Bond
A debt instrument in which an investor loans a certain amount of money (principal) to a borrower for a defined period of time at which point (maturity date) the principal is returned
Interest Rate
Amount of compensation which a lender is willing to accept to forgo consumption today to some period in the future
Four Factors Affecting Cost of Money:
- Production Opportunities
- Time Preferences for Consumption
- Risk
- Inflation
Production Opportunities
The availability of opportunities in productive assets
- As production opportunities increase, demand for money increases
- Interest rates rise
Time Preferences for Consumption
The preference of consumers for current consumption as opposed to saving for future consumption
Risk
The chance of low or negative returns
- Higher risk demands higher interest rates
Inflation
Amount by which prices rise and decrease purchasing power over time
- Higher inflation rates demand higher interest rates
Nominal Rate
Rate of interest stated on a bond or loan
Real Rate
Interest rate after removing the effects of inflation
Required Return on a Debt Security (r)
The total interest rate investors demand to lend money to a borrower
Maturity Risk Premium (MRP)
The extra interest investors demand for holding longer-term bonds
- Some investors argue that this doesn’t exist bc of pure expectations theory
Real Risk-Free Rate of Interest (R*)
Shows the true return an investor would earn in a perfectly safe world where prices don’t rise
Inflation Premium (IP)
The extra interest lenders demand to compensate for expected inflation
Default Risk Premium (DRP)
The extra interest lenders charge to compensate for the chance that a borrower might not repay the loan
Liquidity Premium (LP)
The extra interest investors demand for holding an asset that is harder to sell quickly without losing value
Term to Maturity
The time remaining on life of bond before maturity
Short-term Bonds
Bonds that have maturities 0-5 years
Intermediate Bonds
Bonds that have maturities 5-11 years
Long-term Bonds
Bonds that have maturities greater than 11 years
Maturity Spread
The spread between any two maturity sectors
“Normal” Yield Curve Shape
Longer-term bonds typically yield higher interest rates
Flat yield curve
Long-term and short-term bonds yield same rate
Inverted Yield Curve
Short-term rates are higher than long-term
Pure Expectations Theory
Theory that contends that the shape of the yield curve depends on investors’ expectations about the level of future interest rates
- If interest rates are expected to increase in the future, long-term rates will be higher than short-term
