Determinants of Interest rates

Other things being equal, the price of a bond falls when the required rate of return rises and the price of a bond rises when the required rate of return falls. Since the required rate of return has an important bearing on bond price, you would know, what drives the required rate of return, which will hereafter, for the sale of simplicity, be referred to as interest rate.

The interest rate on a bond is determined by four factors or variables: short term risk free interest rate, maturity premium, default premium and special features. These are discussed below is some detail.

Short term Risk free Interest Rate:

The short term risk interest rate is the yield on a one year government security, say a 364-day Treasury bill(note that government securities are considered to be risk free because the government is not expected to default on its obligation). This may be decomposed into two parts:

Short term risk free interest rate = Expected real rate of return + Expected inflation.

Expected Real rate of Return: Intuitively, the expected real rate of return represents the rate at which society is willing to trade current consumption for future consumption. For example, if the society is willing to give up 100 units of real goods in return for 103 units a year now, the expected real rate of return is three percent. As three is a preference for current consumption over future consumption, the expected real estate rate is positive but it tends to vary widely across time and across economies.

Expected Rate of inflation: To get a handle over the determinants of the expected rate of inflation, let us look at the following identity:

Price level = (Money supply in the economy)(Velocity of money in circulation]
Real output in the economy

Hence, the expected rate of inflation which is nothing but the expected change in price level:
[Change in money supply in economy][change in the velocity of Expected rate of inflation = circulation]

Changes in the real output of the economy

For example, if money supply increases by 13 percent and velocity of money in circulation increase by one percent and when the real output rises by seen percent the expected inflation rate is:

(1.13) (1.01) / (1.07) – 1= 0.067 or 6.7 percent

Maturity Premium:

Maturity premium represents the difference between the yield to maturity on a short term (one year) risk security and the yield to maturity on a risk free security of a longer maturity.

The yield curve is depicted. It shows graphically how the yield to maturity is related to the term to maturity. The yield curve ordinarily slopes upward because investors expect a higher yield for making investment over a longer period of time. This implies that the maturity premium increases wit time.

Expectations Theory: The yield curve depends on the expectations of the investors. If investors expect short term rates to rise (fall) in the future curve will be ascending (descending).

Liquidity Preference Theory: Investors have a preference for liquidity. So they ask for a higher yield as an inducement to hold bonds of longer maturity.

Preferred Habitat Theory: The shape of the yield curve is determined by the supply and demand of funds in different maturity ranges (Habitats).

Default Premium: While there is no risk if default in government securities corporate bonds may default on interest and/or principal payment. When such a possibility exists, investors will ask for a default premium in additions, of course to the maturity premium.

The default premium increases with default risk which interalia is a function of the following:

1. The business risk of the issuer as reflected in the volatility of its operating income.
2. The financial risk of the issuer measured usually by the ratio of outside liabilities to shareholders funds.
3. The size if the business and the value of collateral assets that are offered as security.

Credit rating agencies consider these factors and several others and express their opinion on default risk through their ratings.

Note that default premiums reflect default risk as well as the state of the economy. Other things being equal, default premiums tend to increase during economic recession when investors turn risk averse and decrease during economic expansion when investors become more confident.