Title: The Cost of Money (Interest Rates)
1The Cost of Money(Interest Rates)
Chapter 5
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2The Cost of Money
- Interest rates represent the prices paid to
borrow funds - Equity investors expect to receive dividends and
capital gains
3Realized Returns (Yields)
4Factors 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
5Factors 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
6Interest Rates - Supply Demand for Funds
7Determinants of Market Interest Rates
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
8The 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
9Nominal 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
10Inflation Premium (IP)
- A premium for expected inflation that investors
add to the real risk-free rate of return
11Default 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
12Liquidity 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
13Interest Rate Risk
- Risk of capital losses to which investors are
exposed because of changing interest rates
14Maturity 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
15Term Structure of Interest Rates
- Relationship between yields and maturities of
securities - The graph is a yield curve
16U.S. Treasury Bond Interest Rates
17Yield Curve
- Normal Yield Curve
- upward sloping yield curve
- Inverted (Abnormal) Yield Curve
- downward sloping yield curve
18Why 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
19Why 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
20Other Factors That Influence Interest Rate Levels
- Federal Reserve policy
- Level of the federal budget deficit
- Foreign trade balance
- Level of business activity
21Interest 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
22End of Chapter 5
The Cost of Money(Interest Rates)