The Cost of Money (Interest Rates)

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

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

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

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

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

6. Interest Rate Levels • Financial markets are interdependent

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

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

9. 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 1 to 4 percent in the U. S. in recent years

10. The 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

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

12. 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

13. 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

14. Interest Rate Risk • Risk of capital losses to which investors are exposed because of changing interest rates

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

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

17. 1 5 10 20 Years to Maturity Yield Curve Figure 5-4

18. Yield Curve • “Normal” Yield Curve • upward sloping yield curve • Inverted (“Abnormal”) Yield Curve • downward sloping yield curve

19. Term Structure Theories (Explanations) • 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 rather than long-term loans (all else equal)

20. Term Structure Theories (Explanations) • 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

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

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

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