1. INTEREST RATES CHAPTER 6 Cost of Credit Determinants of Interest Rates Term Structure

2. Cost of Credit A.Interest rates reflect the cost of borrowing money (or capital) B.Four Principal Factors Influencing Rates 1.Investment opportunities 2.Time preferences for consumption 3.Riskiness of objectives 4.Inflation

3. Cost of Credit C. Other Factors Influencing Interest rates. 1. Federal Reserve Monetary Policy. 2. Investor expectations about economy. 3. Business Decisions.

4. TERM STRUCTURE OF INTEREST RATES A. Composition of Nominal Interest Rates. 1. Real rate of return. 2. Inflation premium. 3. Default premium. 4. Liquidity premium. 5. Maturity Risk premium

5. TERM STRUCTURE OF INTEREST RATES C.r = r* + IP + DRP + LP + MRP  r =required return on a debt security  r*=real risk-free rate of interest  IP=inflation premium  DRP=default risk premium  LP=liquidity premium  MRP=maturity risk premium

6. TERM STRUCTURE OF INTEREST RATES Years to Maturity Real risk-free rate 0 5 10 15 1 10 20 Interest Rate (%) Maturity risk premium Inflation premium

7. HOMEWORK ASSIGNMENT A.Self-Test: ST-1, parts b, c, d, e, f B.Questions: 6-1, 6-3, 6-8, 6-9 C.Problems: 6-2, 6-5