Definition of Interest Rate/ Rate of

Interest/ Price of Credits :

 Interest rate is the reward against investment
in debt securities.
 It is a rate at which lenders & borrowers are
promise to receive / pay for lending /
borrowing funds for an agreed upon period of
time.
 It is a promised rate of return.
 Interest rate is the factor that ties saving &
lending, borrowing & investing are intimately
linked.
Functions of Interest Rate in the Economy:

 It helps guarantee that current savings will

flow into investment to promote economic
growth.
 It allocates the available supply of credit,
generally providing loanable funds to those
investment projects with the highest expected
returns.
 It brings the supply of money into balance with
the public’s demand for money.
 contd.

 It is an important tool of government policy

through its influence on the volume of saving
& investment.
~ If the economy is growing too slowly and
unemployment is rising, the government can
use its policy tools to lower interest rates in
order to stimulate borrowing & investment.
~ On the other hand, an economy experiencing
rapid inflation has traditionally called for a
government policy of higher interest rates to
slow borrowing & spending and thereby
encourage more saving.
 Coupon Rate:
The coupon rate is the contracted interest rate that
the bond issuer agrees to pay at the time of bond is
issued and often is set close to prevailing interest
rates on comparable financial assets at the time a
bond is sold ( unless the debt security is a zero
coupon instrument.)
Example: A company issues a bond with a par
value of $ 1,000 and with a coupon rate of interest
of 9%.
 Coupon:
The amount of promised annual interest income
paid by a bond issuer is called it’s coupon.
Example: A company issues a bond with a par
value of $ 1,000 and with a coupon rate of interest
of 9%.
Therefore,
Coupon = Par value * Coupon rate
= $ 1,000 * 9%
= $ 90
 Current Yield:
Current yield is the ratio of the annual income
( dividend/ interest) generated by the asset relative to
its current market value.

Annual income/ Annual cash inflow/ Annual coupon

Current Yield = Market price of asset / Current bond price
 Yield to Maturity:
Yield to Maturity is the annualized rate of interest
that equates the purchase price of a financial asset
with the present value of all its expected net cash
inflows (income) until the asset reaches its
maturity date.
 Yield- Asset Price Relationship:
Interest Rates & the Prices of Debt Securities:
The price of a financial asset (especially for a
bond or other debt security) and its yield or rate
of return are inversely related ~
a rise in yield implies a decline in price;

conversely,
a fall in yield is associated with a rise in the

financial asset’s price.

 Nominal & Real Interest Rate:
Nominal Interest Rate:
The nominal or quoted, risk-free rate is the real
rate of return plus a premium for expected
inflation.
In fact, the nominal interest rate is the published
or quoted interest rate on a financial asset.
For example, Rate of interest on bank
accounts, bonds, loans, etc. all are nominal
interest rates.
Contracted nominal interest rate
≈ Real interest rate + Expected inflation rate.
Real Interest Rate:

The real interest rate is the return to the

lender or investor measured in terms of its
actual purchasing power.
Real interest rate
≈ Nominal interest rate − Inflation rate.
 Nominal vs. Real Interest Rate:
Example:
Suppose, Mr. X gives $1000 to Mr. Y expecting that the
prices of goods & services will rise to 10% during the
year, however he charged 12% (nominal interest rate) on
the loan.
So, Mr. X’s real rate of return would be ~
(12%-10%) = 2%
( i.e., $ 1,000 * 2% = $20).
However, if the actual rate of inflation during the period
turns out to 13%.
Here, Mr. X’s real rate of return is 0%.
(i.e., he suffered a real decline in the purchasing power of
the monies loaned.)
 Fisher Effect:
The Fisher effect was developed by an economist
named Irvin Fisher which describes the
relationship between inflation and both real &
nominal interest rates.
We know that the nominal interest rate comprises
a real interest rate and an expected rate of
inflation. The nominal rate of interest adjusts
when the inflation rate is expected to change. The
nominal interest rate will be higher when a higher
inflation rate is expected and it will be lower
when a lower inflation rate is expected. This is
referred to as the Fisher Effect.
Let,
Expected real rate = 3%
Expected rate of inflation = 10%
So, Expected nominal interest rate
= 3% + 10% = 13%
According to Fisher’s hypothesis,
if expected rate of inflation rise to 12%
( expected real return/rate will remain
unchanged.)
i.e., Expected nominal interest rate would be
~ 3% + 12% = 15%
The Fisher equation is expressed through the
following formula:
(1 + i)  = (1 + r) (1 + π)
Where:
i – the nominal interest rate
r – the real interest rate
π – the inflation rate
However, one can also use the approximate
version of the previous formula:
i ≈ r + π
 Yield Curve/The Term Structure of
Interest Rates:

Yield refers to interest rate.

~ yield on short-term security is low.
~ yield on long-term security is high.
( because investors like to get compensated with
premium for taking more risk.)
Term structure of interest rates, commonly known as
the yield curve which depicts the relationship between
interest rates / bond yields and different terms /
maturities. When this relationship is graphed ( the term
structure of interest rates), it is called as a yield curve.
In fact, a yield curve is a line on a graph that
illustrates the relationship between the yields
and maturities of fixed income securities.
 Shape of Yield Curve:
Bonds are issued with different maturities, ranging from the very short term
(less than a year) to the very long term (up to 30 years). Bonds of different
maturities but the same credit quality, issued by a single issuer, will have
different yields, reflecting the perceived risk of investing in them. In general,
the longer the maturity of the bond, the higher the risk to the investor, and so
the higher the yield. The yields of bonds of equal credit quality but different
maturities can be plotted and joined up into a curve. Investors often use the
yield curve of a country’s government bonds to tell them how the economy of
that country is expected to behave. The slope of the yield curve is a leading
indicator of where the country’s economy is heading. This is so because the
shape of the yield curve reflects investors’ expectations about future interest
rates, and by extension, economic growth. Different types of yield curves are
as follows:

 Normal yield curve

 Inverted yield curve
 Steep yield curve
 Flat yield curve
 Humped yield curve
The normal yield curve is a yield curve in which short-term debt
instruments have a lower yield than long-term debt instruments
of the same credit quality. This gives the yield curve an upward
slope. This is the most often seen yield curve shape, and it's
sometimes referred to as the "positive yield curve."

Normal Yield Curve indicates that the market expects the

economy to function at normal rate of growth, no significant
changes in inflation or available capital. So, investors who risk
their money for longer periods expect higher yields.
 An inverted yield curve represents a situation in which
long-term debt instruments have lower yields than short-
term debt instruments of the same credit quality. An
inverted yield curve is sometimes referred to as a negative
yield curve.
An inverted yield curve indicates that the market expects
the economy to slow down and interest rates to drop in the
future. Long term investors want to take the opportunity
to lock in interest rates before they fall even further.
 A steep yield curve indicates that long-term yields are
rising at a faster rate than short-term yields. Steep yield
curves have historically indicated the start of an
expansionary economic period. Both the normal and steep
curves are based on the same general market conditions.
The only difference is that a steeper curve reflects a larger
difference between short-term and long-term return
expectations.
 A flat yield curve happens when all maturities have similar
yields. This means that the yield of a 10-year bond is
essentially the same as that of a 30-year bond. A flattening of
the yield curve usually occurs when there is a transition
between the normal yield curve and the inverted yield curve, it
simply implies that the market is at the point of inflection.
From there, it could either go into either a recession or some
economic pick-up. It indicates that economic / business activity
is slowing down, and investors are uncertain about the future.
 A humped yield curve occurs when medium-term
yields are greater than both short-term yields and
long-term yields. A humped curve is rare and typically
indicates a slowing of economic growth.
Theories of the Term Structure of Interest
Rates:
The shape of the yield curve has two major
theories, one of which has three variations,
which are ~

1. Market Segmentation Theory

2. Expectations Theories
1. Market Segmentation Theory:
 Assumes that borrowers and lenders live in
specific sections of the yield curve based on
their need to match assets and liabilities. The
theory goes further to assume that these
participants do not leave their preferred
maturity section. Thus, the yield curve
shape is determined by supply and demand
at different maturities. The Market
Segmentation Theory could be used to
explain any of the three yield curve shapes.
2. Expectations Theories:
There are three variations in the Expectations
Theory, one being “pure” and the other two
are “biased”. All three variations share a
common assumption that short term forward
interest rates reflect market expectations of
short term rates will be in the future. These
theories are ~
a) Pure Expectations Theory (“pure”)
b) Liquidity Preference Theory (“biased”)

c) Preferred Habitat Theory (“biased”)

a) Pure Expectations Theory (“pure”):
 Only market expectations for future rates will
consistently impact the yield curve shape. A
positively shaped curve indicates that rates will
increase in the future, a flat curve signals that
rates are not expected to change, and an
inverted yield curve points to interest rates
falling in the future.
b) Liquidity Preference Theory (“biased”):
 Assumes that investors prefer short term bonds to
long term bonds because of the increased
uncertainty associated with a longer time horizon.
Therefore investors demand a liquidity premium
for longer dated bonds. This theory has a natural
bias toward a positively sloped yield curve.
c) Preferred Habitat Theory (“biased”): 
Postulates that the shape of the yield curve
reflects investor expectations of future
interest rates, but rejects the notion of a
liquidity preference because some investors
prefer longer holding periods. The
Preferred Habitat Theory relies heavily on
the notion that investors will match assets
and liabilities.
Thank you.