Principles of Managerial Finance

CHAPTER 6 Interest Rates and Bond Valuation 265

nominal rate of interest
The actual rate of interest
charged by the supplier of funds
and paid by the demander.

funds, causing the supply function in Figure 6.1 to shift to, say, S 1. This could

result in a lower real rate of interest, k 1 *, at equilibrium (S 1 D). Likewise, a

change in tax laws or other factors could affect the demand for funds, causing the

real rate of interest to rise or fall to a new equilibrium level.

Nominal or Actual Rate of Interest (Return)

The nominal rate of interestis the actual rate of interest charged by the supplier

of funds and paid by the demander. Throughout this book, interest rates and

required rates of return are nominal rates unless otherwise noted.The nominal

rate of interest differs from the real rate of interest, k*, as a result of two factors:

(1) inflationary expectations reflected in an inflation premium (IP), and (2) issuer

and issue characteristics, such as default risk and contractual provisions, reflected

in a risk premium (RP). When this notation is adopted, the nominal rate of inter-

est for security 1, k 1 , is given in Equation 6.1:

k 1 k*IPRP 1 (6.1)

risk-free risk

rate, RF premium

As the horizontal braces below the equation indicate, the nominal rate, k 1 , can be

viewed as having two basic components: a risk-free rate of interest, RF,and a risk

premium, RP 1 :

k 1 RFRP 1 (6.2)

To simplify the discussion, we will assume that the risk premium, RP 1 , is

equal to zero. By drawing from Equation 6.1,^3 the risk-free rate can (as earlier

noted in Equation 5.9) be represented as

RFk*IP (6.3)

FIGURE 6.1

Supply–Demand
Relationship
Supply of savings and
demand for investment funds

3. This equation is commonly called the Fisher equation,named for the renowned economist Irving Fisher, who first
   presented this approximate relationship between nominal interest and the rate of inflation. See Irving Fisher, The
   Theory of Interest(New York: Macmillan, 1930).

Funds Supplied/Demanded

Real Rate of Interest

k* 1

k* 0

S 0 = D S 1 = D

D

S 1

S 1

S 0

S 0

D