FIN 614: Financial Management Larry Schrenk, Instructor.

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Presentation transcript:

FIN 614: Financial Management Larry Schrenk, Instructor

1.Decomposition of the Interest Rate 2.Real Risk Free Rate (r * ) 3.Premia 1.Inflation Premium (IP) 2.Default Risk Premium (DRP) 3.Liquidity Premium (LP) 4.Maturity Risk Premium (MRP)

Market Rate of Interest r d = r * + IP + DRP + LP Liquidity Risk Premium Market Rate of Interest r d = r * + IP + DRP Default Risk Premium Market Rate of Interest r d = Market Rate of Interest r d = r * Real Risk Free Rate Market Rate of Interest r d = r * + IP + DRP + LP Liquidity Premium Recall Nominal vs. Real Distinction from Economics Market Rate of Interest r d = r * + IP Inflation Premium Market Rate of Interest r d = r * + IP + DRP + LP + MRP Maturity Risk Premium

Compensation for Opportunity Cost Contrast Nominal Risk Free Rate (r f ) Rate without Inflation Proxy: TIPS

Compensation for Inflation Average Expected Inflation over the Time Horizon Distinguish Actual Inflation from Expected Inflation Future, not Past Inflation Proxy: Short Term Treasury Bills NOTE: Nominal Risk Free Rate (r f ) r f = r * + IP

Compensation for Default Risk Default Risk: Possibility that a Firm will Default on their Bonds Factors: Indenture Clauses Collateral Seniority Bonds Ratings (Later Video)

Compensation for Lack of Liquidity ‘Liquidity’: Ability to Convert Asset into Cash In a Short Time at Fair Market Value Liquidity Different for Different Bond Markets E.g., Long Term Bonds Generally Less Liquid than Short Term Bonds

Compensation for Sensitivity to Interest Rate Risk Longer Bond, Greater Sensitivity Interest Rate Risk Price Risk Reinvestment Risk NOTE: Terminology here differs from the textbook

FIN 614: Financial Management Larry Schrenk, Instructor