Presentation is loading. Please wait.

Presentation is loading. Please wait.

The Cost of Money (Interest Rates)

Similar presentations

Presentation on theme: "The Cost of Money (Interest Rates)"— Presentation transcript:

1 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

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

3 Realized Returns (Yields)

4 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

5 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

6 Interest Rates - Supply & Demand for Funds

7 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

8 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

9 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

10 Inflation Premium (IP)
A premium for expected inflation that investors add to the real risk-free rate of return

11 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

12 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

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

14 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

15 Term Structure of Interest Rates
Relationship between yields and maturities of securities The graph is a yield curve

16 U.S. Treasury Bond Interest Rates

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

18 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

19 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

20 Other Factors That Influence Interest Rate Levels
Federal Reserve policy Level of the federal budget deficit Foreign trade balance Level of business activity

21 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

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

Download ppt "The Cost of Money (Interest Rates)"

Similar presentations

Ads by Google