Morton Handley

Integrated Case 6-21

Morton Handley & Company - Interest Rate Determination

(A) What are the four most fundamental factors that affect the cost of money, or the general level of interest rates, in the economy?

* The four most fundamental factors affecting the cost of money are (1) production opportunities, (2) time preferences for consumption, (3) risk, and (4) inflation

* Production opportunities are the investment opportunities in productive assets. Time preferences for consumption are the preferences of consumers for current consumption. Risk is the probability of investments generating a low or negative return. Lastly, Inflation is the amount by which prices increase over time.

* Interest rates paid to savers is determined by:

o (i) on the rate of return producers expect to earn on invested capital

o (ii) on savers' time preferences for current versus future consumption,

o (3) on the riskiness of the loan

o (4) on the expected future rate of inflation

(B) What is the real risk-free rate of interest (r*) and the nominal risk-free rate (rRF)? How are these two rates measured?

r = r* + IP + DRP + LP + MRP

rRF = r* + IP

* The real risk-free rate, r*, is the rate that would exist on default-free securities in the absence of inflation

* The nominal risk-free rate, rRF, is equal to the real risk-free rate plus an inflation premium,

* The real risk-free rate, r*, is measured by subtracting the expected rate of inflation from the rate on short-term treasury securities

(C) Define the terms inflation premium (IP), default risk premium (DRP), liquidity premium (LP), and maturity risk premium (MRP). Which of these premiums is included when determining the interest rate on (1) short-term U.S. Treasury securities, (2) long-term U.S. Treasury securities, (3) short-term corporate securities, and (4) long-term corporate securities? Explain how the premiums would vary over time and among the different securities listed.

* Inflation premium (IP) is a premium added to the real risk-free rate of interest to compensate for expected inflation

* Default risk premium (DRP) is a premium based on the probability that the issuer will default on the loan, and it is measured by the difference between the interest rate on a U.S. Treasury bond and a corporate bond of equal maturity and marketability

* Liquid asset is one that can be sold at a predictable price on short notice; a liquidity premium is added to the rate of interest on securities that are not liquid

* Maturity risk premium (MRP) is a premium that reflects interest rate risk

o Short-term treasury securities include only an inflation premium.

o Long-term treasury securities contain an inflation premium plus a maturity risk premium

o The rate on short-term corporate securities is equal to the real risk-free rate plus premiums for inflation, default risk, and liquidity. The size of the default and liquidity premiums will vary depending on the financial strength of the issuing corporation and its degree of liquidity, with larger corporations generally having greater liquidity because of more active trading.

(4) The rate for long-term corporate securities also includes a premium for maturity risk. Thus, long-term corporate securities generally carry the highest yields of these four types of securities.

(D) What is the term structure of interest rates? What is a yield curve?

o The term structure of interest rates is the relationship between interest rates, or yields, and maturities of securities. When this relationship is graphed, the resulting curve is called a yield curve.