The Cost of Money Interest Rates Chapter 5

The Cost of Money (Interest Rates) Chapter 5

The Cost of Money u Interest rates represent the prices paid to borrow funds u Equity investors expect to receive dividends and capital gains

The Cost of Money u 1. Production opportunities F returns available within an economy from investment in productive assets u 2. Time preferences for consumption F the preferences of consumers for current consumption as opposed to saving for future consumption

The Cost of Money u 3. Risk F the chance that a financial asset will not earn the return promised u 4. Inflation F the tendency of prices to increase over time

Interest Rate Levels u Supply and demand interact to determine interest rates between capital markets u Demand typically declines during business recessions, shifting the equilibrium rate down

Interest Rate Levels u Financial markets are interdependent

Interest Rate Levels u Financial markets are interdependent u Shifts in risk premiums, inflation rates, supply, and demand affect segments of the market differently

Determinants of Market Interest Rates u Quoted interest rate = F k = k* + IP + DRP + LP + MRP v k=the quoted or nominal rate v k*=the real risk-free rate of interest v IP=inflation premium v DRP=default risk premium v LP=liquidity, or marketability, premium v MRP, maturity risk premium

The Real Risk-Free Rate of Interest, k* u The rate of interest that would exist on default-free U. S. Treasury securities if no inflation were expected u Ranges from 1 to 4 percent in the U. S. in recent years

The Nominal Risk-Free Rate of Interest, k. RF u k. RF = k* + IP u The rate of interest on a security that is free of all risk, except inflation u Proxied by the T-bill rate or T-bond rate u k. RF includes an inflation premium

Inflation Premium (IP) u A premium for expected inflation that investors add to the real risk-free rate of return

Default Risk Premium (DRP) u Difference between the interest rate on a U. S. Treasury bond a corporate bond of equal maturity and marketability u Compensates for risk that a borrower will default on a loan

Liquidity Premium (LP) u Premium added to the rate on a security if the security cannot be converted to cash on short notice and at close to the original cost

Interest Rate Risk u Risk of capital losses to which investors are exposed because of changing interest rates

Maturity Risk Premium (MRP) u Premium that reflects the interest rate risk u Bonds with longer maturities have greater interest rate risk u Reinvestment rate risk

Term Structure of Interest Rates u Relationship between yields and maturities of securities u The graph is a yield curve

Yield Curve Figure 5 -4 1 5 10 20 Years to Maturity

Yield Curve u “Normal” Yield Curve F upward sloping yield curve u Inverted (“Abnormal”) Yield Curve F downward sloping yield curve

Term Structure Theories (Explanations) u Expectations theory F shape of the yield curve depends on investors’ expectations about future inflation rates u Liquidity preference theory F lenders prefer to make short-term loans rather than long-term loans (all else equal)

Term Structure Theories (Explanations) u Market segmentation theory F each borrower has a preferred maturity and the slope of the yield curve depends on the supply of and demand for funds in the long-term market relative to the short-term market

Other Factors That Influence Interest Rate Levels u Federal Reserve policy u Level of the federal budget deficit u Foreign trade balance u Level of business activity

Interest Rates and Stock Prices u Higher interest rates increase costs and thus lower a firm’s profits u Interest rates affect the level of economic activity and corporate profits u Interest rates affect investment competition between stocks and bonds

End of Chapter 5 The Cost of Money (Interest Rates)