FINANCIAL MANAGEMENT

Chapter 7: Interest Rates

Comprehensive Exam Reviewer

HOW TO USE THIS REVIEWER

This reviewer covers all topics from Chapter 7: Interest Rates. Each section includes: core
concept explanations, key formulas with step-by-step solving, decision rules, and exam
traps to avoid. Work through each section systematically and test yourself using the Quick
Recall and True/False Trap sections.

SECTION 1: INTRODUCTION TO INTEREST RATES

1.1 What Are Interest Rates?

Interest rates represent the cost of borrowing money (for the borrower) and the reward for lending
money (for the lender). Companies raise funds through either debt or equity; this chapter focuses on
debt financing.

Why Interest Rates Matter

• They influence business financing decisions (borrow short-term vs. long-term)
• They affect investment decisions and project feasibility
• They reflect economic conditions (inflation, risk, growth)
• No single interest rate exists — rates vary by risk, time, collateral, and economic conditions

1.2 The Four Fundamental Factors Affecting the Cost of Money

Factor Definition & Significance

(1) Production Opportunity The investment opportunities in productive (cash-generating)
assets. When businesses have profitable opportunities, they
compete for funds, driving interest rates UP.
(2) Time Preferences for Consumers' preference to spend NOW vs. save for LATER. If
Consumption people prefer to consume today (low savings), the supply of
loanable funds falls and rates go UP.
(3) Risk The probability that an investment will provide a low or negative
return. Higher risk = higher interest rate demanded by lenders
(risk premium).
 (4) Inflation The general increase in prices over time. Lenders demand
compensation for the loss of purchasing power, so higher
expected inflation = higher interest rates.

EXAM TIP - True/False Trap:

FALSE: 'There is one universal interest rate for all borrowers.' TRUE: Interest rates vary by
borrower risk, loan maturity, collateral, and economic conditions.

SECTION 2: INTEREST RATES & INFLATION

2.1 The Inflation-Interest Rate Relationship

Inflation and interest rates move in the SAME direction. This is one of the most important relationships
in finance.

COVID-19 Case Study (Real-World Application)

During COVID-19: Central banks LOWERED interest rates and injected money into the
economy → increased demand while supply was limited → prices rose (INFLATION). To
control inflation, central banks then RAISED interest rates → made borrowing expensive →
reduced spending → inflation slowed. This illustrates how inflation is a primary driver of
interest rate decisions.

Inflation Scenario Central Bank Response & Effect on Rates

Inflation is RISING Central bank RAISES interest rates → borrowing becomes more
expensive → spending decreases → inflation is controlled →
rates go UP
Inflation is FALLING / Low Central bank LOWERS interest rates → borrowing is cheaper →
spending increases → economy stimulated → rates go DOWN
Expected future inflation Lenders demand higher rates NOW to compensate → long-term
HIGH rates rise
Expected future inflation Lenders accept lower rates → long-term rates fall
LOW

EXAM TIP - Decision Rule:

When inflation RISES, interest rates RISE. When inflation FALLS, interest rates FALL. This
is not coincidence — central banks deliberately use interest rates as a tool to control
inflation.
 SECTION 3: INTEREST RATE LEVELS & MARKET
DYNAMICS

3.1 Market Supply and Demand for Funds

Interest rates are determined by supply and demand for loanable funds in the market, just like prices for
any good or service.

Change in Market Effect on Interest Rates

Supply of funds INCREASES Interest rates DECREASE
(more lenders)
Supply of funds Interest rates INCREASE
DECREASES (fewer lenders)
Demand for funds Interest rates INCREASE
INCREASES (more
borrowers)
Demand for funds Interest rates DECREASE
DECREASES (fewer
borrowers)
Firms with MOST profitable Willing to pay HIGHEST rates for capital
investments

3.2 Risk Premium & Flight to Quality

Concept Explanation
Risk Premium The extra interest rate demanded by lenders to compensate for
taking on higher risk. Higher-risk borrowers pay higher rates.
Formula: Risk Premium = Rate on risky security - Rate on risk-
free security
Flight to Quality When investors become fearful (e.g., recession, crisis), they
shift funds from HIGH-risk securities to LOW-risk securities (like
U.S. Treasury bonds). This RAISES demand for safe securities
(pushing yields down) and LOWERS demand for risky securities
(pushing yields up).

EXAM TIP:
During a 'flight to quality': Treasury bond prices RISE (yields fall) while corporate/risky bond
prices FALL (yields rise). The SPREAD between risky and safe securities WIDENS.
 SECTION 4: DETERMINANTS OF MARKET INTEREST
RATES

4.1 The Master Formula

The quoted (nominal) interest rate on any security is composed of several components:

r = r* + IP + DRP + LP + MRP

Where each variable represents a specific risk or cost component:

Component Full Name, Definition & Key Facts

r Quoted (Nominal) Interest Rate — the actual stated rate you see
in the market
r* Real Risk-Free Rate — the rate on default-free U.S. Treasury
securities IF no inflation were expected. Represents the 'pure'
time value of money. Typically assumed ~1-3%.
IP Inflation Premium — a premium added equal to EXPECTED
(not actual) inflation. Compensates lenders for expected loss of
purchasing power. IP = average expected inflation over the life
of the security.
DRP Default Risk Premium — extra return for the chance the
borrower won't repay. DRP = 0 for U.S. Treasury securities
(assumed default-free). Higher for corporate bonds, especially
lower-rated ones.
LP Liquidity Premium — extra return if a security CANNOT be
quickly converted to cash at fair market value. Illiquid securities
require higher LP. Treasury bonds have LP ≈ 0 (very liquid).
MRP Maturity Risk Premium — extra return for holding LONGER-term
bonds, which are more sensitive to interest rate changes.
Longer maturity = higher MRP. Always POSITIVE in practice.

4.2 Risk-Free Rate: Real vs. Nominal

Nominal Risk-Free Rate (rRF) = r* + IP

Key Distinction:
r* (Real Risk-Free Rate) — strips out inflation. Reflects the PURE time value of money. rRF
(Nominal Risk-Free Rate) — includes inflation premium. This is the T-bill or T-bond rate you
 observe in the market.

4.3 For Treasury vs. Corporate Bonds

T-bond yield = r*t + IPt + MRPt

Corporate bond yield = r*t + IPt + MRPt + DRPt + LPt

Why do Treasury bonds have lower yields than corporate bonds?

Treasury bonds have DRP = 0 (U.S. government assumed default-free) and LP ≈ 0 (very
liquid). Corporate bonds must add DRP and LP to compensate investors for additional risks.
Higher-rated (AAA) corporates have small DRP; lower-rated (BBB) have larger DRP.

4.4 Corporate Bond Yield Spread

Yield Spread = Corporate Bond Yield - Treasury Bond Yield

= DRPt + LPt

The yield spread tells you how much EXTRA return investors require for a corporate bond vs. a
Treasury bond of the same maturity. Wider spread = MORE risk perceived.

Bond Rating Interpretation of Yield Spread

AAA-Rated Corporate Smallest yield spread — highest quality, lowest default risk
BBB-Rated Corporate Larger yield spread — more default risk than AAA
Junk/High-Yield Bonds Very large yield spread — significant default risk
During recession/crisis Spreads WIDEN as investors demand more compensation for
risk

EXAM TIP - Common Mistakes:

1) IP is based on EXPECTED future inflation, NOT current inflation. 2) DRP for U.S.
Treasury = ZERO (not low, but ZERO). 3) MRP is always POSITIVE and increases with
maturity. 4) LP = 0 for liquid securities like T-bills/T-bonds.
 SECTION 5: COMPUTATION — CALCULATING INTEREST
RATES

5.1 Step-by-Step Problem Solving Guide

Identify what you're solving for

Step
1 Read the problem and determine: Are you finding r? r*? IP? DRP? LP? MRP? One
of the component yields?

Write the applicable formula

Step
2 Use r = r* + IP + DRP + LP + MRP. For Treasury bonds: omit DRP and LP. For T-
bills: also omit MRP.

Plug in known values

Step
3 Substitute all given values into the formula. Leave the unknown as a variable (e.g., r*
= ?)

Step Solve for the unknown

4 Use algebra to isolate and calculate the unknown variable.

Interpret the result

Step
5 State what the answer means: Is this a risk premium? A premium for default risk? An
expected inflation rate?

5.2 Worked Example 1 — Finding the Quoted Rate

PROBLEM:
A corporate bond has: r* = 2%, IP = 3%, DRP = 1.5%, LP = 0.5%, MRP = 1%. What is the
quoted interest rate?

SOLUTION:
r = r* + IP + DRP + LP + MRP
r = 2% + 3% + 1.5% + 0.5% + 1%
r = 8%
 INTERPRETATION:
The corporate bond must yield 8% to compensate investors for all components of risk and
the time value of money.

5.3 Worked Example 2 — Finding IP (Inflation Premium)

PROBLEM:
A Treasury bond yields 6%. The real risk-free rate is 2.5% and the MRP is 0.5%. What is the
inflation premium?

SOLUTION:
For a T-bond: r = r* + IP + MRP (no DRP or LP for Treasury)
6% = 2.5% + IP + 0.5%
IP = 6% - 2.5% - 0.5% = 3%

INTERPRETATION:
The market expects inflation of approximately 3% over the life of this bond.

5.4 Worked Example 3 — Finding DRP

PROBLEM:
A T-bond and a corporate bond have the same 10-year maturity. T-bond yields 5.5%;
corporate bond yields 7.2%. The LP on the corporate is 0.3%. What is the DRP?

SOLUTION:
Yield spread = Corporate yield - T-bond yield = DRP + LP
7.2% - 5.5% = DRP + 0.3%
1.7% = DRP + 0.3%
DRP = 1.7% - 0.3% = 1.4%

INTERPRETATION:
The corporate bond carries a 1.4% default risk premium — investors require 1.4% extra
return to compensate for the risk that the corporation may default.
 SECTION 6: TERM STRUCTURE OF INTEREST RATES &
THE YIELD CURVE

6.1 Key Definitions

Term Definition
Term Structure of Interest The relationship between interest rates (or bond yields) and
Rates different maturities. Describes HOW rates differ as loan/bond
maturity changes.
Yield Curve A GRAPH showing the relationship between bond yields (y-axis,
%) and years to maturity (x-axis). A snapshot of the term
structure at a point in time.

6.2 Types of Yield Curves

Type Shape What It Signals

Normal (Upward- Rates increase as maturity Economy is healthy; inflation
Sloping) increases. Short-term < Long- expected to remain stable or rise
term rates. moderately. Lenders demand more
for longer commitments.
Inverted / Abnormal Rates DECREASE as maturity Often signals an UPCOMING
(Downward-Sloping) increases. Short-term > Long- RECESSION. Investors expect rates
term rates. to fall in the future (lower inflation or
economic slowdown expected).
Humped Intermediate-term rates are Unusual shape; intermediate-term
HIGHER than both short-term risk is highest. Often transitional.
and long-term rates.
Flat All maturities have approximately Uncertain about future direction of
the same rate. rates; transitional phase.

EXAM TIP - The Inverted Yield Curve:

An inverted yield curve is historically one of the best predictors of a recession. If short-term
rates are HIGHER than long-term rates, the market expects rates (and possibly economic
activity) to fall in the future.

6.3 What Determines the Shape of the Yield Curve?

The yield curve's shape is determined primarily by:

 • Expected Inflation: If inflation is expected to RISE in the future, long-term bonds have higher
inflation premiums → upward-sloping curve. If inflation expected to FALL, long-term rates are
lower → inverted/downward curve.
• Maturity Risk Premium (MRP): Since MRP is always positive and increases with maturity, this
alone pushes the yield curve upward. Long-term bonds always carry higher MRP.
• Default Risk & Liquidity: Also vary with maturity and affect the shape, especially for corporate
bonds.

Key Insight:
If ONLY the MRP varied (and everything else was constant), the yield curve would ALWAYS
be upward sloping. But because inflation expectations can change, the curve can flatten or
invert.

6.4 Effect of Inflation Expectations on the Yield Curve

Inflation Expectation Effect on Yield Curve Example

Inflation expected to Yield curve slopes UPWARD 1-yr bond: 5.50%; 5-yr bond:
INCREASE (e.g., 3% → 4% → (Normal). Long-term IP is 6.08%; 30-yr bond: 7.70%
5%) higher.
Inflation expected to Yield curve slopes 1-yr bond: 7.50%; 5-yr bond:
DECREASE DOWNWARD (Inverted). 7.28%; 30-yr bond: 6.36%
Long-term IP is lower.
Inflation expected STABLE Yield curve is relatively flat Rates gradually increase but
(slight upward slope due to only slightly with maturity
MRP)

SECTION 7: PURE EXPECTATIONS THEORY &

ESTIMATING FUTURE RATES

7.1 Pure Expectations Theory — Core Concept

Core Assumption of Pure Expectations Theory:

Bond traders establish prices and rates SOLELY based on expectations for future interest
rates. Under this theory, traders are INDIFFERENT to maturity — they do not view long-term
bonds as riskier. Therefore, MRP = 0 in the pure theory.

Key implication: Long-term interest rates are simply a WEIGHTED AVERAGE of current and expected
future short-term interest rates.
 Important Caveat:
The pure expectations theory is a simplification. In reality, most evidence suggests MRP > 0
because long-term bonds ARE riskier (more sensitive to rate changes). The modified
version accounts for a positive MRP.

7.2 The Formula — Estimating Future Short-Term Rates

(1 + r1-yr) × (1 + X) = (1 + r2-yr)²

Where: r1-yr = current 1-year rate, r2-yr = current 2-year rate, X = expected 1-year rate ONE YEAR
FROM NOW

Solving for X:

X = [(1 + r2-yr)² / (1 + r1-yr)] - 1

7.3 Step-by-Step: The Classic Exam Problem

PROBLEM (From Lecture):

A 1-year Treasury bond currently yields 5.00%. A 2-year Treasury bond yields 5.50%. Using
the Pure Expectations Theory, what is the expected 1-year rate ONE YEAR FROM NOW?

Step Identify what you need

1 Find X = the expected 1-year rate 1 year from today

Set up the equation

Step
2 Both investment options (buy 2-yr bond OR roll over two 1-yr bonds) must give equal
returns: (1.05)(1 + X) = (1.055)²

Step Expand the right side

3 (1.055)² = 1.113025

Step Solve for (1 + X)

4 (1 + X) = 1.113025 / 1.05 = 1.0600238

Step Solve for X

 5 X = 1.0600238 - 1 = 0.0600238 = 6.00238%

Interpret
Step
6 The market expects the 1-year rate to RISE from 5% to approximately 6.00% one
year from now. This is why the 2-year bond yields more than the 1-year bond.

ANSWER: X ≈ 6.00238%
If X were any different (e.g., if the 2-year bond only yielded 5.25% instead of 5.50%),
arbitrage opportunities would exist and traders would quickly restore equilibrium through
buying/selling.

7.4 When Maturity Risk Premium (MRP) is NOT Zero

Modified Problem (With MRP):

Same setup: 1-yr rate = 5.00%, 2-yr rate = 5.50%. BUT now assume MRP on 2-yr bond =
0.20% (while MRP on 1-yr = 0%). Find the expected 1-year rate.

Key insight: The 2-yr bond yields 0.20% MORE than a pure expectations rate because of MRP. So the
implied return from rolling over two 1-yr bonds is LESS by 0.20%:

Expected return on 2-yr series = 5.50% - 0.20% = 5.30%

(1.05)(1 + X) = (1.053)²
(1.05)(1 + X) = 1.108809
(1 + X) = 1.108809 / 1.05 = 1.0560086
X = 5.60086%

KEY COMPARISON:
Without MRP: X = 6.00238% With MRP of 0.20%: X = 5.60086% The 0.50% rise in the
yield curve (5.00% → 5.50%) is split: 0.20% from MRP + 0.30% from rising rate
expectations.

EXAM TRAP - Common Mistake:

When MRP is given, do NOT ignore it. Subtract the MRP from the observed long-term rate
BEFORE calculating the expected future rate. The formula becomes: (1 + short-term rate)(1
+ X) = (1 + long-term rate - MRP)²
SECTION 8: MACROECONOMIC FACTORS INFLUENCING
INTEREST RATES

Macroeconomic Factor How It Affects Interest Rates

Federal Reserve Policy The Fed controls the MONEY SUPPLY. Increasing money
supply → more funds available → rates FALL. Decreasing
money supply → less funds → rates RISE. The Fed also directly
sets the federal funds rate.
Federal Budget Deficits When the government SPENDS MORE than it collects in taxes,
it runs a deficit and must BORROW → increases demand for
funds → rates RISE. The larger the deficit, the higher the
pressure on rates (all else equal).
Federal Budget Surpluses Government takes in MORE than it spends → borrows less →
reduces demand for funds → rates may FALL.
Foreign Trade Deficit A country buys more from abroad than it sells (imports >
exports). Must borrow from foreigners to finance the gap →
increases demand for funds → can push rates UP.
Interest Rates Abroad Higher interest rates in other countries attract capital away from
the U.S. → U.S. must raise rates to retain investors.
International rates influence domestic rates.
Business Activity During EXPANSION: high investment demand + potential
(Economic Cycle) inflation → rates RISE. During RECESSION: low demand for
loans + Fed may cut rates to stimulate economy → rates FALL.

EXAM TIP - Decision Rule for Government Deficits:

Larger federal deficit → HIGHER interest rates (all else held constant). This is because
government competes with private borrowers for available funds, pushing rates up.

SECTION 9: INTEREST RATES AND BUSINESS

DECISIONS

9.1 Short-Term vs. Long-Term Financing Decision

Financing Type Key Characteristics & When to Choose

Short-Term Debt Company must RENEW the loan periodically (e.g., annually).
Advantage: Lower initial rate during normal yield curve. Risk:
Rate may RISE at renewal. Best when rates are expected to
FALL or when yield curve is inverted.
Long-Term Debt Interest cost LOCKED IN for the duration. Advantage: Certainty
 and protection from rising rates. Cost: Typically higher initial rate
(due to MRP). Best when rates are expected to RISE or when
yield curve is normal/upward.

Decision Rule: Which Maturity to Choose?

Normal yield curve (rates expected to rise): Consider LONG-TERM financing to lock in
current rates before they rise. Inverted yield curve (rates expected to fall): Consider SHORT-
TERM financing and refinance later at lower rates. Your choice of maturity has a MAJOR
effect on investment performance and future income.

9.2 Companies and the Yield Curve

Companies analyze the yield curve to decide:
• WHEN to issue debt (borrow when rates are low)
• WHAT MATURITY to choose (short vs. long-term)
• HOW to structure their capital (mix of debt maturities)
• Whether to REFINANCE existing debt

SECTION 10: QUICK RECALL — KEY FORMULAS

SUMMARY

Formula Name Formula

Quoted/Nominal Interest r = r* + IP + DRP + LP + MRP
Rate
Nominal Risk-Free Rate rRF = r* + IP
Treasury Bond Yield T-bond yield = r* + IP + MRP (no DRP, LP)
Corporate Bond Yield Corp. yield = r* + IP + MRP + DRP + LP
Corporate Bond Yield Spread = Corp. yield - T-bond yield = DRP + LP
Spread
Pure Expectations (2-yr) (1 + r1)(1 + X) = (1 + r2)²
Solving for Expected Future X = [(1 + r2)² / (1 + r1)] - 1
Rate
With MRP Adjustment (1 + r1)(1 + X) = (1 + r2 - MRP)²

SECTION 11: KEY TERMS & DEFINITIONS

 Term Definition
Real Risk-Free Rate (r*) Rate on default-free U.S. Treasury securities assuming ZERO
inflation. Pure time value of money.
Nominal (Quoted) Rate (r) The actual stated interest rate that includes all premiums. What
you see advertised.
Inflation Premium (IP) Premium added to compensate for EXPECTED future inflation
over the life of the security.
Default Risk Premium (DRP) Extra return demanded because borrower might not repay. Zero
for U.S. Treasuries.
Liquidity Premium (LP) Extra return for securities that cannot be quickly sold at fair
market value.
Maturity Risk Premium Extra return for longer-term bonds that are more sensitive to
(MRP) interest rate changes. Always positive.
Interest Rate Risk The risk of capital LOSSES to investors due to CHANGING
interest rates. Longer bonds have MORE interest rate risk.
Term Structure of Interest The relationship between bond yields and their maturities at a
Rates given point in time.
Yield Curve A graph plotting bond yields (y-axis) against maturity (x-axis).
Normal Yield Curve Upward-sloping yield curve. Short-term rates < Long-term rates.
Most common.
Inverted Yield Curve Downward-sloping. Short-term rates > Long-term rates. Often
predicts recession.
Humped Yield Curve Intermediate-term rates higher than both short and long-term
rates.
Pure Expectations Theory Theory that long-term rates = weighted average of expected
future short-term rates. Assumes MRP = 0.
Risk Premium Any additional return above the risk-free rate to compensate for
risk.
Flight to Quality Investor shift from risky to safe securities during uncertainty.
Raises Treasury prices, lowers yields.
Federal Funds Rate The overnight lending rate between banks, controlled by the
Federal Reserve.

SECTION 12: EXAM PREPARATION GUIDE

12.1 Multiple-Choice Focus Areas

• The four fundamental factors affecting the cost of money (production opportunity, time
preference, risk, inflation)
 • What each component of r = r* + IP + DRP + LP + MRP represents and equals for specific
bonds
• Which premium is zero for Treasury bonds (DRP and LP)
• How inflation affects interest rates (direct/positive relationship)
• Types of yield curves and what each signals about the economy
• What the Pure Expectations Theory assumes (MRP = 0, no maturity preference)
• Effects of federal deficits, Fed policy, foreign trade on rates
• Yield spread = DRP + LP (how to calculate and interpret)

12.2 True/False Traps — Watch Out For These!

Statement TRUE or FALSE — and Why

There is one universal FALSE — rates vary by risk, maturity, liquidity, and economic
interest rate for all conditions.
borrowers.
U.S. Treasury bonds have TRUE — U.S. government is assumed to be default-free.
zero default risk premium
(DRP = 0).
An inverted yield curve FALSE — INVERTED means short-term rates are HIGHER than
means long-term rates are long-term rates.
higher than short-term rates.
The inflation premium is FALSE — IP is based on EXPECTED future inflation over the
based on ACTUAL current bond's life.
inflation.
The maturity risk premium FALSE — evidence shows MRP > 0 for most bonds. It is only
(MRP) is zero in practice. assumed zero in the PURE expectations theory.
Under Pure Expectations FALSE — the theory ASSUMES investors are INDIFFERENT to
Theory, long-term bonds are maturity and don't view long-term as riskier.
riskier than short-term
bonds.
Raising interest rates helps TRUE — higher rates reduce borrowing and spending, reducing
control inflation. demand-pull inflation.
A larger federal deficit leads TRUE — government competes for funds, increasing demand
to higher interest rates, all and pushing rates up.
else equal.
The real risk-free rate FALSE — r* EXCLUDES inflation. rRF = r* + IP includes
already includes expected inflation.
inflation.
Short-term debt always FALSE — when yield curve is inverted, short-term rates are
costs less than long-term HIGHER than long-term rates.
debt.
12.3 Problem-Solving Checklist

1. Read carefully — identify what is GIVEN and what is UNKNOWN

2. Identify the security type: Treasury (no DRP/LP) or Corporate (includes DRP and LP)
3. Write the correct formula based on the security type
4. If MRP is mentioned, include it and don't confuse it with the rate expectation adjustment
5. For expectations theory problems: set up (1 + r_short)(1 + X) = (1 + r_long)²
6. If MRP exists in expectations theory: subtract MRP from long-term rate BEFORE solving
7. Double-check your algebra; it's easy to make errors in simple percentage arithmetic
8. Interpret your answer — explain what the number MEANS, not just its value

12.4 Commonly Confused Concepts

Concept Pair How to Keep Them Straight

r* vs. rRF r* = NO inflation included. rRF = r* + IP (includes inflation). rRF
is what you observe on T-bills.
IP vs. Actual Inflation IP is based on EXPECTED inflation (forward-looking), not what
inflation is today.
DRP vs. LP DRP = risk of NON-PAYMENT (default). LP = risk of not being
able to SELL quickly at fair value. Both are zero for T-bonds.
Normal vs. Inverted Yield Normal = upward slope = long > short rates. Inverted =
Curve downward slope = short > long rates.
MRP and Interest Rate Risk Interest rate risk is the RISK itself (capital losses from rate
changes). MRP is the PREMIUM paid to compensate for that
risk.
Pure vs. Modified Pure: MRP = 0. Modified: MRP > 0 and must be subtracted
Expectations Theory when estimating future rates.
Federal Deficit vs. Surplus Deficit → government BORROWS MORE → rates rise. Surplus
→ government borrows less → rate pressure falls.

12.5 Final Summary — The Big Picture

WHAT DRIVES INTEREST RATES — REMEMBER THIS:

1. INFLATION is the #1 driver — rates follow inflation expectations. 2. RISK matters —
riskier borrowers always pay more. 3. TIME matters — longer maturities carry more
uncertainty (MRP). 4. MARKET forces (supply/demand of funds) determine the actual rate.
5. GOVERNMENT policy (Fed, fiscal deficit) influences the overall level. 6.
INTERNATIONAL rates and trade affect domestic rates through capital flows.
 Good luck on your exam!
Review each section, practice the computations, and remember the decision rules.