CHAPTER 6
INTEREST RATES
SOURCE OF CAPITAL
EQUITY DEBT
METHOD : Issuance of shares of stocks METHOD : Issuance of bonds
BALANCE SHEET EFFECT: BALANCE SHEET EFFECT:
+ Cash + Cash
+ Common stock + Bonds payable / Notes payable
PAYMENT TO INVESTORS (Shareholders): PAYMENT TO INVESTORS (Creditors):
Dividends Interest expense
(Considered as ROI by investors) (Considered as ROI by investors)
COST OF MONEY
FUNDAMENTAL FACTORS AFFECTING COST OF MONEY:
1. Production opportunities – Increased capacity due to infusion of capital.
2. Time preferences for consumption – Acceptable period and return of investment.
3. Risk – Inherent in the project.The higher the risk, the higher is the return.
4. Inflation – The higher the inflation rate, the higher is the required return of investment.
1 Fish each day = Buy Net
Increased production
After 1 year = Fish + Fish
Return on investment
The interest rate paid to savers depends
(1) on the rate of return that producers expect to earn on invested capital,
(2) on savers’ time preferences for current versus future consumption,
(3) on the riskiness of the loan, and
(4) on the expected future rate of inflation.
§ Producers’ expected returns on their business investments set an upper
limit to how much they can pay for savings,
§ while consumers’ time preferences for consumption establish how much
consumption they are willing to defer and hence how much they will save
at different interest rates.
§ Higher risk and higher inflation also lead to higher interest rates.
§ Borrowers whose credit is strong enough to participate in this market can obtain funds at a
a lower cost, and investors who want to put their money to work without much risk can obtain a lower return.
§ Riskier borrowers must obtain higher cost funds in Market H, where investors who are more willing to
take risks expect to earn a higher return but also realize that they might receive much less.
In this scenario, investors are willing to accept the higher risk in Market H in exchange for a risk premium.
§ Risk premium – Difference between the rate of returns of high risk portfolios versus low risk portfolios
§ Inflation has a major impact on interest rates because it erodes the real value
of what you receive from the investment.
§ Investors are well aware of all this; so when they lend money, they build an
inflation premium (IP) equal to the average expected inflation rate over the life of
the security into the rate they charge.
Actual interest rate on a short-term = real risk-free rate + Inflation premium
default-free treasury bills
rT-Bill = rRF = r* + IP
Therefore, if the real risk-free rate was r* = 1.7% and if inflation was expected to be 1.5%
(and hence IP = 1.5%) during the next year, the quoted rate of interest on 1-year T-bills would
be 1.7% + 1.5% + 3.2%.
Default Risk Premium (DRP)
§ The risk that a borrower will default, which means the
borrower will not make scheduled interest or principal payments,
§ Also affects the market interest rate on a bond:
The greater the bond’s risk of default, the higher the market rate.
Liquidity Premium (LP)
§ A “liquid” asset can be converted to cash quickly at a “fair market value.”
§ Real assets are generally less liquid than financial assets, but different
financial assets vary in their liquidity.
§ Because they prefer assets that are more liquid, investors include a
liquidity premium (LP) in the rates charged on different debt securities.
§ Although it is difficult to measure liquidity premiums accurately, we can get
some sense of an asset’s liquidity by looking at its trading volume.
Assets with higher trading volume are generally easier to sell
and are therefore more liquid.
§ The average liquidity premiums also vary over time.
Liquidity Premium (LP)
§ A “liquid” asset can be converted to cash quickly at a “fair market value.”
§ Real assets are generally less liquid than financial assets, but different
financial assets vary in their liquidity.
§ Because they prefer assets that are more liquid, investors include a
liquidity premium (LP) in the rates charged on different debt securities.
§ Although it is difficult to measure liquidity premiums accurately, we can get
some sense of an asset’s liquidity by looking at its trading volume.
Assets with higher trading volume are generally easier to sell
and are therefore more liquid.
Interest Rate Risk and the Maturity Risk Premium (MRP)
§ The prices of long-term bonds decline whenever interest rates rise, and
because interest rates can and do occasionally rise, all long-term bonds,
even Treasury bonds, have an element of risk called interest rate risk.
§ As a general rule, the bonds of any organization have more interest rate
risk the longer the maturity of the bond.
§ Therefore, a maturity risk premium (MRP), which is higher the
greater the years to maturity, is included in the required interest rate.
§ The effect of maturity risk premiums is to raise interest rates on long-term
bonds relative to those on short-term bonds.
Actual interest rate (r)
=
Nominal risk-free rate (r*)
+
Default Risk Premium (DRP)
+
Liquidity Premium (LP)
+
Maturity Risk Premium (MRP)
The Term Structure of Interest Rates
§ The term structure of interest rates describes the relationship
between long- and short-term rates.
§ The term structure is important to corporate treasurers deciding
whether to borrow by issuing long- or short-term debt and to investors
who are deciding whether to buy long- or short-term bonds.
§ Therefore, both borrowers and lenders should understand
(1) how long- and short-term rates relate to each other; and
(2) what causes shifts in their relative levels.
