The Structure of Interest Rates

Chapter 4


Interest rates:


The rental price of money.

The price changes over time as the demand and supply changes.








Factors that determine the level of IR

Opportunities for investment

Other factors

Other Factors that determine the level of IR

N = r + INF + LP + DRP + MRP

    N = Nominal Rate

    r = Real Rate

    INF = expected inflation

    LP = liquidity premium

    DRP = default risk premium

    MRP = maturity risk premium










Default Risk

Ratings by Standard and Poor’s

AAA                               CCC

AA                                 CC

A                                    C

BBB                               CI

BB                                  D

B                                    NR             

Term Structure of Interest Rates









Pure Expectation Theory

Pure Expectation Theory




2 year rate = average of the one year rates


Liquidity Preference Theory

Borrowers pay a premium to induce lender to make long-term loans.



Market Segmentation Theory










Reconciling the Theories

They are all probably relevant


When IR increase, corporate profits decline because of:

                   Increased interest expense

Reduced expansion

Slower economy

As a result, stock prices tend to fall as IR increase.