INTEREST RATE

CHAPTER 11

Content
Interest rate structure
Yield curve
Determination of interest
rates
The relationship between
interest rate and foreign
exchange rate

Introduction
An interest rate is the rate at which interest
is paid by a borrower for the use of money
that they borrow from a lender.
Nominal interest rates are the interest rates
actually observed in financial markets.
Real interest rate = nominal interest rate
expected inflation
If nominal interest rate is 8% and expected
inflation is 8%, so, real interest rate is 0%
Thus, no benefit from the loan given to the
customers.

Introduction
The benchmark interest rate in Malaysia was
reported at 3.25 percent on 6 November 2014. In
Malaysia the interest rate decisions are taken by
The Central Bank of Malaysia (Bank Negara
Malaysia). The official interest rate is the overnight
rate.
Historically, From 2004 until 2010, Malaysia's
average interest rate was 2.91 percent reaching an
historical high of 3.50 percent in April of 2006 and
a record low of 2.00 percent in February of 2009
(
http://www.tradingeconomics.com/Economics/Inte
rest-Rate.aspx?Symbol=MYR
)

 These rates affect the price or value of

most securities traded in the money and
capital markets.
The overnight rate is the benchmark rate.
The
benchmark
rate-the
minimum
interest rate investors will accept for
investing in a non-Treasury security. In
general, this is the yield that is being
earned on the most recent Treasury
security of similar maturity plus a
premium. Also called base interest rate.

Term Structure of Interest Rates

In finance, the term yield describes the amount in cash
that returns to the owners of a security. Example, the
investor or stockholder of common stocks
Example-yield applies to various stated rates of return on
stocks (common and preferred, and convertible), fixed
income instruments (bonds, notes, bills, strips, zero
coupon), and some other investment type insurance
products (e.g. annuities).
The term structure of interest rates, also known as the yield
curve, is a very common bond valuation method. The yield
curve is a measure of the market's expectations of future
interest rates given the current market conditions.
As general current interest rates increase, the price of a
bond will decrease and its yield will increase.

 An easy way to grasp why bond prices move opposite to interest

rates is to consider zero-coupon bonds, which don't pay coupons
but derive their value from the difference between the purchase
price and the par value paid at maturity.
For instance, if a zero-coupon bond is trading at $950 and has a
par value of $1,000 (paid at maturity in one year), the bond's
rate of return at the present time is approximately 5.26% ((1000950) / 950 = 5.26%).
But his or her satisfaction with this return depends on what else
is happening in the bond market. Bond investors, like all
investors, typically try to get the best return possible.
If current interest rates were to rise, giving newly issued bonds a
yield of 10%, then the zero-coupon bond yielding 5.26% would
not only be less attractive, it wouldn't be in demand at all.
Who wants a 5.26% yield when they can get 10%? To attract
demand, the price of the pre-existing zero-coupon bond would
have to decrease enough to match the same return yielded by
prevailing interest rates. In this instance, the bond's price would
drop from $950 (which gives a 5.26% yield) to $909 (which gives
a 10% yield).

Yield Curve
A plot of the yields on bonds with differing terms
to maturity but the same risk, liquidity and tax
considerations is called a yield curve, and it
describes the term structure of interest rates for
particular types of bonds.
Yield curves can be classified as upward-sloping,
flat or downward-sloping

Term Structure of Interest Rates

Flat

Upward sloping

10
Downward sloping

Yield Curve
Upward-sloping
The most usual case
Long-terms interest rates are above short-term
interest rates

Flat
Short-term and long-term interest rates are the
same

Downward-sloping (inverted yield curve)

Long-term interest rates are below short-term
interest rates
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Yield Curve
Theories to explain term structure of interest rates
The expectations theory
The market segmentation theory
The liquidity premium theory

12

The Expectations Theory

the interest rate on a long-term bond will equal
an average of the short-term interest rates that
people expect to occur over the life of the longterm bond.

13

The Expectations Theory

Example: the current interest rate on a one-year
bond is 9% and you expect the interest rate on
the one-year bond next year to be 11%. What is
the expected return over the two years? What
interest rate must a two-year bond (long-term
bond) have to equal to the two one-year bonds
(short-term bonds)?
Bonds of different maturities are perfect
substitutes.

14

The Expectations Theory

When the yield curve is upward-sloping, the
expectation theory suggests that short-term
interest rates are expected to rise in the future
When the yield curve is inverted, the average of
future short-term interest rates is expected to be
lower than the current short-term rate.
Flat yield curve indicates short-term interest rates
are not expected to change.

15

The Market Segmentation Theory

Sees markets for different maturity bonds as
completely separate and segmented
The interest rate is determined by supply and
demand for that bond, not by expected returns of
other bonds with other maturities
Bonds of different maturities are not substitutes at
all

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The Market Segmentation Theory

Yield curves typically slope upward.
Normally, the demand for long-term bonds is
relatively lower than short-term bonds, long-term
bonds will have lower prices and higher interest
rates, hence the yield curve will typically slope
upward.

17

The Liquidity Premium

Theory
This theory states that the interest rate on a longterm bond will equal an average of short-term
interest rates expected to occur over the life of
the long-term bond plus a liquidity premium that
responds to supply and demand conditions for
that bond.
It combines features of the expectations theory
and market segmentation theory.
Bonds of different maturities are assumed to be
substitutes, but not perfect substitutes.
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The Liquidity Premium

Theory
Investors tend to prefer shorter-term bonds
because these bonds bear less interest-rate risk.
To induce investors to hold longer-term bonds,
they must be offered a positive liquidity premium
which is always positive and rises with the term to
maturity.
The yield curve implied by the liquidity premium
theory is always above the yield curve implied by
the expectations theory and generally has a
steeper slope.
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The Liquidity Premium

Theory
Even though the theory indicates that the yield
curve usually slope upward, the yield curve can
also be inverted and flat.
The theory helps predicting the movement of
short-term interest rates in the future by
observing the slope of yield curves.

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Determinants of Interest Rates For

Individual Securities

Inflation
Real interest rate
Default risk
Liquidity risk
Special provisions or covenants
Term to maturity

21

Determinants of Interest Rates For

Individual Securities
Inflation
The higher the level of actual or expected inflation
rate, the higher will be the level of interest rates
An investor who buys a financial asset must earn a
higher interest rate when inflation increases to
compensate for the increased cost of foregoing
consumption of real goods and services today and
buying them at a higher price in the future

22

Determinants of Interest Rates For

Individual Securities
Real interest rates
It is the interest rate that would exist on a default
free security if no inflation were expected
Fisher Effect
Nominal interest rates =
real interest rates + expected inflation

23

Determinants of Interest Rates For

Individual Securities
Default or credit risk
The risk that a security issuer will default on that
security by being late on or missing an interest or
principal payment
The higher the default risk, the higher interest rate
that will be demanded by the buyer
What about Government bonds? Do they have
default risks?

24

Determinants of Interest Rates For

Individual Securities
Liquidity Risk
The risk that a security can be sold at a predictable
price with low transaction costs on short notice
Highly liquid assets carry low interest rates
For illiquid security, investors add a liquidity risk
premium to the interest rate on the security

25

Determinants of Interest Rates For

Individual Securities
Special provisions or covenants
Special provisions or covenants that may be written
into the contracts underlying the issuance of a
security
Securitys taxability free tax low interest rate
Convertibility low interest rate
Callability higher interest rate

26

Determinants of Interest Rates For

Individual Securities
Term to Maturity
Term structure of interest rates or the yield curve
The change in required interest rates as the maturity
of a security changes is called the maturity premium

27

Determinants of Interest Rates For

Individual Securities
ij = f (IP, RIR, DRPj, LRPj, SCPj, MPj)
Where
IP = Inflation premium
RIR = Real interest rate
DRPj = Default risk premium on the jth security
LRPj = Liquidity risk premium on the jth security
SCPj = Special feature premium on the jth security
MPj = Maturity premium on the jth security
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The Relationship between Interest

Rate and Foreign Exchange Rate
Interest rate parity
The theory that the domestic interest rate should
equal the foreign interest rate minus the expected
appreciation of the domestic currency

29

The Relationship between Interest

Rate and Foreign Exchange Rate
Example: Suppose a US citizen has excess funds
available to invest in either US or British bank
deposits. The interest rate available on British pound
one-month time deposits is 0.5% monthly. The spot
exchange rate is $2.0494/, and the one-month
forward rate is $2.0475/. According to the interest
rate parity, the interest rate on comparable US onemonth deposits should be:

1+ ius = (1/2.0494) X (1 + .005) X

2.0475 = 1.004068
ius = 0.4068%

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