Intro to Financial Management

Financial Markets and Interest Rates

Review

• Homework• What is the goal of the firm?

– Measured how?– What affects this measure?

• True or false, a business must focus on profits.• Explain the time value of money.• True or false, all risk is rewarded.• What is the Efficient Market Hypothesis?• What are agency problems?• What are the different corporate forms?• What are spot and future markets?• What is a spread?

Interest Rates

• Interest is the cost of money• Expressed in percent

– “Basis points”, bps, or “beeps”

• Nominal rate – quoted rate• Real risk-free interest rate – required rate of return on a

fixed-income security that has no risk with zero inflation– How much you want to get above inflation

• Premiums – rate required to take on additional risks

Interest Rates

Interest Rates

• Practical issues:– Which term security should be used for risk-free asset?– How should we measure inflation?

• Consider these:• 3-month T-Bill• 30-year Treasury Bond• Inflation rate• 30-year Aaa bond• 30-year TIPS

• How would you calculate:• Real risk-free rate of return• Inflation risk rate• Default rate risk• Maturity premium

Comparing Rates

• When you want to find out a rate or premium for which you don’t have a specific measure, find two other rates that differ only in that specific respect. (OK, I know that needs more explanation.)

• Example:– You want to know the default risk premium on a 30-year bond– No security shows that buy itself– Find two bonds that are similar in every respect except one has

a default risk and the other does not– See next slide

Comparing Rates

Maturity Inflation Risk

Default Risk

Risk-free Return

3-month T-Bill

3 months Yes No Yes

30-year Treasury Bond

30 years Yes No Yes

30-year Aaa bond

30 years Yes Yes No

30-year TIPS

30 years No No Yes

Comparing Rates - Example

• We want to know the default risk in 30 years.• Look at the previous table and find 3 bonds that mature

in 30 years.• Notice that the Aaa and T-Bond have the same risk

premiums with the only exception being default risk.• So, the difference in rates between the two bonds much

be because of the default risk premium.• Subtract the two rates and you get the default risk

premium.

Comparing Rates - Example

• We want to know the inflation risk in 30 years.• Look at the previous table and find 3 bonds that mature

in 30 years.• Notice that the TIPS and T-Bond have the same risk

premiums with the only exception being inflation risk.• So, the difference in rates between the two bonds much

be because of the inflation risk premium.• Subtract the two rates and you get the inflation risk

premium.

Comparing Rates – You Do It

• How do we find the maturity risk premium for 30-year bonds?

• How would you find the default risk premium of a Aaa bond vs. an BB bond?

Interest Rates

• Do Chapter 2 “Can You Do It?” p. 35

Interest Rates

(1 + nominal rate) = (1 + real rate)*(1 + inflation rate)

or

nominal rate = real rate + inflation rate + (real * inflation)

In practice, often use approximation:

nominal rate = real rate + inflation rate

Interest Rates

Examples

1.Want a real rate of return of 4%, inflation is 2%. What nominal rate do you need?

2.Bond yields are 10%, inflation is 6%. What is real rate?

3.30-year TIPS yield 6%, 30-year Treasuries yield 4%. What is the expected rate of inflation?

Interest Rates

• Simple, one-period, future value• The next period’s amount

– Your money back– Plus interest

FV = (1 + r) * PV

• Problems– Calculate how much money you will have next year– Calculate how much money you need now– Calculate what interest rate you need

Term Structure of Interest Rates

• Relationship between interest rates and maturity• “Yield to maturity”

The Yield Curve

Yield Curve

• Why does it look the way it does?