Question

Define the six factors that determine the nominal interest rate on a security.

Define the concept of term structure of interest rates. What are three theories that explain the future yield curve of interest rates?

Answer 1

The Six factors that determine the nominal interest rate on a security are :

a. Real Risk free rate which the rate of return on primarily riskless government securities.

b. Default Risk : Investors would demand a additional premium on account of risk of default undertaken by them.

c. Maturity Risk : Investors would want return for holding a risk to maturity especially for higher maturity instruments.

d. Liquidity Risk : For securities which are not that liquid and do not have a liquid market would demand a higher liquidity risk.

e. Premium for expected inflation.

f. Quoted rate on a risk free security.
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The YTM of a 1 year zero coupon bond and a two year zero coupon bond need not be same. The investor might demand a different return on a two year bond when compared to a one year bond depending on many things like his outlook of interest, liquidity needs etc.

In general thus this brings the concept of term structure of interest rates, Term structure of interest rates shows the various interest rates for lending funds for different periods of time. Thus it is the YTM of zero coupon bonds for different maturities.

Three theories that explain the expectation on future yield on interest rates are :

1. Pure Expectation Theory : The theories suggests that in general the yield curve is a function of expectated increase in short term rates. For E.g a two year YTM can be determined today using the 1 year YTM today and the expectation of a 1 year YTM, One year from today.

2. Liquidity Preference Theory : The theory general states that in general the investors would demand higher YTM or interest rate for long maturity securities to compensate for the fact that longer maturity securities are in general more illiquid.

3. Market Segmentation Theory : The theory believes that the YTM at differnet times would depend upon how the investors and market would generally behave during different time frames, when they will invest more etc.

Thanks.