percent, and the yield on one-year T-bills was about 2.43 percent, so the real risk-free
rate on short-term securities at that time was 1.25 percent.^12
It is important to note that the inflation rate built into interest rates is the inflation
rate expected in the future,not the rate experienced in the past. Thus, the latest reported
figures might show an annual inflation rate of 2 percent, but that is for the pastyear. If
people on average expect a 6 percent inflation rate in the future, then 6 percent would
be built into the current interest rate. Note also that the inflation rate reflected in the
quoted interest rate on any security is the average rate of inflation expected over the secu-
rity’s life.Thus, the inflation rate built into a one-year bond is the expected inflation
rate for the next year, but the inflation rate built into a 30-year bond is the average rate
of inflation expected over the next 30 years.^13
Expectations for future inflation are closely, but not perfectly, correlated with rates
experienced in the recent past. Therefore, if the inflation rate reported for last month
increased, people would tend to raise their expectations for future inflation, and this
change in expectations would cause an increase in interest rates.
Note that Germany, Japan, and Switzerland have over the past several years had
lower inflation rates than the United States, hence their interest rates have generally
been lower than ours. South Africa and most South American countries have experi-
enced high inflation, and that is reflected in their interest rates.Default Risk Premium (DRP)
The risk that a borrower will defaulton a loan, which means not pay the interest or the
principal, also affects the market interest rate on the security: the greater the default
risk, the higher the interest rate. Treasury securities have no default risk, hence they
carry the lowest interest rates on taxable securities in the United States. For corporate
bonds, the higher the bond’s rating, the lower its default risk, and, consequently, the
lower its interest rate.^14 Here are some representative interest rates on long-term
bonds during October 2001:34 CHAPTER 1 An Overview of Corporate Finance and the Financial Environment(^12) There are several sources for the estimated inflation premium. The Congressional Budget Office regu-
larly updates the estimates of inflation that it uses in its forecasted budgets; see http://www.cbo.gov/
reports.html, select Economic and Budget Projections, and select the most recent Budget and Economic
Outlook. An appendix to this document will show the 10-year projection, including the expected CPI infla-
tion rate for each year. A second source is the University of Michigan’s Institute for Social Research, which
regularly polls consumers regarding their expectations for price increases during the next year; see
http://www.isr.umich.edu/src/projects.html, select the Surveys of Consumers, and then select the table
for Expected Change in Prices. Third, you can find the yield on an indexed Treasury bond, as described in
the margin of page 32, and compare it with the yield on a nonindexed Treasury bond of the same maturity.
This is the method we prefer, since it provides a direct estimate of the inflation risk premium.
(^13) To be theoretically precise, we should use a geometric average.Also, because millions of investors are active
in the market, it is impossible to determine exactly the consensus expected inflation rate. Survey data are
available, however, that give us a reasonably good idea of what investors expect over the next few years. For
example, in 1980 the University of Michigan’s Survey Research Center reported that people expected infla-
tion during the next year to be 11.9 percent and that the average rate of inflation expected over the next 5
to 10 years was 10.5 percent. Those expectations led to record-high interest rates. However, the economy
cooled in 1981 and 1982, and, as Figure 1-5 showed, actual inflation dropped sharply after 1980. This led to
gradual reductions in the expected futureinflation rate. In winter 2002, as we write this, the expected infla-
tion rate for the next year is about 1.2 percent, and the expected long-term inflation rate is about 2.5 per-
cent. As inflationary expectations change, so do quoted market interest rates.
(^14) Bond ratings, and bonds’ riskiness in general, are discussed in detail in Chapter 4. For now, merely note
that bonds rated AAA are judged to have less default risk than bonds rated AA, while AA bonds are less risky
than A bonds, and so on. Ratings are designated AAA or Aaa, AA or Aa, and so forth, depending on the rat-
ing agency. In this book, the designations are used interchangeably.