In Partial Fulfillment

Of the Course Requirements

in Financial Management II

Morton Handley and Company

Interest Rate Determination

Submitted to
Ms. Eliza Rose G. Juane

Submitted by:
Queene G. Balaoro

October 10, 2016

Interest Rate Determination

Maria Juarez is professional tennis player and your firm manages her money. She
ask you to give her information about what determines the level of various interest
rates. Your boss has prepared some questions for you to consider.
a. What are the four most fundamental factors that affect the cost of money, or
the general level of interest rates in the economy?
ANSWER: 1. Production opportunities investment opportunities in productive (cash
generating) assets
2. Time preference for consumption preferences of consumers for current
consumption as opposed to savings for future consumption
3. Risk chance that an investment will provide a low or negative return
4. Inflation amount by which prices increases over time
Interest rate paid to savers depends on rate of return producers expect,
savers preference on time consumption, loan riskiness as well as
expected inflation rate. Producers expected return set an upper limit on
how much money they can pay for savings while time prefences on
consumption sets how much consumption consumers are willing to defer,
how much save at different interest rates. The higher risk and inflation,
the higher the interest rate.
b. What is the real risk free rate of interest and nominal risk free rate? How are
these two rates measured?
ANSWER:
Real risk-free rate risk on default free securities in the absence of inflation
Nominal risk-free rate risk free rate + inflation premium
***Inflation premium- ave rate of inflation expected over the life of security
There is no riskless security but the closest is the short-term treasury bill
which is free of most risks. Its not riskless but free of default risks
c. Define the terms inflation premium (IP), default risk premium (DRP), liquidity
premium (LP) and maturity risk premium (MRP). Which premium is include on

short term/long term treasury secuirites, long term/short term corporate

securities and how premiums vary over time and among different securities.
ANSWER:
Inflation premium premium added to real risk-free rate to compensate for
expected inflation
Default risk premium premium based on probability that issuer will default on the
loan, measured by diff. between interest rate on treasury bond and corporate bond
of equal maturity and marketability
Liquid asset can be sold at predictable price at short notice
Liquidity premium added to rate of interest of securities that are not liquid
Maturity risk premium premium reflecting interest rate risk

short term treasury securities include only inflation premium

long terms contains inflation premium and maturity risk premium (due to

rising interest rate in the long run)

short term corporate securities = real risk free rate + premiums for inflation,

default risk and liquidity

long term corporate securities includes premium for maturity risk, hence

this security carries the highest yield among the 4

d. what s structure of interest rates?whats yield curve?
ANSWER:
Structure of interest rates relation between interest rates/yields and
maturities of securities
Yield curve when abovementioned relationship is graphed (see graph below
as example)

e. supposed expected inflation rate is 5%, 6% following year, 8% thereafter.

Real risk free rate is 3%, maturity risk premium is 0 for bond maturing 1 year
or less and 0.1% for 2-year bonds, then yearly increase of 0.1% /year
thereafter for 20 years, after which it is stable. What is interest rate on
1-,10- and 20-year treasury bond? Draw yield curve and explain why upward
sloping.
ANSWER:
STEP 1 Find average expected inflation rate over yrs 1- 20:
YR 1 : IP = 5%
YR 2: IP = 7.5% i.e. (5+6+8+8+8+8+8+8+8+8)/10
YR 20 : IP = 7.75% i.e. (5+6 + 8*18)/20

STEP 2 Find MRP each year:

YR 1: MRP = 0%
YR 10: MRP = 0.1% x 9 = 0.9%
YR 20: MRP = 0.1% x 19 = 1.9%

STEP 3 IP + MRP + r*
YR 1: rRF = 3% + 5% + 0% = 8%
YR 10: rRF = 3% +7. 5% + 0.9% = 11.4%
YR 20: rRF = 3% + 7.75% + 1.9% = 12.65%

SHAPE depends on 2 factors : expectations on future inflation and relative riskiness

with different maturities. Upward due to expected inflation and increasing MRP

F. At any given time, how would yield curve facing AAA rated company compare
with yield curve for US treasury securities? At any given time, how would yield curve
facing BB rated company compare with yield curve for US treasury securities?
Draw graph.
ANSWER:

Corporate yield curve will always lie above government yield curve and the riskier
the corporation the higher its yield curve

G. What is pure expectations theory? What does it imply about term structure of
interest rate?
ANSWER:
Theory assumes that investors establish bond prices and interest rates strictly on
the basis of expectations for interest rates, meaning theyre indifferent with
respect to maturity in the sense that they dont view long term bonds as being
riskier than short term bonds. If this were true, then MRP would be zero and long
interest rate would simply be the weighted ave of current and expected future

short term interest rates. If this theory is correct, yield curve can be used to back
out expected future interest rates