The Cost of Money (Interest Rates)

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

• Interest rates represent the prices paid to
  borrow funds
• Equity investors expect to receive dividends and
  capital gains

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Realized Returns (Yields)
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Factors that Affect the Cost of Money

• Production opportunities
• returns available within an economy from
  investment in productive assets
• Time preferences for consumption
• the preferences of consumers for current
  consumption as opposed to saving for future
  consumption

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Factors that Affect the Cost of Money

• Risk
• the chance that a financial asset will not earn
  the return promised
• Inflation
• the tendency of prices to increase over time

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Interest Rates - Supply Demand for Funds
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Determinants of Market Interest Rates

• Quoted interest rate

k (k IP) DRP LP MRP kRF
DRP LP MRP

• k the quoted or nominal rate
• k the real risk-free rate of interest
• kRF the quoted, or nominal risk-free rate
• IP inflation premium
• DRP default risk premium
• LP liquidity, or marketability, premium
• MRP maturity risk premium

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The Real Risk-Free Rate of Interest, k

• The rate of interest that would exist on
  default-free U. S. Treasury securities if no
  inflation were expected
• Ranges from 2 to 4 percent in the U. S. in recent
  years

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Nominal Risk-Free Rate of Interest, kRF

• kRF k IP
• The rate of interest on a security that is free
  of all risk, except inflation
• Proxied by the T-bill rate or T-bond rate
• kRF includes an inflation premium

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Inflation Premium (IP)

• A premium for expected inflation that investors
  add to the real risk-free rate of return

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Default Risk Premium (DRP)

• Difference between the interest rate on a U. S.
  Treasury bond and a corporate bond of equal
  maturity and marketability
• Compensates for risk that a borrower will default
  on a loan

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Liquidity Premium (LP)

• 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

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Interest Rate Risk

• Risk of capital losses to which investors are
  exposed because of changing interest rates

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Maturity Risk Premium (MRP)

• Premium that reflects the interest rate risk
• Bonds with longer maturities have greater
  interest rate risk
• Reinvestment rate risk is greater for short-term
  bonds

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Term Structure of Interest Rates

• Relationship between yields and maturities of
  securities
• The graph is a yield curve

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U.S. Treasury Bond Interest Rates
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Yield Curve

• Normal Yield Curve
• upward sloping yield curve
• Inverted (Abnormal) Yield Curve
• downward sloping yield curve

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Why Do Yield Curves Differ?

• Expectations theory
• shape of the yield curve depends on investors
  expectations about future inflation rates
• Liquidity preference theory
• lenders prefer to make short-term loans borrowers
  prefer long-term debt

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Why Do Yield Curves Differ?

• Market segmentation theory
• 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

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Other Factors That Influence Interest Rate Levels

• Federal Reserve policy
• Level of the federal budget deficit
• Foreign trade balance
• Level of business activity

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Interest Rates and Stock Prices

• Higher interest rates increase costs and thus
  lower a firms profits
• Interest rates affect the level of economic
  activity and corporate profits
• Interest rates affect investment competition
  between stocks and bonds

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