1. CHAPTER 6: Interest Rates - Po-Hsuan (Paul) Hsu
What’re interest rates?
Determinants of interest rates
The term structure and yield curves

2. What’re interest rates (r)?
Interest is a charge for borrowed capital.
Interest rates vary across different types of money borrowed (debt securities) – why?
3 major money borrowers:
1. Banks (checking, saving, CD)
2. Governments (Fed, State, City)
3. Firms/corporates

3. The duration of the money borrowed:
1. Short-term (1m, 3m, 6m, 9m)
2. Long-term (1y, 2y, 3y, 5y, 10y, 30y, etc.)
We mainly discuss the following 4 types of debt securities:
1. Government: Long-term (T-bonds), short-term (T-bills). “T” denotes treasury
2. Corporate: Long-term bond, short-term (notes)

4. “Nominal” vs. “real” interest rates
r = represents any nominal rate
r* = represents the “real” risk-free rate of interest.
? What’s the most secured debt?

5. Determinants of interest rates
r = r* + IP + DRP + LP + MRP
r = required/expected return on a debt security
r* = real risk-free rate of interest – existing?
IP = inflation premium
DRP = default risk premium
LP = liquidity premium – Corporate only
MRP = maturity risk premium – Corporate only

6. Premiums added to r* for different types of debtIP
MRP
DRP LP
Short-term Treasury 
Long-term Treasury
Short-term Corporate
Long-term Corporate

7. Treasury bills and bonds: Hypothetical T-bond yield curve
Years to
Maturity
Real risk-free rate 5 10 15
Interest
Rate (%)
Maturity risk premium
Inflation premium
An upward sloping yield curve.
Upward slope due to an increase in expected inflation and increasing maturity risk premium.

8. Calculating inflation premium (IP)
IP for future t years: Find the average expected inflation rate (INFL) over years 1 to t:

9. Assume inflation is expected to be 5% next year, 6% the following year, and 8% thereafter.
IP1 = 5% / 1 = 5.00%
IP10= [5% + 6% + 8%(8)] / 10 = 7.50%
IP20= [5% + 6% + 8%(18)] / 20 = 7.75%
- Any nominal r must earn these IPs to break even vs. inflation

10. Computing maturity risk premium (MRP)
Find the appropriate maturity risk premium (MRP). The following equation will be used to find a bond’s MRP at t:

11. Using the given equation:
MRP1 = 0.1% x (1-1) = 0.0%
MRP10 = 0.1% x (10-1) = 0.9%
MRP20 = 0.1% x (20-1) = 1.9%
Notice that the MRP is increasing in t (as the time to maturity increases), as it should be.

12. Add the IPs and MRPs to r* to construct the T-bond yield curve
By adding IP and MRP to r*:
rt = r* + IPt + MRPt
Assume r* = 3%,
r1 = 3% + 5.0% + 0.0% = 8.0%
r10 = 3% + 7.5% + 0.9% = 11.4%
r20 = 3% % + 1.9% = 12.65%

13. Pure Expectations Hypothesis (PEH)
The yield curve reflects the market’s expectation of “future interest rates”
We can break down a long-term interest rate into an average of current short-term rates and future short-term rates

14. An example: Observed Treasury rates and the PEH
Maturity Yield
1 year 6.0%
2 years 6.2%
3 years 6.4%
4 years 6.5%
5 years 6.5%
If PEH holds, what does the market expect will be the interest rate on one-year securities, one year from now? Three-year securities, two years from now?

15. One-year forward rate (i.e. future one-year interest rate)
6.0% x%
6.2%
(1.062)2 = (1.060) (1+x)
/1.060 = (1+x)
6.4004% = x
PEH says that one-year securities will yield %, one year from now.

16. Three-year security, two years from now
6.2% x%
6.5%
(1.065)5 = (1.062)2 (1+x)3
/ = (1+x)3
6.7005% = x
PEH says that three-year securities will yield %, two years from now.
Note: You may want to learn how to use Yx in your financial calculator!!

17. How about corporate bond yields? Corporate and Treasury yield curves
Interest
Rate (%) 15
BB-Rated 10
AAA-Rated
Treasury
Yield Curve
6.0% 5
5.9%
5.2%
Years to
Maturity 1 5 10 15 20

18. Compare T-bill to short-term corporate bond
Interest rate
(yield) LP
DRP
1-year T-bill
4.65% -
1-year AAA
? %
0.10%
0.40%
1-year BBB
0.20%
0.80%
Hint: Page 5 of this handout!

19. End

20. Other factors that influence interest rate levels
Federal reserve policy
Federal budget surplus or deficit
Level of business activity
International factors

21. Risks associated with investing overseas
Exchange rate risk – If an investment is denominated in a currency other than U.S. dollars, the investment’s value will depend on what happens to exchange rates.
Country risk – Arises from investing or doing business in a particular country and depends on the country’s economic, political, and social environment.

22. Top 5 countries (least risk)
Country risk rankings
Top 5 countries (least risk)
Rank
Country
Score 1
Switzerland
95.2 2
Luxembourg
93.9 3
United States
93.7 4
Norway 5
United Kingdom
93.6
Bottom 5 countries (most risk)
Rank
Country
Score
169
Afghanistan
11.0
170
Liberia
9.4
171
Sierra Leone
9.3
172
North Korea
8.9
173
Somalia
8.2
Source: “Country Ratings by Region,” Institutional Investor, September 2004.