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What is the cost of money, and how is it determined?

What factors affect interest rates?

What is a yield curve?

How do government actions and business activity affect interest rates?

How does the level of interest rates affect the values of stocks and bonds?

The Cost of Money

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Yield Dollar return

Beginning value

Dollar income + Capital gains

Beginning value

Dollar income + (Ending value -Beginning value)

Beginning value

Realized Returns

50.0%0.50$10

$5

$10

$10) - ($12 + $3

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Cost of Money

Interest rates are based on:Production Opportunities—greater production opportunities, greater demand for fundsTime Preference for Consumption—individuals save less if they have a great need for current consumptionRisk—investors demand higher returns for riskier investmentsInflation—investors save to increase their ability to purchase in the future

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Interest Rates—Levels

Function of supply and demand

Dollars

InterestRate, r

S1

D1

7.0

D2

8.5

Interest rates fluctuate continuously

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Interest Rates—Determinants

0 Risk

Return (r)

rRF

Risk-Free Return = rRF

Risk Premium = RP r = rRF + RP

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Interest Rates—Determinants

r = rRF + RP

=[r* + IP]

r* = real risk-free rateIP = inflation premiumDRP = default risk premium

LP = liquidity (marketability) premiumMRP = maturity risk premium

r* = real risk-free rateIP = inflation premium

= rRF

DRP = default risk premiumLP = liquidity (marketability) premiumMRP = maturity risk premium

= RP

r = rRF + RP

=[r* + IP] + [DRP + LP + MRP]

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Premiums Added to r* for Different Types of Debt

Short-Term Treasury: only IP for S-T inflation

Long-Term Treasury: IP for L-T inflation, MRP

Short-Term corporate: Short-Term IP, DRP, LP

Long-Term corporate: IP, DRP, MRP, LP

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Term Structure of Interest Rates—Yield Curve

Rate(Yield)

Maturity

Rate(Yield)

Upward sloping

Downward sloping

Flat

Short-Term Bonds Long-Term Bonds

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U.S. Treasury Bond Interest Rates on Different Dates

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Term Structure of Interest Rates

Explanations for the shape of a yield curve: Expectations Theory—slope of yield

curve is the same as expected interest movements

Liquidity Preference Theory—investors prefer more liquidity to less

Market Segmentation Theory—market is segmented by maturity (LT or ST)

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Interest Rates

Other Factors that Influence Interest Rates

Federal Reserve Policy

Federal Deficits

Foreign Trade Balance

Business Activity

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Interest Rates

Interest Rate Levels and Stock Prices:highly correlated

Interest Rates and Business Decisions:a firm’s decisions concerning what types of financing should be used for invest-ments in assets is based on forecasts of future interest rates

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Forecasting Interest Rates

Exp Infl

Year Each Yr Avg Inflation Per Yr, IPt

20x1 1%20x1 1% = 1%/1 = 1%

20x2 5% = (1%+5%)/2 = 3%

20x3 6% = (1%+5%+6%)/3 = 4%

20x1 1% = 1%/1 = 1%20x1 1% = 1%/1 = 1%

20x2 5%

20x1 1% = 1%/1 = 1%

20x2 5% = (1%+5%)/2 = 3%

20x1 1% = 1%/1 = 1%

20x2 5% = (1%+5%)/2 = 3%

20x3 6%

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Forecasting Interest Rates

If the real risk-free rate, r*, is 3 percent, then the forecasted yields on bonds will be:

Bond Type r* + IPt = Nominal Rate,

rRF1-year bond 3% + 1% = 4%

2-year bond 3% + 3% = 6%

3-year bond 3% + 4% = 7%

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Forecasting Interest Rates

Expected Rate on aYear r* Annual Infl 1-Year Bond

20x1 3% 1% 4%20x2 3% 5% 8%20x3 3% 6% 9%

1-year bond 4%/1 =4.0%2-year bond (4% + 8%)/2 =6.0%3-year bond (4% + 8% + 9%)/3 =7.0%

Bond Type Average of 1-Year Rates rRF

1-year bond (4% + 8%)/2 =6.0%3-year bond (4% + 8% + 9%)/3 =7.0%

1-year bond (4% + 8%)/1 =8.0%3-year bond (4% + 8% + 9%)/3 =7.0%

1-year bond (4% + 8%)/1 =8.0%2-year bond (4% + 8% + 9%)/3 =7.0%

1-year bond (4% + 8%)/1 =8.0%2-year bond (4% + 8% + 9%)/2 =8.5%

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The Cost of Money as a Determinant of Value

nn

22

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r)(1CF

r)(1CF

r)(1CF

Asset an of Value

r r r

r = required rate of return

tCF

= expected cash flow in Period t

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Answers to Questions

What is the cost of money, and how is it determined?The interest rate that lenders charge

borrowers. Determined by the supply of funds and the demand for those funds.

What factors affect interest rates?Production opportunities, time preferences

for consumption, risk, inflation.

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Answers to QuestionsWhat is a yield curve?A snapshot of the relationship between short-

term and long-term interest rates at a particular time.

How do government actions and business activity affect interest rates?Government borrowing exerts pressure on the

demand for funds and may inflate interest rates.

How does the level of interest rates affect the values of stocks and bonds?When rates increase in the financial markets, the

values of assets decrease.