Interest Rates
INTRO TO BUSINESS FINANCE – FALL 2025
Classification of Returns
Dollar return on a financial asset can be divided into two categories:
1. Dollar income - income paid by the issuer of the financial asset
2. Capital gain/loss - the change in value of the financial asset in the financial market
Dollar Return = dollar income + capital gain/loss
= dollar income + ending value – beginning value
Ending value represents the market value of the financial asset at the end of the period.
Beginning value represents the market value of the financial asset at the start of the
period.
Types of dollar income
• If the financial asset is an equity, the income from investment is
dividend paid by a corporation
• If financial asset is a debt instrument, such as a bond, the income
from investment is the interest paid by the seller of the bond
Yield
To determine an investment he stated dollar return as a percentage
of the dollar amount that was originally invested:
Yield =
Example: You bought a bond on January 1st, 2008 for $980.00 and
sold it on December 31st, 2008 for $990.25. If you receive $100 in
interest income on December 31st, 2008. What is your yield?
Question
Capital gains = 990.25-980 = $10.25
Dollar income = $100
Yield = = 0.1125 = 11.25%
Calculate the Current Yield??
$income/current price
=100/980*100= 10.2%
Calculate the Capital gains/loss yield?
=(Capital gain/loss)/beginning price
= (990.25-980)/980*100=1.05%
What Is the Cost of Money?
The price paid for borrowing funds (interest rate).
Reflects trade-offs between current and future consumption, production, risk,
and inflation.
The Four Fundamental Factors affecting the Cost of Money
1. Production Opportunities
2. Time Preferences for Consumption
3. Risk
4. Inflation
Four fundamental Factors
Factor Effect on Interest Rates
Higher Production
↑ Interest Rates
Opportunities
Higher Time
↑ Interest Rates
Preference
Higher Risk ↑ Interest Rates
Higher Inflation ↑ Interest Rates
Moreover, Interest Rates are
determined through the interaction of
demand and supply forces
Interest rates also move in line with the economic
situation of the country. During times of recession,
interest rates fall. During boom interest rates rise.
Short-term interest rates are especially volatile,
rising rapidly during booms and falling equally
rapidly during recessions.
The Quoted Interest Rate
The quoted (or nominal) interest rate on a debt security, r, is composed of a
real risk-free rate, r*, plus several premiums
The Determinants of Market
Interest Rates
r* = The real risk-free rate Return on a riskless asset with no inflation.
IP = Inflation Premium. Compensation for expected price increases.
rRF = r* + IP. It is the quoted rate on a risk-free security such as a U.S. Treasury
bill.
DRP = Default Risk Premium. Compensation for potential borrower default. DRP
is zero for U.S. Treasury securities.
LP = Liquidity (or marketability) Premium. Compensation for assets difficult to
sell quickly.
MRP = Maturity Risk Premium. Accounts for the risk of price declines due to
increases interest rates (interest rate risk).
Calculation of IP
IP is the average of expected inflation of future years.
Let’s consider the inflation expectation using two simple examples, where r* is 2% :
1. Inflation rate is expected to increase in the future. Calculate the IP for a 5 year security.
2. Inflation rate is expected to decrease in the future. Calculate the IP for a 10 year security.
Calculation of IP
Increasing inflation for 5-year security:
IP = (1 + 1.8 + 2 + 2.4 + 2.8)/5 = 2%
Decreasing inflation for a 10-year security:
IP = (5 + 4.2 + 4 + 3.4 + 3.2 + 2.4*5)/10 = 3.18 %
Question
An analyst evaluating securities has obtained the following information.
The real rate of interest is 2% and is expected to remain constant for the next 3
years. Inflation is expected to be 3% next year, 3.5% the following year, and 4%
the third year. The maturity risk premium is estimated to be 0.1 x (t – 1)%,
where t = number of years to maturity. The liquidity premium on relevant 3-year
securities is 0.25%, and the default risk premium on relevant 3-year securities is
0.6%.
a. What is the yield on a 1-year T-bill? (Answer = 5%)
b. What is the yield on a 3-year T-bond? (Answer= 5.7%)
c. What is the yield on a 3-year corporate bond? (Answer = 6.55%)
The Term Structure of Interest
Rates
The relationship between maturity profile of bonds and interest rates is called
the term structure of interest rates.
Plotting of this relationship is called the yield curve.
Potential Shapes for Yield Curves
o Upward sloping
o Downward sloping
o Flat
o Humped
What determines the shape of
yield curves
Treasury bonds
Affected by Inflation and Maturity risk premium.
Inflation expected to increase → upward-sloping curve.
Inflation expected to decrease → downward-sloping curve
The MRP always increases with maturity, even if inflation expectations are
constant.
What determines the shape of
yield curves
Corporate bonds
o Spread shows extra compensation investors require for corporate bonds.
o It varies with market conditions and firm credit quality.
The yield spread between corporate and Treasury bonds is larger the longer the maturity. This
occurs because longer-term corporate bonds have more default and liquidity risk than shorter-term
bonds, and both of these premiums are absent in Treasury bonds.
Yield Curves Summary
• Yield curve shape reflects:
◦ Expected inflation trends
◦ Maturity risk
◦ Default and liquidity premiums
• Upward slope = rising inflation, growth expectations.
Downward slope = falling inflation, possible recession.
Corporate yield spreads = measure of risk in corporate bonds.
• Yield curves rise sharply over the first 5–10 years, then flatten as people forecast short-term
inflation more precisely than long-term.
• Yields go in the following order:
Long-term corporate yields > Short-term corporate yields > Treasuries.
Real vs Nominal Rates
Basic Equation:
Formula for 1 year nominal rate:
Example:
Loaf of bread costs $1 today.
Real interest rate = 3%, expected inflation = 5%.
Consumer trades 100 loaves today for 103 loaves next year (3% real return).
Next year, price = $1.05 → 103 loaves = $108.15.
To achieve a 3% real return, must earn 8.15% nominal.
Pure Expectations Theory
The shape of the yield curve depends entirely on investors’ expectations about
future interest rates.
Key Assumptions:
◦ Treasury bonds have no maturity risk premium (MRP = 0).
◦ Investors are indifferent to bond maturity (no added risk for long-term bonds).
◦ Long-term rates = average of expected future short-term rates.
Time horizons in Expectations
Theory
According to expectations theory, there is no reinvestment risk and there is no price risk.
No matter in what way the investors invest for a particular time horizon, the return is going to be
the same.
For Eg: If the investor wants to invest for 10 years, no matter if he invests for
◦ 10 years
◦ 5 years + 5 years
◦ 2 years+ 8 years
◦ 1 year +1 year+ 1year……
The return is going to be the same.
Question - PET
1 year security 10%
2 years security 12%
3 years security 12.5%
What is the return on a 1-year security after 1 year?
What is the return on a 1-year security after 2 years?
What is the return on a 2-year security after 1 year?
Example of Pure Expectations
Theory
1-year T-bond = 5.00%, 2-year T-bond = 5.50%
Two investment options:
Buy a 2-year bond at 5.5%
Buy a 1-year bond at 5%, then reinvest for 1 more year
Find expected rate on a 1-year Treasury security 1 year from now:
Therefore, X, the 1-year rate 1 year from today, must be 6.00238%; otherwise, one option will
be better than the other, and the market will not be in equilibrium.
Arbitrage and Market
Adjustment - PET
If rates are not in equilibrium, traders exploit differences:
◦ Borrow at lower long-term rate
◦ Invest in short-term securities with higher expected return
Result:
◦ Increased demand raises short-term yields
◦ Increased supply lowers long-term yields
◦ Market returns to equilibrium
Question - PET
Given Rates:
1-year = 5.00%, 2-year = 5.50%, 4-year = 6.25%
Find expected 3-year rate next year:
→Expected 3-year yield next year = 6.67%
Accounting for MRP
Evidence suggests positive MRP exists.
Example:
1-year = 5.00%
2-year = 5.50%
MRP for 2-year = 0.20%
Equilibrium return on 2-year series = 5.50% − 0.20% = 5.30%
Adjustment for MRP
(1.05)(1+X)=(1.053)^2
→ Expected 1-year rate next year = 5.60%
Decomposition:
◦ Total increase = 0.50%
◦ MRP = 0.20%
◦ Expected rate increase = 0.30%
Macroeconomic Factors Affecting
Interest Rates
1. Federal Reserve Policy
The Fed controls the money supply
Increasing money supply:
◦ Stimulates economy
◦ Lowers short-term rates
◦ May raise inflation expectations → higher long-term rates
Tightening has the opposite effect
Note: Fed has more control over short-term than long-term rates
Macroeconomic Factors Affecting
Interest Rates
2. Federal Budget Deficits/Surpluses
Deficit → higher interest rates
Government borrowing increases demand for funds
Printing money increases inflation expectations
Surplus → lower rates
Example: Post-2017 tax cuts and COVID relief increased deficits → upward pressure
on rates.
Macroeconomic Factors Affecting
Interest Rates
3. International Factors
Foreign Trade deficit = imports > exports. Must be financed by foreign borrowing or asset sales
U.S. rates depend on:
◦ Global interest rates
◦ Foreign investment in U.S. bonds
High global rates → higher U.S. rates
If U.S. rates fall below foreign rates:
◦ Foreigners sell U.S. bonds → dollar weakens
◦ Higher imports → inflation risk
Result: Fed’s power over U.S. rates becomes limited.
Macroeconomic Factors Affecting
Interest Rates
4. Business Activity
Recessions: lower demand for money → lower rates
Expansions: higher demand → higher rates
During recessions:
◦ Fed increases money supply
◦ Short-term rates fall more sharply than long-term
LT vs ST debt
Short-term loans must be renewed annually
Risk if: Rates rise → interest cost increases
Banks refuse to renew → liquidity crisis
May lead to bankruptcy
Long-term loans offer fixed interest rates and protection from rate increases but
are disadvantageous because:
Higher initial rate
Could be disadvantageous if future rates fall
Balanced Financing Strategy
Since interest rate forecasts are uncertain:
Firms should use a mix of short- and long-term debt
Match short-term debt with current assets
Match long-term debt with fixed assets