CHAPTER 6 Interest Rates

1. CHAPTER 6Interest Rates Determinants of interest rates The term structure and yield curves Investing overseas

2. The cost of money • The price, or cost, of debt capital is the interest rate. • The price, or cost, of equity capital is the required return. The required return investors expect is composed of compensation in the form of dividends and capital gains.

3. What four factors affect the cost of money? • Production opportunities • Time preferences for consumption • Risk • Expected inflation

4. “Nominal” vs. “Real” rates k = represents any nominal rate k* = represents the “real” risk-free rate of interest. Like a T-bill rate, if there was no inflation. Typically ranges from 1% to 4% per year. kRF = represents the rate of interest on Treasury securities.

5. Determinants of interest rates k = k* + IP + DRP + LP + MRP k = required return on a debt security k* = real risk-free rate of interest IP = inflation premium DRP = default risk premium LP = liquidity premium MRP = maturity risk premium

6. Premiums added to k* for different types of debt

7. Yield curve and the term structure of interest rates • Term structure – relationship between interest rates (or yields) and maturities. • The yield curve is a graph of the term structure. • A Treasury yield curve from October 2002 can be viewed at the right.

8. Add the IPs and MRPs to k* to find the appropriate nominal rates Step 3 – Adding the premiums to k*. kRF, t = k* + IPt + MRPt Assume k* = 3%, kRF, 1 = 3% + 5.0% + 0.0% = 8.0% kRF, 10 = 3% + 7.5% + 0.9% = 11.4% kRF, 20 = 3% + 7.75% + 1.9% = 12.65%

9. Interest Rate (%) 15 Maturity risk premium 10 Inflation premium 5 Real risk-free rate Years to Maturity 0 1 10 20 Hypothetical yield curve • An upward sloping yield curve. • Upward slope due to an increase in expected inflation and increasing maturity risk premium.

10. What is the relationship between the Treasury yield curve and the yield curves for corporate issues? • Corporate yield curves are higher than that of Treasury securities, though not necessarily parallel to the Treasury curve. • The spread between corporate and Treasury yield curves widens as the corporate bond rating decreases.

11. BB-Rated AAA-Rated Illustrating the relationship between corporate and Treasury yield curves Interest Rate (%) 15 10 Treasury Yield Curve 6.0% 5.9% 5 5.2% Years to Maturity 0 0 1 5 10 15 20

12. Other factors that influence interest rate levels • Federal reserve policy • Federal budget surplus or deficit • Level of business activity • International factors

13. Risks associated with investing overseas • Exchange rate risk – If an investment is denominated in a currency other than U.S. dollars, the investment’s value will depend on what happens to exchange rates. • Country risk – Arises from investing or doing business in a particular country and depends on the country’s economic, political, and social environment.

14. Top 5 countries (least risk) Bottom 5 countries (most risk) Rank Country Score Rank Country Score 1 Switzerland 95.2 169 Afghanistan 11.0 2 Luxembourg 93.9 170 Liberia 9.4 3 United States 93.7 171 Sierra Leone 9.3 4 Norway 93.7 172 North Korea 8.9 5 United Kingdom 93.6 173 Somalia 8.2 Country risk rankings Source: “Country Ratings by Region,” Institutional Investor, www.institutionalinvestor.com, September 2004.

15. Factors that cause exchange rates to fluctuate • Changes in relative inflation • Changes in country risk