Determinants of Interest Rates - Vocabulary

Vocabulary flashcards covering key terms from the determinants of interest rates, loanable funds, yield curves, and time value of money.

Nominal interest rate

Interest rate observed in financial markets; directly affects the value of most securities and investors’ decisions.

Real risk-free rate (RFR)

Rate on a risk‑free security with no inflation; higher when society prefers current consumption.

Inflation

Persistent rise in the price level; measured by CPI and PPI; higher (actual or expected) inflation raises interest rates.

Fisher effect

Relationship where nominal rate ≈ real rate plus expected inflation (i ≈ RFR + E(IP)).

Default risk

Risk that an issuer will fail to make promised payments; higher risk leads to a higher required return.

Default risk premium

Extra yield added to compensate for default risk, over a risk-free rate.

Liquidity risk

Risk that a security cannot be sold quickly at a predictable price.

Liquidity risk premium (LRP)

Additional yield to compensate for illiquidity; often rises with maturity.

Special provisions or covenants

Contract features like taxability, convertibility, and callability that affect interest rates.

Tax-exempt municipal securities

Municipal bond interest is free from federal (and often state/local) taxes.

Convertible feature

Option to exchange a security for another type of issuer’s security at a preset price; generally lowers yields.

Callability

Issuer option to redeem a security before its stated maturity; affects the security’s price and yield.

Term to maturity

Remaining time until a security’s maturity; influences the shape of the yield curve.

Maturity premium (MP)

Change in required interest rate as maturity changes; can be positive, negative, or zero.

Yield curve

Graph of yields across maturities for securities with similar risk; shapes vary over time.

Unbiased expectations theory

Yield curve reflects market expectations of future short-term rates.

Liquidity premium theory

Long-term rates include a liquidity premium in addition to expected short-term rates.

Market segmentation theory

Investors have preferred maturities; rates are determined within separate maturity segments.

Time value of money

Idea that a dollar today is worth more than a dollar in the future due to potential earning capacity.

Present value (PV)

Value today of future cash flows, discounted by a rate.

Future value (FV)

Value at a future date of a current cash flow or series of cash flows.

Lump sum valuation

Valuation of a single future cash flow (PV and FV) over time.

Annuity valuation

Valuation of a series of equal payments received at regular intervals.