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The Cost of Money (Interest Rates)

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Title: The Cost of Money (Interest Rates)


1
The Cost of Money(Interest Rates)
Chapter 5
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2
The Cost of Money
  • Interest rates represent the prices paid to
    borrow funds
  • Equity investors expect to receive dividends and
    capital gains

3
Realized Returns (Yields)
4
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

5
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

6
Interest Rates - Supply Demand for Funds
7
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

8
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

9
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

10
Inflation Premium (IP)
  • A premium for expected inflation that investors
    add to the real risk-free rate of return

11
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

12
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

13
Interest Rate Risk
  • Risk of capital losses to which investors are
    exposed because of changing interest rates

14
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

15
Term Structure of Interest Rates
  • Relationship between yields and maturities of
    securities
  • The graph is a yield curve

16
U.S. Treasury Bond Interest Rates
17
Yield Curve
  • Normal Yield Curve
  • upward sloping yield curve
  • Inverted (Abnormal) Yield Curve
  • downward sloping yield curve

18
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

19
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

20
Other Factors That Influence Interest Rate Levels
  • Federal Reserve policy
  • Level of the federal budget deficit
  • Foreign trade balance
  • Level of business activity

21
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

22
End of Chapter 5
The Cost of Money(Interest Rates)
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