Bonds and the term

structure of interest
rates
Interest Rate Fundamentals
• Interest rate
• The compensation paid by the borrower of funds to the lender; from
the borrower’s point of view, the cost of borrowing funds.
• Required return
• The cost of funds obtained by selling an ownership interest; it reflects
the funds supplier’s level of expected return.
• Liquidity preferences
• General preferences of investors for shorter-term securities.
• The interest rate or required return represents the cost of money. It is
the compensation that a demander of funds must pay a supplier.
When funds are lent, the cost of borrowing the funds is the interest
rate. When funds are obtained by selling an ownership interest—as in
the sale of stock—the cost to the issuer (demander) is commonly
called the required return, which reflects the funds supplier’s level of
expected return. In both cases the supplier is compensated for
providing funds. Ignoring risk factors, the cost of funds results from
the real rate of interest adjusted for inflationary expectations and
liquidity preferences—general preferences of investors for shorter-
term securities.
The Real Rate of Interest

• The rate that creates an equilibrium between the supply of savings

and the demand for investment funds in a perfect world, without
inflation, where funds suppliers and demanders are indifferent to the
term of loans or investments and have no liquidity preference, and
where all outcomes are certain.
• Assume a perfect world in which there is no inflation and in which
funds suppliers and demanders are indifferent to the term of loans or
investments because they have no liquidity preference and all
outcomes are certain.1 At any given point in time in that perfect
world, there would be one cost of money—the real rate of interest.
The real rate of interest creates an equilibrium between the supply of
savings and the demand for investment funds. It represents the most
basic cost of money.
Interest Rates & Required Returns
• The interest rate or required return represents the price of money.
• Interest rates act as a regulating device that controls the flow of
money between suppliers and demanders of funds.
• The Board of Governors of the Federal Reserve System regularly
asses economic conditions and, when necessary, initiate actions to
change interest rates to control inflation and economic growth.

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Interest Rates & Required Returns: Interest Rate
Fundamentals
• Interest rates represent the compensation that a demander of funds
must pay a supplier.
• When funds are lent, the cost of borrowing is the interest rate.
• When funds are raised by issuing stocks or bonds, the cost the
company must pay is called the required return, which reflects the
suppliers expected level of return.

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Interest Rates & Required Returns: The Real Rate
of Interest
• The real interest rate is the rate that creates an equilibrium between
the supply of savings and the demand for investment funds in a
perfect world.
• In this context, a perfect world is one in which there is no inflation,
where suppliers and demanders have no liquidity preference, and
where all outcomes are certain.

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The supply-demand relationship that
determines the real rate

Figure 6.1 Supply–Demand Relationship

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6-10
• Clearly, the real rate of interest changes with changing economic
conditions, tastes, and preferences. A trade surplus could result in an
increased supply of funds.
• This could result in a lower real rate of interest, k1*, at equilibrium.
Likewise, a change in tax laws or other factors could affect the
demand for funds, causing the real rate of interest to rise or fall to a
new equilibrium level.
Interest Rates & Required Returns:
Nominal or Actual Rate of Interest (Return)

• The nominal rate of interest is the actual rate of interest charged by

the supplier of funds and paid by the demander.
• The nominal rate differs from the real rate of interest, k* as a result
of two factors:
• Inflationary expectations reflected in an inflation premium (IP), and
• Issuer and issue characteristics such as default risks and contractual
provisions as reflected in a risk premium (RP).

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• Using this notation, the nominal rate of interest for security 1, r1 is
given in equation 6.1, and is further defined in equations 6.2 and 6.3.

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• The premium for inflationary expectations in Equation 6.3 represents
the average rate of inflation expected over the life of a loan or
investment. It is not the rate of inflation experienced over the
immediate past; rather, it reflects the forecasted rate.
Yield Curve
• In finance, the yield curve is a curve showing several yields or interest
rates across different contract lengths (2 month, 2 year, 20 year,
etc. ...) for a similar debt contract. The curve shows the relation
between the (level of the) interest rate (or cost of borrowing) and the
time to maturity, known as the "term", of the debt for a given
borrower in a given currency.
• The Yield Curve is a graphical representation of the interest
rates on debt for a range of maturities. It shows the yield an
investor is expected to earn if he lends his money for a given
period of time.  The graph displays the bonds’ yield on the
vertical axis and the time to maturity across the horizontal
axis.  The curve may take different shapes at different points
in the economic cycle, but it is typically upward sloping.
Term Structure of Interest Rates
• The relationship between the interest rate or rate of return and the
time to maturity.
• The term structure of interest rates relates the interest rate to the
time to maturity for securities with a common default risk profile.
• Typically, treasury securities are used to construct yield curves since
all have zero risk of default.

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• yield to maturity
• Annual rate of return earned on a debt security purchased on a given
day and held to maturity.
• yield curve
• A graph of the relationship between the debt’s remaining time to
maturity (x axis) and its yield to maturity (y axis); it shows the pattern
of annual returns on debts of equal quality and different maturities.
Graphically depicts the term structure of interest rates.
• A debt security’s yield to maturity (discussed later in this chapter)
represents the annual rate of return earned on a security purchased
on a given day and held to maturity. At any point in time, the
relationship between the debt’s remaining time to maturity and its
yield to maturity is represented by the yield curve. The yield curve
shows the yield to maturity for debts of equal quality and different
maturities; it is a graphical depiction of the term structure of interest
rates.
• inverted yield
• curve A downward-sloping yield curve that indicates generally
cheaper long-term borrowing costs than short-term borrowing costs.
• normal yield curve
• An upward-sloping yield curve that indicates generally cheaper short-
term borrowing costs than long-term borrowing costs.
• flat yield curve
• A yield curve that reflects relatively similar borrowing costs for both
short- and longer term loans.
Theories of Term Structure
• Expectations theory
• The theory that the yield curve reflects investor expectations about
future interest rates; an increasing inflation expectation results in an
upward-sloping yield curve, and a decreasing inflation expectation
results in a downward-sloping yield curve
• liquidity preference theory
• Theory suggesting that for any given issuer, long-term interest rates
tend to be higher than short-term rates because (1) lower liquidity
and higher responsiveness to general interest rate movements of
longer-term securities exists and (2) borrower willingness to pay a
higher rate for long-term financing; causes the yield curve to be
upward-sloping.
• market segmentation theory
• Theory suggesting that the market for loans is segmented on the basis
of maturity and that the supply of and demand for loans within each
segment determine its prevailing interest rate; the slope of the yield
curve is determined by the general relationship between the
prevailing rates in each segment.
Risk Premiums: Issuer and Issue
Characteristics
• So far we have considered only risk-free U.S. Treasury securities. We
now reintroduce the risk premium and assess it in view of risky non-
Treasury issues.
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