CP

The Determinants of Market Interest Rates 31

producers and other corporations from raising prices as they had in the past, and that

constraints on corporate price increases were diminishing labor unions’ ability to

push through cost-increasing wage hikes. As these realizations set in, interest rates

declined. The gap between the current interest rate and the current inflation rate is

defined as the “current real rate of interest.” It is called the “real rate” because it

shows how much investors really earned after taking out the effects of inflation. The

real rate was extremely high during the mid-1980s, but it averaged about 4 percent

during the 1990s.

Inrecentyears,inflationhasbeenrunningatabout3percentayear.However,long-

terminterestrateshavebeenvolatile,becauseinvestorsarenotsureifinflationistruly

undercontrolorisgettingreadytojumpbacktothehigherlevelsofthe1980s.Inthe

yearsahead,wecanbesurethatthelevelofinterestrateswillvary(1)withchangesin

thecurrentrateofinflationand(2)withchangesinexpectationsaboutfutureinflation.

How are interest rates used to allocate capital among firms?

What happens to market-clearing, or equilibrium, interest rates in a capital mar-

ket when the demand for funds declines? What happens when inflation increases

or decreases?

Why does the price of capital change during booms and recessions?

How does risk affect interest rates?

The Determinants of Market Interest Rates

In general, the quoted (or nominal) interest rate on a debt security, r, is composed of a

real risk-free rate of interest, r*, plus several premiums that reflect inflation, the riski-

ness of the security, and the security’s marketability (or liquidity). This relationship

can be expressed as follows:

Quoted interest rate r r* IP DRP LP MRP. (1-1)

Here

r the quoted, or nominal, rate of interest on a given security.^9 There are

many different securities, hence many different quoted interest rates.

r* the real risk-free rate of interest. r* is pronounced “r-star,” and it is the rate

that would exist on a riskless security if zero inflation were expected.

rRFr* IP, and it is the quoted risk-free rate of interest on a security such as a

U.S. Treasury bill, which is very liquid and also free of most risks. Note that

rRFincludes the premium for expected inflation, because rRFr* IP.

IP inflation premium. IP is equal to the average expected inflation rate over

the life of the security. The expected future inflation rate is not necessarily

equal to the current inflation rate, so IP is not necessarily equal to current

inflation as reported in Figure 1-5.

(^9) The term nominalas it is used here means the statedrate as opposed to the realrate, which is adjusted to re-
move inflation effects. If you bought a 10-year Treasury bond in October 2001, the quoted, or nominal, rate
would be about 4.6 percent, but if inflation averages 2.5 percent over the next 10 years, the real rate would
be about 4.6%
2.5% 2.1%. To be technically correct, we should find the real rate by solving for r in
the following equation: (1 r)(1 0.025) (1 0.046). If we solved the equation, we would find r* 
2.05%. Since this is very close to the 2.1 percent calculated above, we will continue to approximate the real
rate by subtracting inflation from the nominal rate.
The textbook’s web site
contains an Excelfile that
will guide you through the
chapter’s calculations. The
file for this chapter is Ch 01
Tool Kit.xls,and we encour-
age you to open the file and
follow along as you read the
chapter.

An Overview of Corporate Finance and the Financial Environment 29