This chapter provides fundamental insights into the valuation of debt and explains why we see many different interest rates in the market. The five sections in the chapter describe the following:

• the relationship between nominal rates and real interest rates,
• the term structure (or variation of interest for different maturities) of interest rates,
• the concept of duration and how it affects the bond values when interest rates change,
• the theories of term structure, and,
• the risk structure and debt value.

The chapter is important and gives you answers to some vexing questions you would have on interest rates, debt values and their changes from time to time. Financial managers have to deal with the valuation of debt at some point or other and it is necessary that they understand the basic theoretical principles, which explain the relationship among the term structure, risk structure, and debt values.

The chapter begins with Irving Fisher's classical theory of interest. Fisher postulated that real rates of return are determined by the equilibration of the supply of and demand for real capital and are reasonably constant over time, and therefore, changes in nominal rates essentially reflect changes in inflation expectations. This insight has been fundamental to our understanding of changes in interest rates over time. While economists debate the validity of the strict version of Fisher’s theory, it appears that the broad relationship among inflation, nominal interest rates, and real interest rates support Fisher’s ideas.