Overview of Interest Rate

7/28/2019 Overview of Interest Rate

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By: Hyder Ali Khawaja


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Interest Overview

Price paid to borrow money

Interest is the charge made for borrowing a sum ofmoney.

It is cost of capital or cost of utilization of money. It is difference between amount returned and

amount borrowed.

Interest

If you borrow Rs.1000 and return Rs.1200, 200 thatyou are supposed to pay in excess of borrowedamount is interest.

Example:

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Interest rate is charge made expressed as apercentage of amount lent.

Interest rate

If you borrow Rs.500 at 10%

10% is interest rate

Example:

Interest Overview (Cont..)

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The Allocative Role of Interest It means to give something to someone to use in a particular way.

Allocate Role

Allocation of money (credit or loanable funds) is defined by

interest.

Allocate Role of Interest

One million is available as credit at 15%

Business A Expected return 12% (Reject)

Business B Expected return 20% (Accept)

Simply one will get the loan that is willing to pay highest rate ofinterest. (In case of scarcity)

For example

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Determination of the Market Rate

of InterestThe Supply of Credit

The Demand for Credit

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of Interest (Cont..)

Supply of credit refers to savings made bynet savers; net savers are those who haveamounts in excess of their expenditure.

Income= Consumption + Savings

Income=2000 Consumption=1500

Savings=500

The Supply of Credit

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of Interest (Cont..) Net Savers

Households

Businesses

Government

Who are the Supplier of Credit?

When interest rates are high net savers aremotivated to save for rainy days and for higherreturns.

When will net savers save??

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of Interest (Cont..) Demand for credit refers to amount of money borrowed by net

borrowers

Who demand credit?

Households, Businesses & Government

The Demand for Credit

If you have business you have an opportunity to invest Rs 100

in new machinery having life of 1 year which will increaseyour cash inflows by 110. Your return will be Rs 10

Return=Inflow-outflow

Return=110-100

Return=10

Example

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of Interest (Cont..) The Demand for Credit (Cont..)

Rate of return will be 10% Rate of return=Inflow-outflow/outflow

Rate of return=110-100/100 or 10/100=0.1 or 10%

If that 100 is available at 8% interest rate, should you take

it or not? In this condition you will demand 100 as credit because it

is profitable for you because on 100 you have to pay 8%interest and your rate of return is 10%, it means even afterpayment of interest you are still earning 2% profit.

Example (Cont..)

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of Interest (Cont..) The Demand for Credit (Cont..)

But if you were asked to pay interestrate of 12% then you must haverejected that credit. So when a

business feels that there is anyprofitable opportunity it willdemand credit.

Example (Cont..)

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of Interest (Cont..) When interest rates are high businesses are discouraged to

take credit and when interest rates are low businesses aremotivated to take more credit.

The Demand for Credit (Cont..)

Return from investment 15%

When interest rate is 12%

Return after paying interest= 15%-12%=3%

But if interest rate is 16%

Return after paying interest= 15%-16%= -1%

Means loss of 1%

Example

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The Market Rate of Interest

It is determined by demand and supply

for credit. Interest rate at which demandand supply are equal is known as marketrate and that point is known asequilibrium point.

It changes with change in demand andsupply of credit

The Market Rate of Interest

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Equilibrium Interest RateThe Interaction of Money Supply and Demand

The condition for equilibrium is:

Ms =Md

The equilibrium condition can beexpressed in terms of aggregate realmoney demand as:

Ms/P= L(R,Y)

Equilibrium

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Determination of the Equilibrium Interest Rate

Aggregate real

money demand,

L(R,Y)

Interest

rate, R

Real money

holdings

Real money supply

MS

P( = Q1)

R2

Q2

2

R1 1

R3

Q3

3

Equilibrium Interest Rate (Cont..)

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An increase (fall) in the money supplylowers (raises) the interest rate, giventhe price level and output.

The effect of increasing the money

supply at a given price level isillustrated in Figure

Interest Rates and the Money Supply


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M2

P

R2

2

M1

P

Real money

supply Real money

supply increase

Effect of an Increase in the Money Supply on the Interest Rate

L(R,Y1)

R11

Interest

rate, R

Real money

holdings

An increase in the

money supply lowers

the interest rate for a

given price level.

A decrease in the

money supply raises

the interest rate for a

given price level.


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An increase (fall) in real output raises(lowers) the interest rate, given the pricelevel and the money supply.

Figure shows the effect on the interest

rate of a rise in the level of output, giventhe money supply and the price level.

Output and the Interest Rate


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Q2

1'

Effect on the Interest Rate of a Rise in Real Income

L(R,Y1)

L(R,Y2)

Increase inreal income

Real money supply

MS

P( = Q1)

R22

R

1

1

Interest

rate, R

Real money

holdings

An increase in

national income

increases equilibrium

interest rates for a

given price level.


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Suppose money supply and demand

functions are given which depend uponthe rate of interest (I)

Ms (I)= 5 + 3I

Md (I) = 45 5I

Find the equilibrium interest rate andquantity of money supplied anddemanded.

Example

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As we know equilibrium is point whereMs = Md So put the values ofMs and Md

5 + 3I = 45 5I

3I + 5I = 45 5

8I = 40

I = 40/8

I = 5

It means equilibrium point (market rate)is 5% interest rate

Solution

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To find the amount of money demanded

& supplied, put value of I in respectiveequations

Ms (I)= 5 + 3I

Ms (I)= 5 + 3(5) = 20 millions

Md (I) = 45 5I Md (I) = 45 5(5) = 20 millions

Solution (Cont..)

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Interest Rate

Money DemandedMd (I) = 45 5I

(In million rupees)

Money SuppliedMs (I)= 5 + 3I

(In million rupees)

2% 35 11

3% 30 144% 25 17

5% 20 20

6% 15 23

7% 10 26

8% 5 29

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Interest Rate

Money DemandedMd (I) = 45 5I

(In million rupees)

Money SuppliedMs (I)= 5 + 3I

(In million rupees)

2% 35 11

3% 30 144% 25 17

5% 20 20

6% 15 23

7% 10 26

8% 5 29

25


Note:

At 5%Money demanded

Is equal to

Money supplied


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Money Market

Where monetary or liquid assets, which are looselycalled money, are lent and borrowed.

Monetary assets in the money market generallyhave low interest rates compared to interest rateson bonds, loans, and deposits of currency in theforeign exchange markets.

Domestic interest rates directly affect rates ofreturn on domestic currency deposits in theforeign exchange markets.

Money market

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Ra

teofinterest

,i(percent)

Amount of money demanded

(billions of rupees)

0 50 100 150 200 250 300

10

7.5

5

2.5

0

Dm

ie

SmSuppose the moneysupply is decreasedfrom Rs200 billion, Sm,to Rs150 billion Sm1.

Money Market (Cont..)

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Ra

teofinterest

,i(percent)



0 50 100 150 200 250 300

10

7.5

5

2.5

0

Dm

ie

SmA temporaryshortageof money will requirethe sale of some assetsto meet the need.

Sm1


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Ra

teofinterest

,i(percent)



0 50 100 150 200 250 300

10

7.5

5

2.5

0

Dm

ie

SmSuppose the moneysupply is increasedfrom Rs200 billion, Sm,to Rs250 billion Sm2.


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Rateofinterest

,i(percent)



0 50 100 150 200 250 300

10

7.5

5

2.5

0

Dm

ie

Sm Sm2A temporarysurplusof money will requirethe purchase of someassets to meet the de-sired level of liquidity.


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When no shortages (excess demand) or surpluses(excess supply) of monetary assets exist, themodel achieves an equilibrium:

Ms = Md

Alternatively, when the quantity of real monetaryassets supplied matches the quantity of real

monetary assets demanded, the model achievesan equilibrium:

Ms/P = L(R,Y)

Equilibrium


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When there is an excess supply of monetary assets,there is an excess demand for interest bearing

assets like bonds, loans, and deposits. People with an excess supply of monetary assets

are willing to offer or accept interest-bearingassets (by giving up their money) at lowerinterest rates.

Others are more willing to hold additionalmonetary assets as interest rates (the opportunitycost of holding monetary assets) falls.

Excess Supply of Monetary Assets


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When there is an excess demand of monetary assets,there is an excess supply of interest bearing assets

like bonds, loans, and deposits. People who desire monetary assets but do not have

access to them are willing to sell non-monetaryassets in return for the monetary assets that theydesire.

Those with monetary assets are more willing togive them up in return for interest-bearing assets asinterest rates (the opportunity cost of holdingmoney) rises.

Excess demand of monetary assets


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Nominal versus Real Interest Rate A rate at which your amount is growing

Example: 10% annually

Nominal Interest Rate

Real rate is adjusted for inflation and is a rate at

which purchasing power of invested money isincreasing.

Real Interest Rate

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Nominal versus Real Interest Rate It is calculated with following formula

Real Rate of Interest = Nominal rate Inflation rate (CPI) or

Real Rate of Interest =

[(1+Nominal)/(1+Inflation)]

1

Nominal Rate = real rate + expectedinflation + (real rate x inflation)

Real Interest Rate (Cont..)

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Nominal versus Real Interest Rate You are offered by a bank to save your

1000 at 10% interest rate for one year.

Here 10% is nominal interest rate, but

consider that after 1 year price of goodswill increase by 6%. What is real rate ofinterest?

Example

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Nominal versus Real Interest Rate Nominal Rate = 10%

Inflation (CPI) = 6%

Real Rate = ?

Real Rate of Interest =[(1+Nominal)/(1+Inflation)] - 1

Real Rate = [1.1/1.06] 1

Real Rate = 3.77%

Example (Cont..)

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Nominal versus Real Interest Rate In zero inflation world, if wheat costs Rs. 1 per Kg

and you lend Rs. 10, youre lending 10 kg wheat.

If you want a real return of 10%, you need 11 Kgwheat (1/10=10%) so you charge 10% interest andget Rs. 11 back

If inf lation is 20%, (mean 1 Kg will cost 1.2) thenyou need Rs. 1.20 x 11 = Rs. 13.20 back to buy 11 Kgand get your 10% real return. This means youmust charge a nominal rate of 32%

Example

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Nominal versus Real Interest Rate Real Rate = 10%

Inflation = 20%

Nominal Rate = ?

Nominal Rate = real rate + expected inflation + (realrate x inflation)

Nominal Rate = 0.1 + 0.2 + (0.1 x 0.2)

Nominal Rate = 0.3 + 0.02

Nominal Rate = 0.32

Nominal Rate = 32 %

Example (Cont..)

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Ex Ante. Vs. Ex Post

Ex Ante real interest rates are the rates investorsexpect based on anticipated inflation rates

Ex Ante real interest rate

Ex Post real interest rates are the rates investors

actually receive after the fact.

Ex Post real interest rate

The difference between the two depends on theaccuracy of inflationary expectations

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Inflation Expectations and Real Returns Inflation expectation tend to be quite persistent (i.e.

investors dont seem to update to new information).Therefore, real interest rates also have a high degree of

persistence.

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Types of Nominal Interest RatesThe Prime Rate

The Corporate Bond Rate

The Federal Funds Rate

Discount rate

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Types of Nominal Interest Rates


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(Cont..) Interest rate charged by banks to their most

creditworthy customers on short term loans.

Same as Products are sold at lower profit margin toloyal customers (Lower Price)

The Prime Rate

Normal nominal interest rate charged by banks is10%, but bank may advance short term loan to itsmost creditworthy customer below 10%.

For example

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Types of Nominal Interest Rates The Prime Rate (Cont..)

Determinants of Customer CreditworthinessProfitability of business

How frequently cash is coming in and going out from account (inflowsand outflows or deposit and withdrawals).

Turnover

Less risky companies have strong capacity to pay their debts.

Risk

Relationship between customer and bank

Rating of business in terms of default risk

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(Cont..) Interest Rate on corporate bonds

This rate is known as the coupon rate because most

bonds used to have coupons that the investors clippedoff and mailed to the bond issuer to claim the interestpayment.

These bonds are issued by highly rated companieshaving low risk of default.

Standard and Poors (S&P) and Moodys provide riskratings of corporate and government bonds.

The Corporate Bond Rate

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(Cont..) According to Moodys

Aaa (best quality) Baa (lower medium quality)

Caa (poor standing)

C (extremely poor)

According to S&P

AAA (best quality)

Corporate Bond Rate (Cont..)

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Including the debt ratio and the times-interest-earned ratio. Thebetter the ratios, the higher the rating.

Various ratios

Is the bond secured by a mortgage? If it is, and if the property hasa high value in relation to the amount of bonded debt, the bondsrating is enhanced.

Mortgage provisions

Some bonds are guaranteed by other firms. If a weak companysdebt is guaranteed by a strong company (usually the weakcompanys parent), the bond will be given the strong companysrating.

Guarantee provisions

Types of Nominal Interest Rates (Cont..) Bond Rating Criteria

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Does the bond have a sinking fund to ensure systematicrepayment? This feature is a plus factor to the ratingagencies.

Sinking fund

A bond with a shorter maturity will be judged less riskythan a longer-term bond, and this will be reflected in the

ratings.

Maturity

Are the issuers sales and earnings stable?

Stability


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Is the issuer regulated, and could an adverse regulatory climatecause the companys economic position to decline? Regulation isespecially important for utilities and telephone companies.

Regulation

Are any antitrust actions pending against the firm that couldwear down its position?

Antitrust

What percentage of the firms sales, assets, and profits are fromoverseas operations, and what is the political climate in the hostcountries?

Overseas operations


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Types of Nominal Interest Rates (Cont..) Is the firm likely to face heavy expenditures for pollution control equipment?

Environmental factors

Are the firms products safe? This refers to public trust; companies with lowpublic trust possess low bond ratings.

Product liability

Are there potential labor problems on the horizon that could weaken thefirms position?

Labor unrest

If a firm uses relatively conservative accounting policies, its reported earningswill be of higher quality than if it uses less conservative procedures. Thus,conservative accounting policies are a plus factor in bond ratings.

Accounting policies

Bond Rating Criteria

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(Cont..) Rate at which banks lend money to other banks

Interbank overnight rate

Federal Fund rate (iff)

Rate at which central bank lends to commercialbanks

Discount Rate (id)

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The Calculation of Interest Yields

Nominal Yield

Current Yield

Yield to Maturity (YTM)

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C l l ti f I t t Yi ld (C t )


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Calculation of Interest Yields (Cont..) Yield is interest on bond also called coupon

amount.

Nominal yield is return on face value or par value.

If bond offers 100 coupon amount on 1000 facevalue, nominal yield will be coupon amountdivided by face value

Nominal yield = I/Face value I = coupon amount = 100 Face value = 1000

Nominal yield = 100/1000 = 10%

Nominal Yield

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Calculation of Interest Yields (Cont..) Yield as percentage of current market price

rather than face value Take above example that if same bond is sold at850 (Discount) current yield will be calculatedas under

Current yield = I/Market value

Current yield = 100 / 850 = 11.76%

Current Yield

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Th C l l ti f I t t Yi ld


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The Calculation of Interest Yields Also known as internal rate of return of bond, it tells how much

return you will get till the maturity of bond

YTM is that discount rate that equates the present value of bondscash flows to the market price. YTM cannot be calculated without

market price

Approximation Formula

YTM = I + (V-P)/T

(V+P)/2

I = Coupon Amount (Par Value x Coupon rate)

V = Par Value

P = Price of Bond

T = Periods remaining to maturity

Yield to Maturity (YTM)

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Interest Rate Changes and Bond


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Price Changes There is inverse relationship between bond prices and interest rates

If interest rate increases, bond prices decreases.

Relationship between bond Price & Interest rate

A bond with 1000 face value 10 years remaining to maturity offering10% coupon rate is currently trading at 1000. Market interest rate is10%.

Example

When coupon rate = market rate . Bond will be sold at par

When coupon rate > market rate .. Bond will be sold at premium

When coupon rate < market rate . Bond will be sold at discount

According to rule:

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Price Changes Now consider that interest rate in the market

increases from 10% to

12%

15%

20%

Example (Cont..)

Market Rate Maturity Coupon Rate Price10% 10 10% 100012% 10 10% 886.9715% 10 10% 748.9820% 10 10% 580.7

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Price Changes

0

100200

300

400

500

600700

800

900

1000

10% 12% 15% 20%

Price

Rupees

Interest Rate

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Price Changes

0

200

400

600

800

1000

1200

10% 12% 15% 20%

Price

Rupees

Interest Rate

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Why different bonds have different

prices and different interest rates? Bonds possess various features and their prices and

interest rates are affected by those features.

Default or credit risk

Liquidity

Tax Treatment Maturity

There are major four features

According to these features we can categorize the causes ofdifferent interest rates for different bonds into; Risk Structure of Interest rates Term Structure of Interest Rates

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Accounting for Different Interest

Rates

Differential Default Risk

Differential Liquidity Differential Tax Treatment

Risk Structure of Interest rates

Segmented Markets Hypothesis

Pure Expectations Hypothesis

Maturity Preference Theory

Term Structure of Interest Rates

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Risk Structure of Interest Rate Risk structure of interest rate refers to the bonds/debt

with same maturity but different characteristics

These bonds have different level of

Default risk

Liquidity risk

Tax treatment

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Risk Structure of Interest Rate (Cont..) Risk of not receiving timely payment of

principal and/or interest

Depends on creditworthiness of issuer Why Government T-bills have low interest

rate than corporate bonds? Simply because Government has zero default

risk and private companies may fail to payinterest or principal amount (face value).

Differential Default Risk

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Risk Structure of Interest Rate (Cont..)

Differential Default Risk (Cont..)

Because T-bills are backed by full faith andcredit of government and government has Power to tax largest economy

Power to issue stable currency

Why T-bills have zero default risk?

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Risk Structure of Interest Rate (Cont..) When there is higher default risk, interest rates will also

be higher to compensate for that risk. Infact investorsare risk averse when default risk increases, company

rating falls and investors require higher yield.


MCB and HBL issue bonds in market paying 10%

coupon with 10 years maturity. Suppose both have samecredit ratings AAA.

After one year HBLs rating falls from AAA to BBB. Thismeans default risk increases.

Example

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Risk Structure of Interest Rate (Cont..) As a result of this;

Example (Cont..)


HBL MCBRating falls

Risk will increase

Demand for bonds will decrease

Price will fall (from 1000 to 950)

YTM will rise (from 10 to 11%)

Rating remains same

Risk remains same

Demand for bonds will increase

Price will rise (from 1000 to 1050)

YTM will fall (from 10 to 9%)71


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Risk Structure of Interest Rate (Cont..) The difference between two interest rates is called

spread, it is measured in percentage points

basis points

1 percentage point = 100 basis points

So in MCB and HBL example difference betweentwo rates means 11% and 9% is known as spread

which is default risk premium.

Example (Cont..)


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Risk Structure of Interest Rate (Cont )


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3 month T-bill 2.75%

3 month Commercial paper 3.25%

Spread (3.25 2.75)

0.5 percentage points

50 basis points

10 year T-note 3.74%

10 year BBB corporate bond 6.54% spread

2.8 percentage points

280 basis points

Other Examples


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Risk Structure of Interest Rate (Cont..) Taking same example of HBL & MCB calculate the

current yield of both bonds

Example (Cont..)


HBL MCBCurrent yield =

Coupon amount / Current price

Current yield = 100/950

Current yield = 10.52%

Current yield =Coupon amount / Current price

Current yield = 100/1050

Current yield = 9.52%

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Risk Structure of Interest Rate (Cont..) Liquidity refers to ability to be converted into cash.

Liquid bonds are those having secondary market, whereinvestors can resell to get their money back.

Differential Liquidity

MCB and SisTech issues bonds which one you will

prefer?? Definatly MCB because it has secondary market you cansell your bond whenever you want.

For example

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Ri k St t f I t t R t (C t )


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Risk Structure of Interest Rate (Cont..) Now take an example of MCB and HBL

If HBL bonds have low liquidity as compared to bonds ofMCB

Example

Differential Liquidity (Cont..)

HBL MCBDemand for bonds will decrease

Price will fall

YTM will rise

Demand for bonds will increase

Price will rise

YTM will fall

Note: More liquid companies pay low interest rates whereas lessliquid companies pay higher rates of interest.

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As tax is a burden for everyone. Some

bonds are tax exempted and some aretaxable. Tax exempt bonds give lessinterest rate (yield) whereas taxable

bonds pay high yield.Why? Because tax exempt provide taxbenefit

Differential Tax Treatment

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Risk Structure of Interest Rate (Cont..) Take two bonds

Example

Differential Tax Treatment (Cont..)

Tax Exempt Bond Taxable BondFace Value = 1000

Coupon rate = 10%Coupon Amount = 100

Tax Rate = 30%

Net Earning = 100 (No tax paid)

Face Value = 1000Coupon rate = 10%

Coupon Amount = 100Tax Rate = 30%

Net Earning = 100

taxesNet Earning = 100 (30% of 100)

Net Earning = 100 30Net Earning = 70

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Risk Structure of Interest Rate (Cont..) We can calculate the after tax yield with the help of

following formula

After tax yield = nominal yield (1 - T)

When tax rate is 30% & nominal yield is 10%

After tax yield = 0.1 (1-0.3)

After tax yield = 0.07 or 7%

This is the reason that taxable bonds have higher rateof yield to cover tax advantage of tax exempt bond.

Differential Tax Treatment (Cont..)

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Risk Structure of Interest Rate (Cont..)Differential Tax Treatment (Cont..)

Personal income tax rates are givenbelow

0-1000 15% 1001-2000 20%

2001-3000 30%

Example # 2

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Person A with Tax Exempt Bond Person B with Taxable BondIncome = Rs. 2000

Bonds 10 (10% coupon rate)

Total Interest earned on 100 on each(100x10 = 1000)

Total Earning = 2000 + 1000 = 3000Taxable Income = 2000

Taxes Payable1000 x 0.15 = 1501000 x 0.2 = 200

Total Taxes = 350

Income after Taxes = 3000 350 =

2650

Income = Rs. 2000Bonds 10 (10% coupon rate)



Taxes Payable1000 x 0.15 = 1501000 x 0.2 = 2001000 x 0.3 = 300

Total Taxes = 650


2350

( ) Differential Tax Treatment (Cont..)

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Person A with Tax Exempt Bond Person B with Taxable BondIncome = Rs. 2000

Bonds 10 (10% coupon rate)



Taxes Payable1000 x 0.15 = 1501000 x 0.2 = 200

Total Taxes = 350


2650

Income = Rs. 2000Bonds 10 (10% coupon rate)



Taxes Payable1000 x 0.15 = 1501000 x 0.2 = 2001000 x 0.3 = 300

Total Taxes = 650


2350

Key point:

Person B has paidmarginal tax rateof 30% on incomeearned from bonds

( ) Differential Tax Treatment (Cont..)

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Term Structure of Interest Rates Bonds with the same characteristics, but different

maturities

Slope of curve indicates relationship betweenmaturity and yield

Normally as maturity increases yield decreases, asthere are some risks involved, so to compensatethose risks, investors require more return.

Yield Curve

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Term Structure of Interest Rates( )


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Interest rates on bonds of different maturitiesgenerally move together

ST bond yields are more volatile than LT bondyields

The yield curve usually slopes up.

Facts about the yield curve

(Cont..)

Yield Curve (Cont..)

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Term Structure of Interest Rates( )


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Maturity YTM (%)1 21.052 15.79

3 14.034 13.155 12.636 12.287 12.038 11.849 11.6910 11.57

(Cont..)Yield Curve (Cont..)

There are 10 different bonds all offer 10% coupon andhave current price of Rs 900 and a par value Rs 1000. But

maturity is different for each bond.

Example

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Term Structure of Interest Rates


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0

5

10

15

20

25

1 2 3 4 5 6 7 8 9 10 Maturity

YTM

Term Structure of Interest Rates(Cont..)

Yield Curve (Cont..)

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T diti l Th i f th T


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Traditional Theories of the Term

StructureMarket Segmentation Theory

Pure Expectations Theory


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Debt markets are segmented by maturity, Distinct markets for short term, intermediateand long term bonds (segmentation)

So interest rates for various maturities are

determined separately in each segment.

Therefore yield curve can take any shape

Market Segmentation Theory


Structure (Cont..)

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This hypothesis assumes that buyer and seller find

bonds of different maturities to be perfect substitutes Investor invests in bonds with different maturities whenhe expects same return on all bonds.

Pure Expectations Theory

A 5 rupees pen can last for 5 days, you will purchase a 10rupee pen when you will expect that 10 rupee pen willlast for 10 days.. equal return.

Example


Structure (Cont..)

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Pure Expectations Theory (Cont..)

Take two bonds

Example:

Bond A Bond BMaturity 2 years

Coupon 10%

Total return = 200

Maturity 1 yearCoupon 8 %

If you choose Bond B than calculate

the reinvestment rate

Return in 1st year = 80You require 120 in 2nd year

Means you expect 12% rate in nextyear

Structure (Cont..)

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Fi = 2i2 i1

Fi= Implied future short term rate i2 =Annualized yield on the 2 year bond

i1 =Annualized yield on the 1 year bond

Fi = 2i2

- i1

Fi = 2(0.1) 0.08

Fi = 0.2 0.08

Fi = 0.12 or 12 %

Formula

Structure (Cont..)

Pure Expectations Theory (Cont..)

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Long-term interest rates contain a maturity premium (termpremium) necessary to induce lenders into making longer

term loans.


Term premium is the premium for holding security for longterm. Bonds with different maturities have different termpremiums During Economic expansion (Low term premium)

During Economic contraction (High term premium)

The Term Premium

Structure (Cont..)

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Modern Term Structure Theories


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Long-term bond prices are much more sensitive to interestrate changes than short-term bonds. This is calledinterest rate risk.

So, the modern view of the term structure suggests that:

NI = RI + IP + RP

In this equation:

NI = Nominal interest rate RI = Real interest rate

IP = Inflation premium

RP = Interest rate risk premium

Theory # 1

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The previous equation showed the component ofinterest rates on default-free bonds that trade in a liquidmarket.

Not all bonds are risk free.

Therefore, a liquidity premium (LP) and a defaultpremium (DP) must be added to the previous

equation:

NI = RI + IP + RP + LP + DP

Theory # 2


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Why The Term Structure of


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Interest Rates is Important? It helps in investment decisions, as cash is most

unproductive asset so it is more profitable for businessto invest in different securities.

Term structure helps in making decisions aboutinvestment in securities (short term vs long term).

For Business & Individuals

Issue short term T-bills or long term bonds?

For Government

Finally it is helpful in forecasting future interest rates, whichhelp businesses in financial planning and decision making.

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The End

Overview of Interest Rate

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