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Chapter 3
Chapter 4

Understanding
interest rates

Understanding interest rates

Meaning & Measuring Interest

Rates

Behavior of Interest Rates

The Risk and Term Structure

of Interest Rates

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PART 1

Meaning & Measuring

Interest Rates

What is an interest rate ?

• An interest rate is the percentage charged on

borrowed money or paid on money in an account,
acting as the cost of borrowing or the return on
saving.

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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.

Discounting the Future

L e t i = .1 0
In o n e ye a r $ 1 0 0 X (1 + 0 .1 0 ) = $ 1 1 0
In tw o ye a rs $ 1 1 0 X (1 + 0 .1 0 ) = $ 1 2 1
o r 1 0 0 X (1 + 0 .1 0 ) 2
In th re e ye a rs $ 1 2 1 X (1 + 0 .1 0 ) = $ 1 3 3
o r 1 0 0 X (1 + 0 .1 0 ) 3
In n y e a rs
$ 1 0 0 X (1 + i ) n

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Simple Present Value

PV = today's (present) value

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

Time line

•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

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Four types of Credit market instruments

Simple Fixed Coupon Discount

Loan Payment Bond Bond
Loan

Yield to Maturity
• The interest rate that equates the present value of
cash flow payments received from a debt instrument
with its value today

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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 equ als the
yield to maturity

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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 =    . . . +
1 + i (1 + i) 2 (1 + i)3 (1 + i) n

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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=    . . . + 
1+i (1+i) 2 (1+i)3 (1+i) n (1+i )n

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Table 1: Yields to Maturity on a 10%-Coupon-Rate Bond

Maturing in Ten Years (Face Value = $1,000)

• 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

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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

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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.

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The Distinction Between Interest Rates and Returns

• Rate of Return:
T h e p a y m e n ts to th e o w n e r p lu s th e c h a n g e in v a lu e
e x p re sse d a s a fra c tio n o f th e p u rc h a se p ric e
C P - Pt
RET = + t 1
Pt Pt
R E T = re tu rn fro m h o ld in g th e b o n d fro m tim e t to tim e t + 1
P t = p ric e o f b o n d a t tim e t
P t  1 = p ric e o f th e b o n d a t tim e t + 1
C = coupon paym ent
C
= c u rre n t y ie ld = ic
Pt
Pt  1 - Pt
= ra te o f c a p ita l g a in = g
Pt

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The Distinction Between Interest Rates and Returns (cont’d)

• The return equals the yield to maturity only if the holding

period equals the time to maturity
• A risein 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

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The Distinction Between Interest Rates and Returns (cont’d)

• 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
• Evenif a bond has a substantial initial interest rate, its return
can be negative if interest rates rise

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Table 2 One-Year Returns on Different-Maturity 10%-Coupon-Rate Bonds

When Interest Rates Rise from 10% to 20%

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Interest rate risk

• Pricesand returns for long-term bonds are more volatile
than those for shorter-term bonds
• Thereis no interest-rate risk for any bond whose time to
maturity matches the holding period

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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
• Exante 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

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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.

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PART 2

Behavior of Interest Rates

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Behavior of Interest Rates

Determinants of Asset Demand

Supply and Demand in the Bond Market

Supply and Demand in the Market for

Money

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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

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Theory of Portfolio choice

Holding all other factors constant:
1. The quantity demanded of an asset is positively
related to wealth
2. The quantity demanded of an asset is positively
related 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
4. The quantity demanded of an asset is positively
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Summary Table 1: Response of the Quantity of an Asset Demanded to

Changes in Wealth, Expected Returns, Risk, and Liquidity

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Supply and Demand in the Bond Market

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

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Figure1: Supply and Demand for Bonds

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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

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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

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Figure 2: Shift in the Demand Curve for Bonds

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Summary Table 2: Factors that shift the Demand curve for Bonds

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Shifts in the Supply of bonds

• Expectedprofitability 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

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Summary Table 3: Factors That Shift the Supply of Bonds

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Figure 3 Shift in the Supply Curve for Bonds

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Figure 4: Response to a Change in Expected Inflation

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Figure 6: Response to a Business Cycle Expansion

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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 = B d + 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 = B d ).

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Figure 8: Equilibrium in the Market for Money

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Demand for Money in the Liquidity Preference

Framework
• As the interest rate increases:
oThe opportunity cost of holding money increases…
oThe relative expected return of money decreases…

• …and therefore the quantity demanded of money

decreases.

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Changes in Equilibrium Interest Rates in the

Liquidity Preference Framework
• Shifts in the demand for money:
o 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
o 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

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Changes in Equilibrium Interest Rates in the

Liquidity Preference Framework
• Shifts in the Supply of Money
o Assume that the supply of money is controlled by the
central bank
o An increase in the money supply engineered by the
Federal Reserve will shift the supply curve for money
to the right

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Summary Table 4: Factors that Shift the Demand and Supply

of Money

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Figure 9: Response to a Change in Income or the

Price Level

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Figure 10: Response to a Change in the Money Supply

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Price-Level Effect and Expected-Inflation Effect

• 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 risingprice 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.

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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.
• Incomeeffect finds interest rates rising because increasing
the money supply is an expansionary influence on the
economy (the demand curve shifts to the right).

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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).

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PART 3

The Risk and Term

Structure
of Interest Rates

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Risk Structure of Interest Rates

• Bondswith the same maturity have different
interest rates due to:
oDefault risk
oLiquidity
oTax considerations

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Risk Structure of Interest Rates (cont’d)

• Defaultrisk: 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).
• Riskpremium: the spread between the interest rates on
bonds with default risk and the interest rates on (same
maturity) Treasury bonds

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Figure 2: Response to an Increase in Default Risk on Corporate Bonds

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Risk Structure of Interest Rates (cont’d)

• Liquidity:
the relative ease with which an asset can be
converted into cash
o Cost of selling a bond
o Number of buyers/sellers in a bond market
• Income tax considerations
o Interest payments on municipal bonds are exempt from
federal income taxes.

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Figure 3: Interest Rates on Municipal and Treasury Bonds

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Term Structure of Interest Rates

• Bondswith 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

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Facts that the Theory of the Term Structure of

Interest Rates Must Explain
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

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Three Theories to Explain the Three Facts

1. Expectations theory explains the first two facts but not

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

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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

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Expectations Theory: Example

• Let the current rate on one-year bond be 6%.

• Youexpect the interest rate on a one-year bond to be 8%
next year.
• Thenthe expected return for buying two one-year bonds
averages (6% + 8%)/2 = 7%.
• Theinterest rate on a two-year bond must be 7% for you to
be willing to purchase it.

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Expectations Theory (cont’d)

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

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Expectations Theory (cont’d)

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

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Expectations Theory (cont’d)

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

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Expectations Theory (cont’d)

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

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Expectations Theory (cont’d)

• Explains why the term structure of interest rates changes at

different times
• Explains
why interest rates on bonds with different maturities
move together over time (fact 1)
• Explainswhy 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)

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Segmented Markets Theory

• Bonds of different maturities are not substitutes at all
• Theinterest 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)

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Liquidity Premium &

Preferred Habitat Theories
• Theinterest 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

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Liquidity Premium Theory

it  it1
e
 it2
e
... it(n1)
e

int   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

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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
• Investorsare likely to prefer short-term bonds over
longer-term bonds

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Figure 5: The Relationship Between the Liquidity

Premium (Preferred Habitat) and Expectations Theory

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Liquidity Premium and Preferred Habitat

Theories (cont’d)
• 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

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Figure 6: Yield Curves and the Market’s Expectations of Future

Short-Term Interest Rates According to the Liquidity Premium
(Preferred Habitat) Theory

THE END

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