While theories of how interest rates are determined usually focus upon a single interest rate in the economy, there are in fact thousands of different interest rates confronting savers and borrowers every day. This chapter has focused our attention upon two major factors that cause interest rates to differ from security to security and from loan to loan: (a) inflationary expectations; and (b) the maturity, term, or duration of a financial instrument.

• One key factor affecting interest rates is expectations about inflation. If lenders expect a higher rate of inflation to prevail during the life of a financial instrument they will demand a higher nominal return before making a loan. The Fisher effect argues that the expected nominal interest rate attached to a loan or security is the sum of its expected real rate plus the inflation premium (or expected rate of inflation). Fisher believed that the real rate would be relatively stable; therefore, changes in the nominal interest rate were due largely to changes in inflationary expectations.



• More recent research suggests that the relationship between inflation and interest rates may not be quite as simple as implied by the Fisher effect. For example, the Harrod-Keynes effect suggests that changes in the expected inflation rate may result, not in changes in the nominal rate, but changes in the real rate of return instead. Moreover, the economy, the structure of tax rates investors face, and the public’s spending and investment habits may significantly impact the linkages between inflation and interest rates. For example, the taxation of interest income may force the expected nominal interest rate to increase by more than expected inflation so that savers can protect their after-tax return.



• Deflation—a fall in the average price level for all goods and services—tends to push nominal interest rates lower and raise real rates. Thus, periods of deflation may slow investment activity and job creation.



• There is great controversy today surrounding the possible linkages between inflation and stock prices. Rising inflation doesn’t necessarily lead to rising stock prices. The stock-price impact from inflation may depend on nominal contracts—that is, whether the revenues and expenses of a stock-issuing corporation are favorably or unfavorably affected by inflation as a result of agreements the company has entered into concerning the wages and salaries paid to its workforce, the goods sold to its customers, and borrowing costs. Inflation doesn’t affect all stocks the same way because different businesses and individuals are involved in different nominal contracts shaping their cash inflows (revenues) and outflows (expenses).



• This chapter explores the usefulness of the yield curve in explaining interestrate movements. The yield curve visually captures the relationship between the annual rate of return on financial instruments and their term to maturity. Yield curves have sloped upward most frequently in recent years, with long-term interest rates higher than short-term rates. However, yield curves can slope downward or become relatively flat (horizontal).



• Why does the yield curve change its shape? The unbiased expectationshypothesis contends that yield curves reflect predominantly the interest-rate expectations of the financial marketplace. A rising yield curve suggests that market interest rates are expected to rise, while a declining yield curve points to lower expected interest rates in the future.



• Other viewpoints on the yield curve stem from the liquidity premium, market segmentation, and preferred habitat theories. For example, the liquidity premium view contends that the greater risk associated with longer-term financial instruments results in these longer-maturity assets bearing higher average returns, giving an upward bias to the slope of yield curves.



• The market segmentation and preferred habitat views of the yield curve suggest that the supply of financial assets of different maturities available to investors can affect the yield curve’s shape. For example, a sudden increase in the supply of longer-term financial instruments may cause long-term asset prices to fall and their yields to rise, tipping the yield curve toward an upward slope.



• Regardless of which view may be valid, yield curves can play a key role in the management of financial institutions, which borrow a substantial portion of their funds at the short end of the maturity spectrum and lend heavily at longer maturities. Yield curves can provide an indication of the marketplace’s overall forecast of future interest rates, with upward-sloping curves implying rising interest rates and downward-sloping curves implying falling interest rates in the future.



• Yield curves may help identify underpriced or overpriced assets whose yields will lie above or below the curve at any moment in time. Moreover, some security traders “ride the yield curve,” taking advantage of opportunities to sell short-term securities bearing the lowest yields and purchasing longer-maturity securities bearing higher interest rates.



• In recent years financial analysts have become somewhat dissatisfied with one of the two key factors making up the yield-curve relationship—the term to maturity or number of months and years until a financial asset is due to be retired. An alternative measure of the maturity of a financial instrument— duration—has become popular in recent years because it is a weighted average measure of the maturity or length of a financial instrument, capturing both the size and the timing of all cash payments from an income-generating asset or portfolio of assets. Duration has grown in popularity among portfolio managers because it can be used to help immunize a single asset or an asset portfolio against possible losses due to changing market interest rates.



• Duration also is linked to the price volatility (or price elasticity) of a financial instrument in a directly proportional way. Duration connects the percentage change in price of a financial asset to the change in its interest return or yield. Longer-term assets tend to have longer durations and, therefore, greater price instability than do shorter-term assets.