7.7The structure of interest rates

Let us now drop our assumption that all interest rates in the economy move together.

There are, indeed, many interest rates and the structure of interest rates is subject

to considerable change. Such changes are important to the operation of monetary

policy.

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7.7 The structure of interest rates

Interest rates vary because of differences in the time period, the degree of risk, and

the transactions costs associated with different nancial instruments. Let us begin

by considering differences in risk. Plainly, the greater the risk of default associated

with an asset, the higher must be the interest rate paid upon it as compensation for

the risk. This explains why some borrowers pay higher rates of interest than others.

The degree of risk associated with a request for a loan may be determined informally,

based upon, for example, a company’s size, protability or past performance; or, it

may be determined more formally by credit rating agencies.

Borrowers with high credit ratings will be able to have commercial bills accepted

by banks, nd willing takers for their commercial paper or borrow directly from banks

at ‘ne’ rates of interest. Such borrowers are often referred to as prime borrowers.

Those less favoured may have to borrow from other sources at higher rates. Much

the same principle applies to the comparison between interest rates on sound risk-

free loans (such as government bonds) and expected yields on equities, the factors

inuencing which were discussed in detail in Chapter 6. There we saw that the

more risky a company is thought to be, the lower will be its share price in relation

to its expected average dividend payment – that is, the higher will be its dividend

yield and the more expensive it will be for the company to raise equity capital. Of

course, not everyone is risk averse and shares of companies that have made no

prots and paid no dividends for several years continue to be bought and sold and

so the loading for risk that must be paid by risky companies need not necessarily be

very great.

Interest rates payable on different forms of assets will also vary with transaction

costs and these are subject to economies of scale. Thus, other things being equal, we

should expect rates of interest to be lower the larger the size of the loan.

7.7.1The term structure of interest rates

Our principal concern here, however, is with instruments that differ only in their

time period – that is, there is an equal risk of default and no difference in trans-

action costs. The relationship between interest rates on short-term securities and

those on long-term ones can be represented on a diagram known as the yield curve.

Yield curve:Shows the relationships between the interest rates payable on bonds

with different lengths of time to maturity. That is, it shows the term structure of

interest rates.

A typical yield curve is shown in Figure 7.4. Here, interest rates rise as the length

of time to maturity increases, but the curve gradually attens out. Yield curves may,

however, be of many different shapes. Figure 7.5 illustrates a range of possibilities.

To examine the circumstances in which a yield curve might assume a particular

shape, we need to consider several theories of the nature of the relationship between

long-term and short-term rates.

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Chapter 7 • Interest rates

Figure 7.4

Figure 7.5