INTEREST
RATES
Is the price that lenders
receive and borrowers pay for
debt capital.
LENDER BORROWER
are individuals, groups, or institutions that let you is any business entity or person who seeks the
borrow money for a set period of time and repay help of financial institutions called lenders to
it with interest. They come in various forms, from borrow the desired funds for investment or
banks and credit unions to friends and family and personal use. Most borrowers borrow at interest,
specialized institutions. meaning they pay a certain percentage of the
principal amount to the lender as compensation
for borrowing.
COST OF
MONEY
Interest rates are believed to
be the cost of money.
COST OF MONEY - is the rental
price of borrowing money. It is
also called “cost of equity”
COST O F E QUITY - it consists of
dividends and capi tal gains
expect ed by the shareholders.
COST OF EQUITY= DIVIDENDS +
CAPITAL GAINS
FOUR FUNDAMENTAL FACTORS
AFFECTING THE COST OF MONEY
Production Time preferences
Risk Inflation
Opportunities for consumption
In a financial market
Th e inv estmen t The preferences of
context, the chance that Th e amou n t by wh ich
o pp o rtu n ities in consumers as opposed
an investment will p rices in crease o v er
pro d u ctiv e (cash - to saving for future
provide a low or time.
gen erating ) assets consumption.
negative return.
EXAMPLE
In the story of Mr. Crusoe the fish that Ms. Robinson giving him now would represent savings and
investment.
The extra fish the net produced would be return on the investment.
Time preference for consumption is what would make Mr. Crusoe offer to appear attractive.
Mr. Crusoe’s ability to repay the loan affects the return that investors require because of the risk
inherent in the fishnet project.
When money is used as a medium of exchange rather than barter with fish, its value in the future is
affected by inflation.
INTEREST RATE PAID TO
SAVERS DEPENDS;
On the rate of return that
producers expect to earn on On the riskiness of the loan.
invested capital.
On saver’s time preferences for
On the expected future rate of
current versus future
inflation.
consumption.
INTEREST
RATE LEVELS
The going interest rate, designated as r, is initially 5% for
the low-risk securities. Borrowers whose credit is strong
enough to participate in this market can obtain funds at a
cost of 5%, and investors who want to put their money to
work without much risk can obtain a 5% return.
Riskier borrowers must obtain higher-cost funds in this
market, where investors who are willing to take risks expect
to earn a 7% return but also realize that they might receive
much less.
LONG- AND SHORT-TERM
INTEREST RATES
This figure shows how long- and
short-term interest rates to business
borrowers have varied.
RELATIONSHIP BETWEEN INFLATION
AND LONG-TERM INTEREST RATES
The relationship between long-term
and short-term rates is called term
The current interest rates minus the structure of interest rates.
current inflation rate is defined as the
“current real rate of interest”.
Long-term interest rates have been
volatile because investors are not sure
if inflation is truly under control or
jump back to the higher levels.
DETERMINANTS OF
MARKET INTEREST
RATES
Treasury Bond (T-Bond)- a marketable, fixed-
interest U.S. government debt security with a
maturity of more than 10 years. T-bonds make
interest payments semi-annually and the income Maturity Risk
that holders receive is only taxed at the federal
Premium (MRP)
level.
Liquidity
Premium (LP) Long-term bonds, even T-bonds, are
exposed to a significant risk of price
Default Risk A premium added to the equilibrium declines due to increases in interest
Inflation Premium (DRP) interest rate on a security if that rates; and a maturity risk premium is
The nominal, or Premium (IP)
security cannot be converted to cash
on short notice and at close to its fair
charged by lenders to reflect the
interest rate risk.
This premium reflects the possibility
quoted, risk-free that the borrower will not make market value.
A premium equal to expected
rate of interest (r*+ inflation that investors add to the
scheduled interest or principal
payments at the stated time.
MRP is paid to cover interest rate
risk- the risk of capital losses to
r* is the interestIP)
rate that would exist real risk-free rate of return. Liquid asset- can be converted to
which investors are exposed because
on a risk-less security if no inflation cash quickly at a fair market value.
If the risk-free rate was r*=1.7% and of changing interest rates.
were expected. DRP is the difference between the
if inflation was expected to be 1.5%;
quoted interest rate on a T-bond and
r*+IP is the real risk-free rate plus a the quoted rate of interest on 1-year Note: Although it is difficult to
that on a corporate bond with a Reinvestment Rate Risk- the risk
premium for expected inflation. This T-bills would be 1.7%+1.5%=3.2%. measure liquidity premiums
similar maturity, liquidity, and other that a decline in interest rates will
should be the interest rate on a accurately, we can get some sense of
features. lead to lower income when bonds
totally risk-free security. an asset’s liquidity by looking at its
mature and funds are reinvested.
trading volume.
TERM
YIELD
STRUCTURE
CURVE
OF
it describes the relationship
A graph showing the relationship
INTEREST
between bond yields and
between long- and short-term maturities.
RATES
rates. The term structure is
• Normal Yield Curve: An upward-
important to corporate treasurers
sloping yield
deciding whether to borrow by • Inverted (Abnormal) Yield Curve: A
issuing long- or short-term debt downward-sloping yield curve
and to investors who are • Humped Yield Curve: a yield curve
where interest rates on intermediate-
deciding whether to buy long- or
term maturities are higher than rates on
short-term bonds. both short- and long-term maturities.
WHAT DETERMINES THE SHAPE OF THE
YIELD CURVE?
PANE L A PANE L B
T hi s panel shows the treasury yield T his panel shows the yield curve
cur ve when inflation is expected to when inflation is expected to
Increase. decline.
L ong- ter m bonds have higher yields If the market expects inflation to
f or two reasons: decline in future, long-term bonds
1. I nf lation is expected to be will have smaller inflation premium
higher in the future. (thus lower rates) than short-ter m
2. T her e i s a positive maturity risk bonds.
pr emium.
FOR
EXAMPLE
PURE
EXPECTATIONS
THEORY
A theory that states that the shape of
the yield curve depends on
investors’ expectations about future
interest rates.
MACROECONOMIC FACTORS THAT
INFLUENCE INTEREST RATE LEVELS
The Fed buy and sells short-term securities to cause
short-term rates to decline. However, a larger
Federal Reserve money supply might lead to an increase in expected
future inflation, which would cause long-term rates
The larger the federal deficit, the higher the Policy to rise.
level of interest rates. Federal Budget
Budget Deficit- demand for funds is increasing. Deficits or
Budget Surplus- demand for funds is decreasing. Surpluses “Open Market Operations”- when businesses and
International individuals buy from and sells to people and firms
all around the globe.
Factors Foreign Trade Deficit- the situation that exists when
As high interest rates slow economic activity by a country imports more than it exports.
dampening overall demand for goods and services, both
businesses and consumers will face weaker economic
Business
prospects.
Activity
INTEREST RATES AND
BUSINESS DECISION
Assume that Leading Edge Co. is considering
building a new plant with a 30-year life that
will cost $1 million, and it plans to raise the $1
million by borrowing rather than issuing new
stock. At the time of its decision, the company
faces an upward-sloping yield curve. If it
borrows on a short-term basis from a bank for
1 year, its annual interest cost would be 4.0%
or $40,000. Therefore, at first glance, it would
seem that Leading Edge should use short-term
debt.
THANK
YOU
