FINANCE 10

Oneof the determinants of market interest rate is liquidity premium.Liquidity premium is the difference in yields and prices that aninvestor is willing to pay for every bond (LaGrandville, 2003). It isa determinant of market interest rates since it causes interest ratesto rise or decrease. In instances where the liquidity premium isexceedingly high, then the security is viewed as being more illiquid.This causes prices to drop, which leads to a rise in the interestrates. Therefore, price is the driving force for the liquiditypremium’s effect on the interest rate. When the price falls due tothe illiquidity of a security, the interest rate goes up and viceversa.

Thedefault risk premium is another determinant of the market interestrate. Default premium describes an extra amount that a borrowershould pay in compensating the lender for the assumption of defaultrisk. The default premium must be paid by all borrowers or companiesindirectly, via the rate at which they need to repay theirobligations. High quality bonds that are issued by establishedorganizations, which earn vast profits, have exceedingly littledefault risk. This implies that such securities will yield a lowinterest rate compared to securities issued by small companies thathave uncertain profitability and remarkably higher default risk(LaGrandville, 2003). Therefore, the default risk premium isstronger, when there is great uncertainty for default implyinginterest rates will be high. On the other hand, the default riskpremium will be weaker when there is less or no uncertainty fordefault. The strength or weakness of the default risk premium isusually determined by the credit worthiness of the borrower.

Inflationpremium is also another determinant of the market interest rate. Themarket usually expects total prices to increase however, thepurchasing power of a given currency becomes reduced by the inflationrate (Copeland, 1982). Therefore, when it comes to securities,inflation premiums may determine the market interest rate. When theexpected inflation is usually high, then the inflation premiums arealso high, which implies that the interest rates also go up. However,when the expected inflation is low, the inflation premiums are alsolow leading to interest rates going down. Therefore, the expectedinflation is stronger when the inflation premiums are higher, andweaker when the inflation premiums are low. The driving force forstrong inflation premiums is high expected inflation, while thedriving force for weak inflation premium is low expected inflation.

Besides,maturity premium entails another vital determinant of the marketinterest rate. The maturity risk premium describes the additionalyield that an investor earns from purchasing a bond that has a longertime to mature. Purchasing a bond, which has a longer period tomaturity offers a higher probability that the interest rates may riseover the maturity period (Madura, 2008). Therefore, the higher thematurity risk of a security, the higher the maturity premiums and thehigher the interest rates. Hence, the maturity premium is strongerwhen the maturity risk is higher and it is weaker, when the maturityrisk is low. A driving force to a strong maturity premium is a longermaturity period for a security, while a driving force to a weakmaturity premium is a shorter maturity period of a security.

Ayield curve entails a line, which plots the interest rates of bondswith equal credit quality, but having varied maturity dates. Thereare three kinds of yield curve shapes, which are inverted, normal,and flat (Choudhry, 2011). A normal yield curve is a yield curve inwhich, the short term bonds have a lower yield compared to the longterm bonds of the same credit quality. This makes the yield curvehave an upward slope. This yield curve shape is the most common. Theyield curve is usually considered ‘normal’ since the marketexpects vast compensation for greater risks.

Aninverted yield curve describes a curve, where the long term debtinstruments indicate a lower yield compared to the short term debtinstruments, which have the same credit quality. Of the three types,this yield curve is usually the rarest. Besides, it is usuallyconsidered as the predictor of an economic recession. The followingimage depicts an inverted yield curve:

Onthe other hand, a flat yield curve is one where there is a depictionof slight difference amid long term and short term rates for bonds ofa similar credit quality. The flat yield curve is usually seen intimes of transitions between the normal and inverted curves. Thefollowing is an image showing the flat yield curve

Yieldcurves are usually affected by the interest rates they move up anddoes as the interest rates change. The inflation rate is a vitalfactor in determining the interest rate this implies that, theexpected inflation rate may help in determining the interest rateswithin a given period (Choudhry, 2011). In case, the future expectedinflation rate is high, it implies that the interest rates for theperiod would be high. On the other hand, in case the expectedinflation rate for a certain period in the future is low, then theinterest rates would also be low. This is likely to be reflected onthe yield curves. Take, for instance, in case the current inflationrate is 1%, but is expected to be 5% in the next 3 years, then thiswill be reflected in the yield curve by the movement of the yieldcurve to a higher level as indicated in the following illustrationthe yield curve will move up from A to B.

Yield

6% B

5% A

4%

3%

2%

1%

1 2 34 5 6 7 8

Timeto maturity (years)

Adebt security describes a negotiable financial instrument that servesas an indication of a debt. There are different types of debtsecurities, which include term loans, debentures, bonds and lease. Aterm loan describes a monetary loan, which is repaid in regularpayments over a given set period. Term loans can be provided on apersonal basis, but are usually utilized for small business loans.The interest rate of a term loan is either floating or fixed. On theother hand, a lease entails a contractual arrangement where the partythat owns an asset (lessor) offers the asset for utilization toanother or transfers the right of using the asset to the user(lessee) for a certain period for a return (Choudhry, 2001). Adebenture describes a debt security offered by a company that willpay interest of the resources borrowed for a given period. They arelong term debt instruments that are issued by the private sectorcompanies. In addition, a bond describes a debt investment where theinvestor loans resources to an entity, which borrows the resourcesfor a definite period at a fixed rate of interest. Bonds mayconstitute Corporate, municipal, or treasury bonds. Corporate bondsrefer to debt securities that are issued by corporations. Municipalbonds are usually issued by municipalities or states.

Priceof the Bond =

c × F ×  |
1 − (1 + r) |
+ |
F |

r |
(1 + r) |

Where,c is the coupon rate of interest F indicates the face value r isthe market rate and t is the time period. Therefore, the price ofbond will be obtained by solving the following equation

Priceof bond (10 years) = 6% * 100,000 * (1- (1 + 8%)^-10) /8% + 100,000 /(1 + 8%)^10

=0.06 * 100,000 * 6.71 + 46319.35

=40260 + 46319.35

=86579.35

Priceof bond (8 years)

=6% * 100,000 * (1- (1 + 8%)^-8) /8% + 100,000 / (1 + 8%)^8

=0.06 * 100,000 * 5.75 + 54026.89

=34500 + 54026.89

=88526.89

Priceof bond (6 years)

=6% * 100,000 * (1- (1 + 8%)^-6) /8% + 100,000 / (1 + 8%)^6

=0.06 * 100,000 * 4.62 + 63016.96

=27720 + 63016.96

=90736.96

Priceof bond (4 years)

=6% * 100,000 * (1- (1 + 8%)^-4) /8% + 100,000 / (1 + 8%)^4

=0.06 * 100,000 * 3.31 + 73502.99

=19860 + 73502.99

=93362.99

Priceof bond (2 years)

=6% * 100,000 * (1- (1 + 8%)^-2) /8% + 100,000 / (1 + 8%)^2

=0.06 * 100,000 * 1.78 + 85733.88

=10680 + 85733.88

=96413.88

Graphrelating bond price and time

Themovement in the bond price across time is vital for an investor sincethe investor can decide on the time to choose depending on the bondprice. The investor can make the best investing decision since thebond price decreases as it matures.

References

Choudhry,M. (2001). *Capitalmarket instruments: Analysis and valuation*.Harlow: Financial Times Prentice Hall.

Choudhry,M. (2011). *Analysingand interpreting the yield curve*.Hoboken: John Wiley & Sons.

Copeland,L.B. (1982). Inflation,Interest Rates and Equity Risk Premia: *FinancialAnalysts Journal *Vol.38, No. 3, pp. 32-43.

LaGrandville,O. (2003). *Bondpricing and portfolio analysis: Protecting investors in the long run*.Cambridge, Mass. [u.a.: MIT Press.

Madura,J. (2008). *Financialmarkets and institutions*.Mason Ohio: Thomson.