Introduction to Finance

LO 8.1 
The interest rate
 
is the price of loanable funds in fi nancial 
markets, and the equilibrium interest rate is the price that equates the 
demand for and supply of loanable funds. Interest rates may move 
from an existing equilibrium level to a new equilibrium level as the 
result of a change in the supply of or demand for loanable funds. For 
example, if the quantity of loanable funds being demanded increases 
due to new business opportunities, suppliers of loanable funds will 
need to be off ered a higher interest rate so that the supply of and 
demand for loanable funds will be brought back into balance. 
LO 8.2 
The major components of market interest rates include a real 
rate of interest plus possible premiums for infl ation expectations, 
default risk, maturity risk, and lack of liquidity. A market interest rate 
that contains only a real rate of interest and an infl ation expectation 
component is considered to be a risk-free interest rate. For many debt 
instruments, there is an additional expected return for assuming the 
risk that the borrower may not pay interest and/or principal when 
due. For debt instruments with longer maturities, an added return 
is usually expected by lenders and debt investors as compensation 
for interest rate risk. Bond investors also may require compensation 
for holding debt instruments that are not easily converted to cash at 
prices close to their estimated fair market values. 
LO 8.3 
Marketable government securities are securities than can be 
purchased and sold through customary market channels. There are 
three types of U.S. Treasury marketable securities. Treasury bills 
are issued with maturities up to one year. Treasury notes are usually 
issued with maturities of two to 10 years. Treasury bonds are issued 
with maturities greater than 10 years. A little more than 40 percent 
of the outstanding Treasury securities are currently held by the Fed-
eral Reserve and in government accounts. Foreign and international 
investors currently hold approximately one-third of the amount of 
outstanding Treasury securities.
LO 8.4 
The term structure of interest rates indicates the relationship 
between interest rates, or yields, and the maturity of comparable quality 

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Review Questions
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debt instruments. This relationship is, typically, depicted through 
the graphic presentation of a yield curve. The three theories used to 
explain the term structure of interest rates are expectations theory, 
liquidity preference theory, and market segmentation theory.
LO 8.5 
Infl ation occurs when an increase in the price of goods or 
services is not off set by an increase in quality. Monetary factors have 
often aff ected price levels in the United States, especially during 
major wars. Since the end of the 1990s, infl ation rates have remained 
at relatively low levels. The four types of infl ation are cost-push infl a-
tion, which occurs when prices are raised to cover rising production 
costs such as wages; demand-pull infl ation, which occurs when an 
excessive demand for goods and services is created during periods 
of economic expansion as a result of large increases in the money 
supply; speculative infl ation; and administrative infl ation. 
LO 8.6 
Because debt investors are risk adverse, they expect higher 
returns for taking on more risk or uncertainty. Default risk is the risk 
that a borrower will not pay interest and/or principal on a debt instru-
ment when due. Diff erences between market interest rates on long-
term risky corporate bonds that are liquid, and the rates on long-term 
Treasury bonds, indicate the then-prevailing default risk premiums. 
Bond investors expect higher default risk premiums on corporate 
bonds that have lower bond ratings. 
Key Terms
administrative infl ation
cost-push infl ation
dealer system
default risk
default risk premium
demand-pull infl ation
equilibrium interest rate
expectations theory
high-yield or junk bonds
infl ation
infl ation premium
interest rate
interest rate risk
investment grade bonds
liquidity preference theory
liquidity premium
loanable funds
loanable funds theory
market interest rate
market segmentation theory
marketable government 
securities
maturity risk premium
nonmarketable government 
securities
real rate of interest
risk-free interest rate
speculative infl ation
term structure of interest rates 
Treasury bills
Treasury bonds
Treasury notes
yield curve
Review Questions