Fundamentals of Financial Management (Concise 6th Edition)

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Chapter 6 Interest Rates 177

Therefore, the best forecast for the future value of r* is its current value. However,
the in" ation premium, IP, varies signi! cantly over time and in a somewhat pre-
dictable manner. Recall that the in" ation premium is the average level of expected
in" ation over the life of the bond. Thus, if the market expects in" ation to increase
in the future (say, from 3% to 4% to 5% over the next 3 years), the in" ation pre-
mium will be higher on a 3-year bond than on a 1-year bond. On the other hand, if
the market expects in" ation to decline in the future, long-term bonds will have a
smaller in" ation premium than will short-term bonds. Finally, since investors con-
sider long-term bonds to be riskier than short-term bonds because of interest rate
risk, the maturity risk premium always increases with maturity.
Panel a of Figure 6-5 shows the yield curve when in" ation is expected to in-
crease. Here long-term bonds have higher yields for two reasons: (1) In" ation is
expected to be higher in the future, and (2) there is a positive maturity risk pre-
mium. Panel b shows the yield curve when in" ation is expected to decline. Such a
downward-sloping yield curve often foreshadows an economic downturn because


Illustrative Treasury Yield Curves
F I G U R E 6! 5

WITH INFLATION
EXPECTED TO INCREASE

WITH INFLATION
EXPECTED TO DECREASE

Maturity r IP MRP Yield Maturity r IP MRP Yield


1 year 2.50% 3.00% 0.00% 5.50% 1 year 2.50% 5.00% 0.00% 7.50%


5 years 2.50 3.40 0.18 6.08 5 years 2.50 4.60 0.18 7.28


10 years 2.50 4.00 0.28 6.78 10 years 2.50 4.00 0.28 6.78


20 years 2.50 4.50 0.42 7.42 20 years 2.50 3.50 0.42 6.42


30 years 2.50 4.67 0.53 7.70 30 years 2.50 3.33 0.53 6.36


Interest Rate
(%)

a. When In"ation Is Expected to Increase

Interest Rate
(%)

b. When In"ation Is Expected to Decrease

8 7 6 5 4 3 2 1

Years to Maturity

Maturity
Risk
Premium

In"ation
Premium

Real Risk-
Free Rate

8 7 6 5 4 3 2 1

Years to Maturity

Maturity
Risk
Premium

In"ation
Premium

Real Risk-
Free Rate

(^01020300102030)

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