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**The Cost of Money (Interest Rates)**

Chapter 5 Requests for permission to make copies of any part of the work should be mailed to: Thomson/South-Western 5191 Natorp Blvd. Mason, OH 45040

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The Cost of Money Interest rates represent the prices paid to borrow funds Equity investors expect to receive dividends and capital gains

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**Realized Returns (Yields)**

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**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

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**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

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**Interest Rates - Supply & Demand for Funds**

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**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

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**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

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**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

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**Inflation Premium (IP)**

A premium for expected inflation that investors add to the real risk-free rate of return

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**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

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**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

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

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**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

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**Term Structure of Interest Rates**

Relationship between yields and maturities of securities The graph is a yield curve

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**U.S. Treasury Bond Interest Rates**

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**Yield Curve “Normal” Yield Curve Inverted (“Abnormal”) Yield Curve**

upward sloping yield curve Inverted (“Abnormal”) Yield Curve downward sloping yield curve

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**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

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**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

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**Other Factors That Influence Interest Rate Levels**

Federal Reserve policy Level of the federal budget deficit Foreign trade balance Level of business activity

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**Interest Rates and Stock Prices**

Higher interest rates increase costs and thus lower a firm’s profits Interest rates affect the level of economic activity and corporate profits Interest rates affect investment competition between stocks and bonds

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

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