Interest rates
Interest rates are the price of borrowing money. They affect everything from mortgages to company valuations.
What determines interest rates
Interest rates reflect the real return lenders require, expected inflation, and compensation for risks such as default and illiquidity. Supply and demand for loanable funds, central bank policy, and economic conditions all influence rates.
Nominal and real rates
The Fisher equation links them: nominal rate is approximately real rate + expected inflation. If lenders want a 2% real return and expect 3% inflation, they will charge about 5%. Unexpected inflation transfers wealth from lenders to borrowers, since loans are repaid in money worth less than expected.
Components of required return
A bond's required return can be thought of as a real risk-free rate plus premiums: an inflation premium, a default risk premium (for the chance the borrower will not pay), a liquidity premium (for bonds that are hard to sell quickly), and a maturity premium (for the extra risk of long-term bonds).
The term structure and yield curve
The yield curve plots yields on government bonds against maturity. Normally it slopes upward: long-term rates exceed short-term rates. An inverted yield curve, with short rates above long rates, has historically often preceded US recessions, though not always.
Theories of the yield curve
The expectations theory says long-term rates reflect expected future short-term rates. The liquidity preference theory adds that investors demand a premium for longer maturities. Market segmentation theory holds that different investors prefer particular maturities, so supply and demand in each segment shape yields.
Central banks and rates
Central banks, such as the US Federal Reserve, set short-term policy rates, influencing borrowing costs throughout the economy. The Fed raised its target range from near zero in early 2022 to 5.25-5.50% by mid-2023 to fight inflation, then began cutting in late 2024. Long-term rates are also shaped by markets' expectations of inflation and growth.
Interest rates and asset prices
When interest rates rise, the present value of future cash flows falls, so bond prices, and often share prices, decline. Rising rates also increase borrowing costs for firms and households, slowing investment and spending. Falling rates have the opposite effects.
Worked example
A one-year government bond yields 4% and a ten-year bond yields 4.5%: a normal, upward-sloping curve. A ten-year corporate bond from a company with a BBB rating yields 6%. The 1.5 percentage-point gap over the government bond (150 basis points) is the credit spread, compensating investors mainly for default and liquidity risk.
Key takeaways
Interest rates reflect real returns, inflation, and risk premiums. The Fisher equation: nominal is about real plus expected inflation. Required returns add inflation, default, liquidity, and maturity premiums. The yield curve usually slopes upward; inversion has often preceded recessions. Theories include expectations, liquidity preference, and segmentation. Central banks set short-term rates; the Fed raised them sharply in 2022-2023. Higher rates lower bond and often stock prices.
Flashcard
Price of borrowing money
Check your understanding
If lenders want a 3% real return and expect 4% inflation, the nominal rate will be about: