Chapter 13

An introduction to interest rate determination and forecasting

True/False questions
1.

T The liquidity effect of a tight monetary policy is likely to see interest rates rise in the first

place, but as the pace of economic activity slows down the income effect is likely to result in some
easing of the interest rates in the market.
2.

F Economic indicators provide market participants with clear and unambiguous messages as

to the future direction of economic activity and growth.

3.

F A lagging indicator is one that might be used to indicate the direction in which the

economy is headed.
4.

T In the loanable funds approach to interest rates, the demand for funds originates from the

business sector and the government sector.

5.

T The supply of loanable funds is derived from the savings of the household sector, changes

in the money supply and dishoarding.

6.

F An increase in the money supply would permanently shift the supply curve of loanable

funds to the right.

7.

F An increase in interest rates is likely to result in a permanently higher level of dishoarding.

8.

F The government sector demand curve in the loanable funds approach is downward sloping,

with the slope changing in response to the size of government expenditures.

9.

T One of the key inadequacies of the loanable funds approach to interest rate determination

is that, because the demand and supply curves are not independent of each other, it is impossible to
determine a unique equilibrium interest rate.
10.

F Applying the loanable funds approach, an increase in inflationary expectations will result

in an increase in interest rates equal to the increase in inflationary expectations.

11.

F The yield curve is a single curve at a point in time that shows the rates of return on all

fixed-interest and discount instruments, which have different terms to maturity and which are issued
by governments and corporations.
12.

F A normal yield curve is one in which short-term interest rates are higher than longer-term

interest rates.
13.

F When a central bank implements an expansionary monetary policy, an inverse yield curve

will eventuate.

14.

T Under the expectations theory of the yield curve, longer-term interest rates are a function

of the current short-term interest rate and forecast future short-term interest rates that will exist over
the longer term.
15.

T Using the expectations approach, if the one-year interest rate is currently 6.00 per cent per

annum, and the current two-year rate is 8.00 per cent per annum, there is an expectation that in 12
months time the one-year interest rate will have increased to 10.00 per cent per annum.
16.

T Under the segmented markets approach to explaining the yield curve, an increase in the

supply of short-term instruments and an equal reduction in the supply of long-term instruments
would cause the short end of the yield curve to rise and the long end to fall.
17.

T The liquidity premium theory suggests that investors will demand a higher rate of interest

to induce them to buy long-term instruments so that they will be compensated for increased risk and
loss of liquidity.
18.

F The existence of an inverse yield curve indicates that investors are not demanding a

liquidity premium in periods of tight monetary policy.

19.

F The risk structure of interest rates includes a premium to compensate the holders of

instruments for the risk that interest rates, and thus the prices of instruments, may change.
20.

F The risk-free rate of interest is the yield paid on longer-term securities issued by corporate

borrowers that have an investment-grade credit rating.

Essay questions
The following suggested answers incorporate the main points that should be recognised by a student.
An instructor should advise students of the depth of analysis and discussion that is required for a
particular question. For example, an undergraduate student may only be required to briefly introduce
points, explain in their own words and provide an example. On the other hand, a post-graduate
student may be required to provide much greater depth of analysis and discussion.

1. Within Australia the Reserve Bank is responsible for the implementation of monetary
policy.

The

central

banks

of

other

developed

economies

also

have

similar

responsibilities. Briefly identify and discuss a range of issues that a central bank would
consider when monitoring its current monetary policy settings. (LO 13.1)
Current monetary policy is principally directed towards containing inflation within a target range of
2 to 3 per cent over the business cycle. In directing its policy decisions to achieve this objective, the
central bank will consider:

the underlying rate of inflation over the business cycle

the rate of employment / unemployment / employment growth

the stability of the currency in particular relative to major trading partners

the welfare of the people

the current economic environment / business cycle

current monetary policy settings

the direction of economic growth

the impact on past monetary policy settings on current and future economic growth

time delays between a change in monetary policy settings and a change in economic growth

economic fundamentals in major trading partner countries

forecast changes in international economic growth

a wide range of economic indicators (discussed in question 3).

2. The open market transactions of the central bank impact interest rates within an economy.
The macroeconomic context of interest rate determination attempts to explain the interactions
of a change in monetary policy settings. The macroeconomic context of interest rate
determination identifies three distinct effects of a change in monetary policy. List, explain and
give examples of each of the three effects. (LO 13.1)
(i) Liquidity effect:

The monetary policy actions of the central bank that impact upon interest rates, particularly the
overnight cash rate

Central bank buys or sell government securities in order to affect the money supply and the level
of liquidity in the financial system

If the central bank buys securities from the financial system then there will be more cash in the
system and interest rates will fall; an easing of liquidity

If the central bank sells securities into the financial system there will be less cash in the system
as the investors pay cash to buy the securities and interest rates will rise; a tightening of liquidity.

(ii) Income effect:

Refers to the flow-on effect from the initial liquidity impact on interest rates

Using the example of the central bank tightening liquidity and increasing interest rates in order to
reduce the levels of spending in the economy

Reduced levels of spending will result in lower incomes in all sectors of the economy: the
household sector, the business sector and the government sector

This occurs as employment growth contracts, demand for goods and services eases, and taxation
revenues to government decline

As the rate of growth in economic activity slows, the demand for loans also slows

The slowing in the demand for funds results in an easing in interest rates.

(iii) Inflation effect:

In so far as the economy was previously experiencing inflationary pressures due to high levels of
demand, now the slowing of the pace of economic activity will cause the rate of inflation to ease

This easing allows rates of interest to ease as well

The nominal rate of interest is said to comprise two components, being the real rate of return
plus compensation for the expected rate of inflation

If the rate of inflation is expected to fall, then market interest rates should fall.

3. A central bank will typically implement monetary policy settings in order to achieve certain
economic outcomes over a business cycle. In order to forecast future economic conditions and
business activity, business managers therefore need to understand the business cycle.
(a) Draw a diagram and explain the structure of a business cycle over time.

The business cycle is a measure of changes in the level of economic activity in an economy over
time

It tends to move in changing cycles of peaks and troughs

The business cycle peakthe highest level of economic activity during a cycle

The business cycle troughthe lowest level of economic activity during a cycle.

(b) Discuss and give examples of different economic indicators that may give an insight into
the stage of a business cycle. (LO 13.1)

Economic indicators are constructed from a set of historic data that provide some insight into
possible future economic growth

Leading indicatorseconomic variables that change before there is a change in the business
cycle

Coincident indicatorseconomic variables that change at the same time as the business cycle
changes

Lagging indicatorseconomic variables that change after there is a change in the business cycle.

There is a wide range of economic indicators. Governments, central banks, corporations and analysts
will select a number of indicators that best inform them, including:

the rate of inflation over the business cycle

the rate of growth in gross domestic product

the balance of payments

credit growth and associated debt levels

the exchange rate relative to major trading partner currencies

the rate of unemployment, job vacancies and ratio of full-time and part-time employment

the balance of payments, imports and exports growth

finance for housing, residential and non-residential building approvals

economic activity and capacity utilisation

wages growth and overtime worked

retail sales

share price movements.

4. The financial markets often use the loanable funds approach when forecasting interest rates.
Describe the concept of the loanable funds approach to interest rate determination. In your
answer identify and explain the elements that comprise the supply of, and the demand for,
loanable funds. Note: you may find it convenient to draw diagrams showing the demand curve,
the supply curve and the equilibrium interest rate. (LO 13.2)

Loanable funds approachthe rate of interest is determined by the supply of and the demand for
loanable funds

Loanable funds are the flows of funds into the market for securities.

Demand for loanable funds:

There are two principal components:

business demand for fundsto finance its liquidity and capital investment requirements. The
lower the rate of interest, all else being constant, the greater will be the volume of funds
demanded. This is represented by the downward-sloping curve (labelled B). Any factors that
cause an increase (decrease) by business in its demand for funds would be represented by a shift
to the right (left) in the B curve. The curve shown represents the net business demand for funds.

government sector demand for fundsthe total public sector borrowing requirement; includes
the Commonwealth, States and local governments and their instrumentalities. It is normally

proposed that the PSBR is independent of the rate of interest, and this is represented by the
vertical curve labelled G. With a smaller (larger) borrowing requirement, the G curve would be
located further to the left (right) in the diagram. The two demand curves are combined to give
the total demand for loanable funds (labelled G + B).
Interest
rates

Interest
rates

Interest
rates

Q
Loanable funds

G+B

Q
Loanable funds

Q
Loanable funds

Supply of loanable funds:

There are three principal sources:

savings of the household sector - the curve (S) is drawn with an upward slope on the basis of the
presumption that as interest rates increase people will save a larger proportion of their incomes.
The curve is steep because empirical evidence suggests increases in interest rates cause only
small increases in the quantity saved.

changes in the money supply (M) - Since the money supply is assumed to be independent of the
rate of interest, changes in the money supply are represented diagrammatically as a vertical line.
When M is added to the savings curve it simply changes the location of the curve (S + M). It
does not change the slope of the curve. If for example, the Reserve Bank increased the money
supply the S + M curve would be to the right of the S curve.

dishoarding (D) - as interest rates increase, there is an incentive to acquire more securities in
order to obtain the increased yields that are available. In attempting to buy more securities
money is given up (or dishoarded). Dishoarding is added to the S + M curve to give the total
supply of loanable funds curve.

Interest
rates

Interest
rates

Interest
rates

S+M
S

S+M

S+M+D

Q
Loanable funds

Loanable funds

Loanable funds

Equilibrium in the loanable funds markets:

the equilibrium interest rate will be at the intersect of the demand and supply curves

Interest
rates

S+M
S+M+D
Equilibrium
G+B

Loanable funds

5. A problem with the loanable funds approach to explaining interest rates is that since the
supply and demand curves are interdependent a unique equilibrium rate of interest cannot be
determined. Explain and illustrate this problem by reference to the effects of:
(a) an increase in inflationary expectations

The traditional approach to the analysis of the effects of inflation on interest rates can be seen in
the following diagram.

The initial equilibrium interest rate is i 0 , at the intersection of the original demand and supply
curves.

With an increase in inflationary expectations, the suppliers of funds will demand a higher rate of
interest in order to maintain the same real rate of return on their funds. Diagrammatically, the

supply curve will move vertically, by the extent of the inflationary expectation (p e), from
supply0 to supply1.

The demand for funds will also change in response to the increased inflationary expectation. The
demand curve increases, by the extent of the inflationary expectations, from demand 0 to
demand 1.

The demand for funds increases because businesses, in anticipating higher inflation, recognise
that they will require a greater quantity of funds merely to maintain their pre-inflation investment
plans.

The result of the increased inflationary expectations is that interest rates will rise to the full
extent of the anticipated inflation, and the quantity of loanable funds will remain unchanged at
Q 0.

This is referred to as the Fisher effect.

Interest
rate
Supply1
i1
Pe

Supply0

i0
Demand1
Q0

Demand0

Loanable funds

It may be argued that non-Fisher effects will be evident which will lower the equilibrium interest
point; for example, increased inflation may reduce government demand for funds and the
demand curve will not move as far to the right.

The supply curve may in fact move to the right rather than the left as savings increase as a result
of higher wages and increased superannuation contributions.

(b) an expectation of a decrease in the level of economic activity. (LO 13.2)

An expectation of decreased economic activity may come from the business sector

This will result in a decrease in business demand for funds to finance investment projects due to
an anticipated fall in demand.

In a loanable funds demand and supply graph, the decrease in B would shift the demand curve to
the left, resulting in a decrease in the rate of interest.

As businesses decrease their investment in inventories and in capital equipment, they will reduce
their need to borrow and sell financial instruments to obtain funds.

As the supply of financial instruments on the market decreases, the prices of those instruments
will rise and their yields will decrease.

The higher prices on the securities (lower yields) will cause some savers to reallocate their
portfolios and sell securities; that is, hoarding will take place.

The forecast decrease in interest rates is only a temporary equilibrium.

There will be feedback mechanisms to consider in forecasting interest rate changes further into
the future.

For example, the hoarding that accompanied the initial decrease in interest rates will cease after
the desired portfolio re-allocations have been completed.

With no further hoarding, interest rates may have to fall further in order to prompt even more
hoarding.

The decrease in business investment adds to the expected decrease in economic activity, as
output levels fall, there will be a decrease in savings and this will relieve some of the downward
pressure on interest rates.

In addition, the decrease in output will see a worsening in the government budget position, with
an associated reduction in the government's borrowing requirement.

The depreciation of the currency that might be expected to accompany the decreased interest rate
is likely to result in increased demand for exports and a decrease in the demand for imports.
Businesses in the export-competing and import-competing sectors of the economy will increase
their investment, and thus increase their demand for funds. This will place some upward
pressures on interest rates.

6. Interest rates play an important role in monetary policy determinations, economic

performance and the business cycle, and the cost of funds. Financial market participants must
therefore understand the term structure of interest rates.
(a) Define the term yield and explain how a yield curve is constructed.

Yieldthe total return on an investment; comprising interest receipts and any capital gain or loss

Yield curvea graph, at a single point in time, of yields on a particular security with different
terms to maturity; for example, it is possible to plot the yield, as at today, for bank bills that have
30 days, 60 days, 90 days and 180 days to maturity.

(b) Identify three different types of yield curves. Briefly describe each of these yield curves and
draw a fully labelled diagram of each curve. (LO 13.3)

Normal/positive/upward-sloping yield curvereflects the preference for higher interest rates if

funds are invested longer-term. Short-term rates are lower than long-term rates.
Yield

Normal yield curve

Time

Inverse/negative/downward sloping yield curveillustrates that yield declines as maturity

lengthens. Short-term rates are higher than long-term rates.
Yield

Inverse yield curve

Time

Humped yield curvecombines the normal yield curve and the inverse yield curve and joined
by a period of a flat or horizontal yield curve.
Yield
Humped yield curve

Time

7. A number of theories attempt to explain the term structure of interest rates. The
expectations theory provides a foundation for our understanding of interest rate
determination. Outline the expectations theory approach to the determination of interest rates.
In your answer, explain the relationships that the theory contends will exist between shortterm and longer-term interest rates. (LO13.3)

Expectations theory refers to the shape of a yield curve as a function of the current and future
short-term interest rates; that is, the return received on a continuous series of short-term
investments should be the same as that received for a longer-term investment.

An investor will therefore be indifferent as to whether they invest for a short period of a longer
period; for example, an investor has two options (1) invest today for a one-year period at 4% per
annum and reinvest the funds in twelve months time, or (2) invest the funds today for a two-year
period at 4.5% per annum. The expectation theory will contend that the one-year investment rate
in twelve months time should be 5% per annum (that is, 4.5% x 2 = 9% - 4% = 5%).

Assumptions of the expectations theory:

There are a large number of financial investors who hold reasonably homogeneous expectations
about the future values of short-term interest rates.

There are no transaction costs, and so investors can move into and out of instruments at no cost
as they change their expectations and as they see market rates that are inconsistent with their
expectations.

There are no impediments to market rates moving to their competitive equilibrium levels.

The goal of investors is to maximise their expected rate of return, that is, if all bonds as perfect
substitutes for each another, regardless of their term to maturity, then longer-term interest rates
paid on bonds will be equal to the average of the short-term interest rates expected to prevail
over the longer-term period.

8. Within the context of interest rate determination, the expectations theory attempts to
explain the various shapes of the yield curve. How is the existence of a normal yield curve and
an inverse yield curve explained by the theory? (LO 13.3)
Normal yield curve:

will result from expectations that future short-term rates will be higher than current short-term
rates
o the central bank may reduce short-term rates, but since the market believes that future shortterm rates will be higher than current short-term rates, longer-term rates will not fall as far as
the policy-induced cut in short-term rates; therefore, the yield curve will be upward-sloping
(that is, if E 1 i 1 > 0 i 1 , then the yield curve will be normal).

Inverse yield curve:

will result if the market expects future short-term rates to be lower than current short-term rates
o even though the central bank may increase rates at the short end of the yield curve to achieve
its monetary policy objectives, market participants expect that once those objectives have
been achieved, short-term rates will be lowered again; in this circumstance, long-term rates
will not rise to the same extent as the policy-induced change in short-term rates, and
therefore the yield curve will slope downwards.

9. The segmented markets theory challenges two of the assumptions of the expectations theory.
(a) Identify the two assumptions challenged, and explain the segmented markets approach.
The segmented markets theory rejects two expectation theory assumptions:

that all bonds are perfect substitutes for one another

that investors are indifferent between holding instruments with a short term to maturity and
holding instruments with a long term to maturity.

Segmented markets approach to explaining the yield curve:

Securities in different maturity ranges, for example a 1 to 3 year range versus a 9 to 10 year
range, are not viewed by various market participants as being perfect substitutes for one another.

Whereas bonds with a very short term to maturity may well be close substitutes for each other,
and likewise for bonds with long terms to maturity, a one-month-to-maturity bond is unlikely to
be seen as a close substitute for a 10-year bond.

Some market participants have a preference for short-dated securities, and others have a
preference for longer-term maturities; that is, different investors have preferences for different
segments of the market.

The particular preferences are motivated out of a desire by the various participants to reduce the
riskiness of their portfolios.

Investors will seek to minimise their exposure to fluctuations in the prices and yields associated
with their assets and liabilities by matching the cash flows and maturities of their assets and
liabilities; for example, life offices have mainly long-term liabilities and therefore tend to hold
more longer-term assets.

The implication of the segmented markets approach is that it is the relative demands for and
supplies of securities in the various maturity ranges that determine yields.

The shape and slope of the yield curve are determined by the relative demand and supply
conditions that exist along the maturity spectrum.

(b) It may be argued that the segmented markets approach is negated by modern risk
management practices, arbitrage and speculation. Explain what is meant by this
assertion. (LO 13.3)

The segmented markets approach emphasises the risk management motivation of market
participants; that is, the matching of cash flows and maturities of assets and liabilities in order to
minimise associated risk exposures. By implication, this approach would cause discontinuities in
a yield curve thus exposing significant speculation and arbitrage opportunities.

Arbitrageurs, who are indifferent about the maturity of the bonds they hold, will sell and buy to
take advantage of the discontinuities along the yield curve. Their actions will smooth out the
yield curve; that is, remove the segmentation distortions.

Therefore, it may be reasonable to argue that certain investors do have segment preferences
along a yield curve, but those preferences are balanced by investors with different preferences,
arbitrageurs and speculators.

10. If financial market participants considered that anticipated inflation would rise
significantly in the future, what effect would you expect this forecast to have on the slope of a
normal yield curve? Why? (LO 13.3)

A normal yield curve is upward sloping.

Yields on a particular security are higher as the term to maturity increases.

Yield %

Time

The nominal interest rate (yield) on an investment incorporates a component of real interest and
a component for anticipated inflation; therefore, all other impacts being equal, an anticipation of
an increase in inflation over time will push up nominal interest rates further out on the maturity
spectrum.

As indicated in the graph below, the slope of the yield curve will become steeper.
Yield %

Time

11. The liquidity premium theory seeks to extend our understanding of the expectations theory
and the determination of interest rates.
(a) Outline the principal contention of the liquidity premium theory.

A criticism of the pure expectations approach is its assumption that investors are indifferent as to
whether they hold long-term or short-term bonds.

There is one important characteristic that distinguishes short-term and longer-term securities that
may result in a violation of the assumption of indifference.

Longer-term-to-maturity bonds are susceptible to a greater risk of larger price fluctuations than
are shorter term instruments.

Given the greater price risk associated with longer term securities, it may be hypothesised that
investors require a premium if they are to be enticed away from the shorter end of the maturity
spectrum.

If this is the case, then the expectations hypothesis explanation of the level of longer term rates
may be presented as being approximately:
0i2

= ( 0 i 1 + E1 i 1 ) + L
2

Where L is the liquidity premium that is demanded in order to hold the higher risk, longer-term
security.

The size of L is likely to increase the longer the term to maturity of the particular instrument.

The effect of the liquidity premium on the expectations hypothesis is shown below:
Yield %
observed yield curve
liquidity premium
expectations yield curve

Time

(b) How does the historic prevalence of a normal yield curve provide indirect evidence of the
existence of a liquidity premium?

Support for the addition of the liquidity premium to the expectations hypothesis is derived from
observations of the shape of the yield curve over time.

The positive or upward-sloping curve is labelled as the normal yield curve.

The normal yield curve is typically the shape most frequently observed over the years.

The combination of the expectations theory and the liquidity premium explains the observed
dominance of the normal curve.

At times, even though the pure expectations outcome is an inverse curve, when the liquidity
premium is added to the curve it results in a positive or normal curve.

At other times, the slope of an inverse yield curve will become flatter as a result of the effect of
the liquidity premium; that is, the inverse curve will move upward.

The combined expectations and liquidity premium theories provide a useful framework for
understanding the behaviour of the yield curve.

(c) Does the existence of an inverse yield curve indicate a violation of the liquidity premium
contention? (LO 13.3)

No; an inverse yield curve is still possible.

In this instance, the downward slope of the inverse yield curve will be reduced by the liquidity
premium effect. That is, the yield curve will become flatter, but still retain an inverse slope.
Yield %
observed yield curve
liquidity premium
expectations yield curve
Time

12. The financial press is continually reporting changes in economic variables and seeking
informed opinion on the impact of changes in variables on the direction of future interest rate
changes. Market participants, including policy makers, regulators and corporate managers
also actively monitor interest rates. Within the context of market participants, what is the
importance of understanding the term structure of interest rates? Provide examples in your
response. (LO 13.3)

The term structure of interest rates represents the relationship of yield to the term to maturity on
a particular security such as Treasury bonds.

Yield is expressed at a given point in time where there is constant risk, the same security, but a
varying period to maturity.

Yield curves may be categorised as normal, inverse and flat. The shape and slope of each of
these types of curves provides information to the market.

Under the pure expectations theory, a normal yield curve implies that future short-term interest
rates are expected to be higher than current short-term rates. On the opposite side, an inverse
yield curve implies that future short-term interest rates are expected to be lower than current
short-term rates.

If the term structure of interest rates within the market are correct and in equilibrium, then the
shape and slope of the yield curve provides some very important indicators to market
participants:
o borrowersassists borrowers to make informed decisions on the future direction of their
borrowing costs. The borrower may be able to restructure or reschedule their existing
funding arrangements to take advantage of expected movements in interest rates. New
borrowing issues may be brought forward, or alternatively delayed, depending on the
forecast future movement in interest rates. Decisions may also be made on the maturity
structure of existing and new funding arrangements.
o investorswill consider the term structure of interest rates in forecasting the future direction
of interest rates. This will influence their investment acquisition and disposal strategies; for
example, an investor with a portfolio of bonds may determine to sell the bonds if an interest
rate rise is forecast so as to avoid the price risk that prevails if yields increased
o financial institutionsare particularly concerned with current and future interest rates. The
price of most financial institution products is based on an interest rate. Therefore, any
movement in rates will have a direct impact on the institutions net interest margins.
Institutions will implement strategies to restructure their existing asset portfolios, together
with their liability commitments (gap management). Institutions will set the pricing of their
borrowing and lending products based on their interpretation of the future movement in
interest rates.
o government and Reserve Bankgovernment will analyse the term structure of interest rates
having regard to its economic, social and political objectives. These will be supported by the
determination and implementation of monetary policy by the Reserve Bank in order to
achieve its objectives of full employment, stability of the currency and maintenance of the
welfare of the people of Australia. To this end, monetary policy is currently directed towards
achieving an underlying inflation rate of 2 to 3 percent over a business cycle. The level of
anticipated inflation will affect the slope or steepness of the yield curve. If inflation is
expected to remain relatively low, then the slope of the yield curve should remain relatively
flat.

13. Explain the term risk-free rate of interest. Why is the existence of the risk-free rate of
interest important when examining the level of interest rates generally in the financial
markets? (LO 13.4)

The risk-free rate of interest is a return (yield) earned with certainty of payment; that is, there is
no risk of default by the issuer

Within the Australian markets, the Treasury bond, issued by the Commonwealth government, is
adopted as a proxy for the risk-free rate of return.

The Treasury bond is accepted as being risk-free in that it is presumed that the government is
able to meet its monetary commitments.

The importance of the risk-free rate of return is that it is the basis upon which other financial
assets are priced.

Securities which have a higher degree of risk attached to them are priced at a margin above the
risk-free rate; therefore, the Treasury bond becomes the benchmark upon which interest rates on
other securities with similar maturities are established.

The risk-free rate of interest is applied in a number of important pricing models, including the
options pricing model developed by Black & Scholes, and the Capital Asset Pricing Model.

The following graph demonstrates the role of the Treasury bond as the risk-free rate. Debentures
are priced above the Treasury bond rate, but unsecured notes are further priced above the
debenture rate. This reflects the relative risk of each of the securities.
Yield %

Unsecured notes
Risk premium
Debentures
Risk premium
Treasury bonds

Time (years)

14. As a finance researcher at a leading university you are interested in risk premiums applied
by the markets on corporate debt issues.
(a) Discuss the concept of a risk premium and the effect that a risk premium will have on the
yield curve for a corporate borrower.

Risk premiums will be applied to corporate borrowers relative to the risk free rate, being the
Treasury bond yield for the similar term to maturity.

Underlying the risk premium charged against a particular corporate borrower will be a range of
operational and financial variables, however, the basic measure will be the level of perceived
credit or default risk; that is, what is the probability that a borrower will be able to meet its future
on-going cash flow commitments when they are due.

The level of the risk premium will impact the cost of funds and the level of profitability of a
corporation.

A standard measure of risk used in the corporate bond market is the credit rating.

The higher the credit rating the lower is the risk premium and the cost of borrowing.

(b) Is it inevitable that the risk premium for a corporate borrower will be constant throughout
the maturity spectrum? Explain your response. (LO 13.4)

Whilst conceptually it is possible for a risk premium attached to a particular corporate borrower
to be constant over the maturity spectrum, it is more likely that the risk premium will change.

One set of conditions under which a widening risk premium gap may occur is if the corporate
borrower has been a highly successful corporation, but its future is somewhat uncertain; for
example, this could occur if the corporation's main products are towards the end of the product
life cycle, and the company has not devoted sufficient resources to the research and development
of a new product or production technique that will maintain its competitive advantage.

The increasing gap could also open up if the company has recently been involved in a takeover
or merger, the likely commercial success of which has not been clearly established by lenders.

In both cases, there is a low risk of default on the near-to-maturity instruments, but greater
uncertainty about the company's performance further into the future.

It is also possible that the yield curve for a higher-risk borrower may show a narrowing of the
risk premium gap as the term to maturity increases.

Such an outcome could result from a concern that, in the current business environment, the
company may have difficulty in redeeming the soon-to-mature instruments, but market
participants believe that if the company survives the near-term, then its prospects are relatively
good.

Another example may be a company that is involved in a reasonably speculative exploration

activity, or the development of a new technology, or an attempt to convert a laboratory discovery

into a commercial product. Near-term risk is high, but if successful the longer-term risk premium
will fall.

Extended learning question

15. This question requires calculations relating to the yield curve and the expectations theory.
(LO 13.5)
(a) If an investor possesses the following information, and expectations on Treasury bond
yields are:
0i1

= 7.50% p.a.

E 1 i 1 = 8.80% p.a.
calculate the yield on a two-year bond ( 0 i 2 ) that would result in the investor being indifferent
between placing funds in a one-year bond now, to be followed by a one-year bond in a years
time, or placing the funds in a two-year bond now.
(1)

Calculation using arithmetic average:

0i2

( 0 i 1 + E1 i 1 )
2

7.5 + 8.8
2

(2)

8.15 %

Calculation using geometric average:

0i2

[( 1 + 0 i 1 ) ( 1 + E 1 i 1 )] 0.5 - 1

[( 1.075 ) ( 1.088 )] 0.5 - 1

[ 1.1696 ] 0.5 - 1

8.148 %

(b) You are given the following data:

0i1

= 10.00% p.a.

E 1 i 1 = 12.00% p.a.
E 2 i 1 = 13.00% p.a.
E 3 i 1 = 13.00% p.a.
On the basis of the expectations theory of the yield curve, complete the following.

Calculate the 0 i 2, 0 i 3 and 0 i 4 rates.

formula: 0 i n = [(1 + 0 i 1 ) (1 + E 1 i 1 ) (1 + E 2 i 1 ) ... (1 + E n - 1 i 1 )]1/n - 1

(i)

0i2

= [(1 + 0.10) (1 + 0.12)]1/2 - 1

= 11.00%

(ii)

0i3

= [(1 + 0.10) (1 + 0.12) (1 + 0.13]1/3 - 1

= 11.66%

(iii)

0i4

= [(1 + 0.10) (1 + 0.12) (1 + 0.13) (1 + 0.13]1/4 - 1

= 11.99%

Explain what is meant by implicit forward rates of interest.

On the basis of the expectations theory, a yield curve provides information on what the onbalance expectations of market participants are concerning a large range of future interest
rates. That is, implicit in the yield curve there are indicators, or information, on a series of
expectations about future interest rates.

List the full range of one-year implicit rates of interest that could be calculated on the basis
of the yield curve data that provide the current rates on bonds with one, two and three
years to maturity.

Yield %

i
0i2
0i3

Years

0 1

Actual rates

i
1i2
1 1

Implicit rates

2 1

Implicit interest rates that could be calculated on the basis of the above yield curve are 1 i 1 , 1 i 2 and
2i1.

Given the following yield curve data, calculate the 2i2, 1i2 and 3i1 implicit rates:
0i1

= 8.00% p.a.

0i2

= 9.00% p.a.

0i3

= 10.00% p.a.

0i4

= 11.00% p.a.

Yield %

Years

8%

i
0i2
0i3
0i4
0 1

9%

Actual rates
10%
11%

i
1i2
1i3
1 1

Implicit rates

i
2i1
2 1

3 1

formula:

nik

= [(1 + 0 i n+ k )n + k]1/k -1
[ (1 + 0 i n )n

(i)

calculate 2 i 2

where: n = 2; k = 2

= [(1 + 0.11)4]1/2 -1
[(1 + 0.09)2]
= 13.04%

(ii)

calculate 1 i 2

where: n = 1; k = 2

= [(1 + 0.10)3]1/2 -1
[(1 + 0.08)1]
= 11.01%

(iii)

calculate 3 i 1

where: n = 3; k = 1

= [(1 + 0.11)4]1/1 1
[ (1 + 0.10)3]
= 14.06%