Chapter 6 Interest rates and bond valuation
6.1 Interest rates and required return
Interest rate fundamentals
The interest rate or required return represents the cost of money.
Interest rate – usually applied to debt instruments such as bank loans or bonds
– the compensation paid by the borrower of funds to the lender
– from the borrower’s point of view, the cost of borrowing funds
Required return – usually applied to equity instruments such as common stock
– the cost of funds obtained by selling an ownership interest
A variety of factors can influence the equilibrium interest rate:
- Inflation – a rising trend in the prices of most goods and services.
- Risk (if the investment is riskier, people expect a higher return)
- Liquidity preference – a general tendency for investors to prefer short-term (more liquid)
securities
Real rate of interest
Imagine a perfect world with no inflation, risk or liquidity preference. Then there would be one cost
of money: Real rate of interest (r*) – the rate that creates equilibrium between the supply of savings
and the demand for investment funds in a perfect world.
Normal or actual rate of interest (return)
Nominal rate of interest (r1) – the actual rate of interest charged by
the supplier of funds and paid by the demander.
The nominal rate differs from the real rate of interest, r* as a result
of two factors:
– Inflationary expectations reflected in an inflation premium (IP),
and
– Issuer and issue characteristics such as default risks and contractual provisions as reflected in a
risk premium (RP).
Investors will demand a higher nominal rate of return if they expect inflation.
Expected inflation premium (IP) – additional return that investors require to compensate them for
inflation.
Investors will demand a higher nominal rate of return on risky investments.
Risk premium (RP) – additional return that investors require to compensate them for bearing risk.
Nominal rate of interest = real rate of interest + inflation premium + risk premium
r1 = r* + IP + RP
r1 = Risk-free rate, Rf + Risk premium
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6.1 Interest rates and required return
Interest rate fundamentals
The interest rate or required return represents the cost of money.
Interest rate – usually applied to debt instruments such as bank loans or bonds
– the compensation paid by the borrower of funds to the lender
– from the borrower’s point of view, the cost of borrowing funds
Required return – usually applied to equity instruments such as common stock
– the cost of funds obtained by selling an ownership interest
A variety of factors can influence the equilibrium interest rate:
- Inflation – a rising trend in the prices of most goods and services.
- Risk (if the investment is riskier, people expect a higher return)
- Liquidity preference – a general tendency for investors to prefer short-term (more liquid)
securities
Real rate of interest
Imagine a perfect world with no inflation, risk or liquidity preference. Then there would be one cost
of money: Real rate of interest (r*) – the rate that creates equilibrium between the supply of savings
and the demand for investment funds in a perfect world.
Normal or actual rate of interest (return)
Nominal rate of interest (r1) – the actual rate of interest charged by
the supplier of funds and paid by the demander.
The nominal rate differs from the real rate of interest, r* as a result
of two factors:
– Inflationary expectations reflected in an inflation premium (IP),
and
– Issuer and issue characteristics such as default risks and contractual provisions as reflected in a
risk premium (RP).
Investors will demand a higher nominal rate of return if they expect inflation.
Expected inflation premium (IP) – additional return that investors require to compensate them for
inflation.
Investors will demand a higher nominal rate of return on risky investments.
Risk premium (RP) – additional return that investors require to compensate them for bearing risk.
Nominal rate of interest = real rate of interest + inflation premium + risk premium
r1 = r* + IP + RP
r1 = Risk-free rate, Rf + Risk premium
1
