1. The Cost of Money (Interest Rates)
Chapter 5
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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)