Fundamentals of Financial Management (Concise 6th Edition)

Chapter 6 Interest Rates 187

In this chapter, we discussed the way interest rates are determined, the term struc-

ture of interest rates, and some of the ways interest rates a! ect business decisions.

We saw that the interest rate on a given bond, r, is based on this equation:

r! r* " IP " DRP " LP " MRP

Here r* is the real risk-free rate, IP is the premium for expected in# ation, DRP is the

premium for potential default risk, LP is the premium for lack of liquidity, and MRP is

the premium to compensate for the risk inherent in bonds with long maturities. Both

r* and the various premiums can and do change over time depending on economic

conditions, Federal Reserve actions, and the like. Since changes in these factors are

di$ cult to predict, it is hard to forecast the future direction of interest rates.

The yield curve, which relates bonds’ interest rates to their maturities, usually

has an upward slope; but it can slope up or down, and both its slope and level change

over time. The main determinants of the slope of the curve are expectations for fu-

ture in# ation and the MRP. We can analyze yield curve data to estimate what market

participants think future interest rates are likely to be.

We will use the insights gained from this chapter in later chapters, when we ana-

lyze the values of bonds and stocks and when we examine various corporate invest-

ment and " nancing decisions.

T Y I N G I T A L L T OG E T HE R

KEY TERMS Define each of the following terms:

a. Production opportunities; time preferences for consumption; risk; inflation

b. Real risk-free rate of interest, r*; nominal (quoted) risk-free rate of interest, rRF

c. Inflation premium (IP)

d. Default risk premium (DRP)

e. Liquidity premium (LP); maturity risk premium (MRP)

f. Interest rate risk; reinvestment rate risk

g. Term structure of interest rates; yield curve

h. “Normal” yield curve; inverted (“abnormal”) yield curve; humped yield curve

i. Pure expectations theory

ST-1ST-1

SELF!TEST QUESTIONS AND PROBLEMS

"Solutions Appear in Appendix A

SEL

F^ TEST If short-term interest rates are lower than long-term rates, why might a bor-

rower still choose to $ nance with long-term debt?

Explain the following statement: The optimal $ nancial policy depends in an

important way on the nature of the $ rm’s assets.