. and shifts the demand for Treasury bonds to the

left . . .
Step 3. with the result that municipal bonds end up with a

higher price and a lower interest rate than on Treasury bonds.

Effects of the Obama Tax Increase
on Bond Interest Rates
• In 2013, Congress approved legislation

favored by the Obama administration to
increase the income tax rate on high-income
taxpayers from 35% to 39%. Consistent
with supply and demand analysis, the
increase in income tax rates for wealthy
people helped to lower the interest rates on
municipal bonds relative to the interest rate
on Treasury bonds.

Term Structure of Interest Rates
• Bonds with identical risk, liquidity, and tax

characteristics may have different interest
rates because the time remaining to
maturity is different

• Yield curve: a plot of the yield on bonds

with differing terms to maturity but the
same risk, liquidity and tax considerations
– Upward-sloping: long-term rates are above
short-term rates
– Flat: short- and long-term rates are the same
– Inverted: long-term rates are below short-term
rates

The theory of the term structure of interest

rates must explain the following facts:
1. Interest rates on bonds of different maturities
move together over time.
2. When short-term interest rates are low, yield
curves are more likely to have an upward
slope; when short-term rates are high, yield
curves are more likely to slope downward and
be inverted.
3. Yield curves almost always slope upward.

Three theories to explain the three facts:

1. Expectations theory explains the first
two facts but not the third.
2. Segmented markets theory explains the
third fact but not the first two.
3. Liquidity premium theory combines the
two theories to explain all three facts.

Figure 4 Movements over Time of
Interest Rates on U.S. Government Bonds
with Different Maturities
Sources: Federal Reserve Bank of St. Louis FRED database:

http://research.stlouisfed.org/fred2/

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.
• Buyers of bonds do not prefer bonds of one
maturity over another; they will not hold
any quantity of a bond if its expected return
is less than that of another bond with a different
maturity.
• Bond holders consider bonds with different
maturities to be perfect substitutes.

Expectations Theory
An example:
• Let the current rate on one-year bond be
6%.
• You expect the interest rate on a one-year
bond to be 8% next year.
• Then the expected return for buying two
one-year bonds averages (6% + 8%)/2 =
7%.
• The interest rate on a two-year bond must
be 7% for you to be willing to purchase it.

Expectations Theory
For an investment of $1
it = today's interest rate on a one-period bond
ite1 = interest rate on a one-period bond expected for next period
i2t = today's interest rate on the two-period bond

Expectations Theory
Expected return over the two periods from investing $1 in the

two-period bond and holding it for the two periods
(1 + i2t )(1 + i2t )  1
 1  2i2t  (i2t ) 2  1
 2i2t  (i2t ) 2
Since (i2t ) 2 is very small
the expected return for holding the two-period bond for two periods is
2i2t

Expectations Theory
If two one-period bonds are bought with the $1 investment

(1  it )(1  ite1 )  1
1  it  ite1  it (ite1 )  1
it  ite1  it (ite1 )
it (ite1 ) is extremely small
Simplifying we get
it  ite1

Expectations Theory
Both bonds will be held only if the expected returns are equal
2i2t  it  ite1
it  ite1
i2t 
2
The two-period rate must equal the average of the two one-period rates
For bonds with longer maturities
it  ite1  ite 2  ...  ite ( n 1)
int 
n
The n-period interest rate equals the average of the one-period
interest rates expected to occur over the n-period life of the bond

6-
Expectations Theory 86
• Upward sloping
– Long-term interest rate > short-term interest
rate.
– The average of future short-term rates is
expected to be higher than the current short-
term rate.
– The average of future expected short-term rates
is high relative to the current short-term rate.
– Long-term interest rates will be substantially
above current short-term rates and thus, the
yield curve is upward sloping.

6-
Expectations Theory 87
• Downward sloping
– Long-term interest rate < short-term interest
rate.
– If the short-term rates are high, people usually
expect them to come down.
– Average future short-term interest rates is
expected to be below the current short-term rate
because short-term interest rates are expected
to fall, on average in the future.

Expectations Theory
• Expectations theory explains:

– Why the term structure of interest rates changes
at different times.
– Why interest rates on bonds with different
maturities move together over time (fact 1).
– Why yield curves tend to slope up when short-
term rates are low and slope down when short-
term rates are high (fact 2).
• Cannot explain why yield curves usually slope
upward (fact 3)

Segmented Markets Theory
• Bonds of different maturities are not substitutes at

all.
• The interest rate for each bond with a different
maturity is determined by the demand for and
supply of that bond.
• Investors have preferences for bonds of one
maturity over another.
• If investors generally prefer bonds with shorter
maturities that have less interest-rate risk, then
this explains why yield curves usually slope upward
(fact 3).

Liquidity Premium &
Preferred Habitat Theories
• 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.
• Bonds of different maturities are partial
(not perfect) substitutes.

Liquidity Premium Theory
it  it1
e
 it2
e
 ... it(
e
int  n1)
 lnt
n
where lnt is the liquidity premium for the n-period bond at time t
lnt is always positive
Rises with the term to maturity

Preferred Habitat Theory
• Investors have a preference for bonds of

one maturity over another.
• They will be willing to buy bonds of different
maturities only if they earn a somewhat
higher expected return.
• Investors are likely to prefer short-term
bonds over longer-term bonds.

Figure 5 The Relationship Between the
Liquidity Premium (Preferred Habitat) and
Expectations Theory
Interest Liquidity Premium (Preferred Habitat) Theory

Rate, int Yield Curve
Liquidity
Premium, lnt
Expectations Theory
Yield Curve
0 5 10 15 20 25 30
Years to Maturity, n

Liquidity Premium &
• Interest rates on different maturity bonds move
together over time; explained by the first term in
the equation
• Yield curves tend to slope upward when short-term
rates are low and to be inverted when short-term
rates are high; explained by the liquidity premium
term in the first case and by a low expected
average in the second case
• Yield curves typically slope upward; explained
by a larger liquidity premium as the term to
maturity lengthens

Liquidity Premium &
• A rise in short-term interest rates indicates that

short-term interest rates will, on average, be
higher in the future and this lead to the rise in
the long-term interest rates.
• Step upward slope (LT > ST)
– Short-term interest rates are low.
– Investors generally expect short-term interest
rates to rise to some normal level.
– The average of future expected short-term rates
will be high relative to the current short-term
rate.
– Additional boost of a positive liquidity premium
will thus lead the long-term rates to be higher
than current short-term rates.

Liquidity Premium &
• Step downward slope (LT < ST)

– Short-term interest rates are high.
– Investors expect them to come back down.
– Long-term rates drop below short-term rates
because average of expected future short-term
rates would be so far below current short-term
rates.
– Thus, the yield curve slope downward.

Yield to Yield to
Maturity Maturity
Figure 6 Yield Steeply upward-

sloping yield curve
Mildly upward-
sloping yield curve
Curves and the
Market’s
Expectations of Term to Maturity Term to Maturity
Future Short- (a) (b)
Term Interest
Rates According Yield to Yield to
Maturity Maturity
to the Liquidity
Premium
(Preferred
Habitat) Theory
Flat yield curve Downward-
sloping yield curve
Term to Maturity Term to Maturity

(c) (d)

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Chapter 4

20-1 © 2016 Pearson Education Ltd. All rights reserved.

• Before we can go on with the study of

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• Calculate the present value of future cash

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• Present value: a dollar paid to you one

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PV = today's (present) value

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•Cannot directly compare payments scheduled in different points in the

$100 $100 $100 $100

PV 100 100/(1+i) 100/(1+i)2 100/(1+i)n

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• Yield to maturity: the interest rate that

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PV = amount borrowed = $100

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The same cash flow payment every period throughout

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Using the same strategy used for the fixed-payment loan:

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can rewrite above equation as this : ic  C / Pc

For any one year discount bond

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The payments to the owner plus the change in value

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• The more distant a bond’s maturity, the

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• Prices and returns for long-term bonds

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• Nominal interest rate makes no

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When the real interest rate is low, there are

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• In this chapter, we examine how the overall

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• Identify the factors that affect the demand

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• Describe the connection between the bond

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• Wealth: the total resources owned by the

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Holding all other factors constant:

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• At lower prices (higher interest rates),

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With excess demand, the

100 200 300 400 500