How to Work Out Interest Rate

One way to describe the great variety of debt securities is to graph the relationship between interest and security life for a particular class of debt securities, such as U.S. Treasury securities. This shows how to work out interest rate depends on the amount of time the money will be invested. This relationship is called a yield curve. 

The Term Structure of Interest Rates

One form of yield curve has a special name. The yield curve for zero-coupon U.S. Treasury securities is called the term structure of interest rates. (Zero-coupon means there are no payments until the end of the security's life, so that such securities always trade on a discount basis). Informally, the phrase term structure is sometimes used to refer to the relationship between the life of a debt security and interest rates generally. We will use this phrase as well. 

Federal Funds Market

Available lives vary widely. At one extreme, investors borrow for less than a day. For example, banks borrow overnight in the federal funds market. At the other extreme, governments and companies regularly issue bonds with lives of up to 30 years and sometimes even as long as 100 years. A virtual continuum of lives exists between life. Figure No. 01 shows an example of the common upward sloping term structure of interest rates. There are much less frequent periods when the reverse is true, the term structure is downward sloping. Figure No. 02 illustrates this unusual structure. Note that in both cases the curve flattens out as remaining life increases, because differences in interest rates typically become less and less significant with longer life.

How to Work Out Interest Rate  Fig 01

How to Work Out Interest Rate  Fig 02

Offset Tax Liabilities

Interest rates are affected by the risk of default and the taxability of the returns. Investors require higher returns to offset tax liabilities and the possibility of default. For this reason, the securities used to compile a yield curve must all have the same default risk and tax status, such as the zero-coupon U.S. Treasury securities used to create the term structure of interest rates. In addition to tax considerations, several other factors affect the term structure of interest rates.

At the most basic level, investors sometimes have a particular desired security life because they plan to use the money for specific needs, such as retirement or a down payment on a house. So investors may seek to invest in securities with lives that match their needs. Beyond specific needs, shorter lives provide more liquidity and greater financial flexibility, a form of option that the Options Principle tells us is valuable.

If all else is equal, longer-lived securities are riskier. Much of this risk depends on inflation expectations, which are an important determinant of interest rates. Therefore, if all else is equal, the Principle of Risk-Return Trade-Off implies that investors will require a higher interest rate (return) to bear the extra risk. This is the basis for the idea that the term structure should usually be upward sloping.

Expect Interest Rates

Finally, investors also take into consideration what they expect interest rates to be in the future. That is, if investors believe that long-term interest rates are going to be higher next in a cookie jar while they wait. They put the money in short-term investments, such as money market securities. This kind of "waiting" increases the supply of short-term funds and at the same time decreases the supply of long-term funds. The shift in these supplies lowers the short term rate and increases the long term rate, which increases the upward slope of the curve. The reverse happens when investors believe interest rates are going to decrease. This can bring about a downward sloping term structure. Unusual expectations can even lead to oddly shaped curves that are not consistently upward or downward sloping.

The Principle of Capital Market Efficiency tells us that the term structure reflects all the available information about the collective impact of all these factors at any point in time.

Business Ethics

Ethics consists of standards of conduct or moral judgment. Business ethics is a topic of great concern because of the complexity of the complexity of business relationship. Recall the set of contracts model of the company. The company is at the center of relationships with many stakeholders, such as customers, employees, managers, shareholders, creditors, suppliers, the community and governmental units. High standards of ethical conduct require that each stakeholder be dealt with in an honest and fair manner.
There are different levels of ethical behavior. At the most basic level, ethical behavior requires that you comply fully with all of the rules and regulations that apply to your behavior. Failure to do so can result in substantial penalties that include time in jail and fines assessed by regulatory agencies and by courts. The financial consequences often go far beyond these penalties. Many individuals have lost their careers and businesses have gone bankrupt, because of unethical behavior. The gains from unethical behavior sometimes have been small compared to the ultimate losses due to the loss of trust and reputation.
But behaving ethically means much more than simply following rules and regulations it requires making personal judgments about right and wrong. Some people believe business is inherently corrupt, immoral and unethical. However, many others assert that high ethical standards are essential to the profitability and survival of the company and that ethics in business may be higher than in other segments of society. Why do so many feel that ethical behavior is essential to profitability? There are some clear answers.

1. Ethical behavior avoids fines and legal expenses.
2. It builds customer loyalty and sales.
3. It helps attract and keep high quality employees and managers.
4. It builds public confidence and adds to the economic development of the communities in which the company operates.
5. A good reputation enhances relations with the company's investors.

Ethical behavior can be a necessity for companies to operate profitably and to survive.
Many companies have formal codes of ethics that are a prominent part of their corporate cultures. Managers are often very careful to explore the ethical dimensions of their decisions. Furthermore, if you join a profession such as accounting, financial analysis, personnel management or real estate brokerage there will be professional societies with codes of ethics you must know and follow and find how to work out interest rate. In addition, professionals in many fields are regulated by government agencies and are thus subject to special licensing procedures and rules of conduct.