Chapter 6: Interest Rates

Chapter 6: Interest Rates Slides for 12th, 13th and 14th session

Topics covered • Cost of Money (Introduction) • Factors affecting cost of money • Fundamental factors • Macroeconomic factors • Interest rate levels • Determinants of market interest rates • Term structure of interest rates • What determines the shape of the yield curve? • Analysis of the impact of different factors (inflation risk, maturity risk, liquidity risk, default risk) on the shape of yield curves for treasury and corporate securities • Risks associated with investment in overseas securities

Problems • 6-2 (2.25%) • 6-3 (2 yr: 6%, 3 yr: 6.33%) • 6-4 (1.5%) • 6-5 (0.2%) • 6-9 (6.8%) • 6-11 (1.55%) • 6-12 (0.35%) • 6-13 (1.775%)

1. INTRODUCTIONCost of money is the rental price of borrowing money • Suppose you go to a bank to borrow $10,000 for paying off college fees, you won’t be able to get this money for free. • The $10,000 come with a price tag attached, i.e. some rate of interest, consider for example a10% rate of interest. • This 10% interest rate is the cost of obtaining $10,000. This cost is also known as the ‘cost of money’.

In a free economy, excess funds of lenders are allocated to borrowers through a pricing system based on the supply of and demand for funds. This pricing system is represented by interest rates, ‘i’ or the cost of money. EXCESS FUNDS BORROWERS LENDERS PRICING SYSTEM (i) i Supply of funds i Demand of funds $

So, Now we know! • Supply and demand of funds determines the interest rates (i). • It is by providing these rates that the borrowers make use of the funds provided by the lenders.

Generally interest rates are believed to be the cost of money. • However, in case of equity capital, • Cost of money is called ‘Cost of equity’ and it consists of dividends and capital gains expected by the share holders • Cost of equity = Dividends + Capital Gains

Remember!

DEBT CAPITAL BANK (PROVIDER) MONEY CORPORATION ABC (USER) COST OF MONEY (i) Return for the funds provider Cost for the user of funds EQUITY CAPITAL STOCK-HOLDERS (PROVIDER) MONEY CORPORATION ABC (USER) COST OF MONEY (D+C.G.) Return for the funds provider Cost for the user of funds

QUICK FLASHBACK! • ‘i’ is the cost of obtaining money. • Supply and demand of funds determines the interest rates.

2. Factors affecting cost of money, ‘i’ i. Fundamental factors affecting cost of money, ‘i’ The four most fundamental factors affecting the cost of money are: • Production opportunities • Rate of return that producers expect to earn on invested capital. • Time preferences for consumption • The preferences of consumers for current consumption as opposed to saving for future consumption. Preference for current consumption Supply of funds Interest rate • Riskiness of loan • The chance that an investment will provide a low or negative return. • Inflation • The amount by which prices increase over time. Expected Inflation Demand of funds Interest rate For highly risky loans investors expect high rate of return, i.e. high ‘i’

ii. Macroeconomic factors affecting cost of money, ‘i’ • Monetary policy tools • Federal Reserve Policies • Open Market Operations • Business boom • Business recession • Government budget deficit and surplus

1. Federal Reserve Policies • An increase in required reserve ratio by central bank means reduction in volume of deposits which raises interest rates. RRR Supply of funds Interest rate • A decrease in required reserve ratio means availability of excess deposits which decreases interest rates. RRR Supply of funds Interest rate

2. Open Market Operations • Central bank buys back securities from open market thus injecting money into the system (increasing supply of money) which decreases interest rates. • Central bank sells securities into open market thus absorbs money from the system (decreasing supply of money) which increases interest rates.

3. Business booms Increased demand of funds Inflationary pressures i 4. Business recession Decreased demand of funds Inflationary pressures i 5. Government budget deficit Government needs funds which means demand for funds i 6. Government budget surplus Government does not need funds which means demand for funds i

3. INTEREST RATE LEVELS • Capital is allocated to borrowers according to interest rates, i. • Most capital across the world is allocated through the price system (that is, interest rate). • As can be seen in the figure below the excess funds of lenders are allocated to the borrowers through a price system that is the interest rate.

INTEREST RATE LEVELS • The firms with the most profitable investment opportunities are willing and able to pay the most for capital, so they tend to attract it away from inefficient firms and firms whose products are not in demand. • There are many different types of capital markets (for example, market for high risk securities, market for low risk securities etc.) and they are all interconnected. • Interdependence of capital markets • Capital markets are interdependent, i.e. changes in supply and demand of funds in one market are going to produce an impact on the supply and demand of funds in the other market/s.

4. THE DETERMINANTS OF MARKET INTEREST RATES • The interest rate quoted on any debt security is composed of a real risk-free rate, r* (k *), plus several premiums that reflect inflation, the security’s risk, its liquidity (or marketability), and the years to its maturity. This relationship can be expressed as follows: Quoted interest rate = k = k* + IP + DRP + LP + MRP The quoted risk free rate can be written as ‘k’ or ‘r’. Similarly the real risk free rate can also be written as ‘k*’ or ‘r*’.

Main determinants of market interest rates • K = the quoted, or nominal, rate of interest on a given security. • k* =the real risk-free rate of interest. k* is pronounced “k-star,” and it is the rate that would exist on a riskless security in a world where no inflation was expected. • Krf= k* x IP. It is the quoted rate on a risk-free security such as a Treasury bill and it includes a premium for expected inflation. • IP =inflation premium. IP is equal to the average expected rate of inflation over the life of the security. • DRP = default risk premium. This premium reflects the possibility that the issuer will not pay the promised interest or principal at the stated time. DRP is zero for Treasury securities, but it rises as the riskiness of the issuer increases. • LP = liquidity (or marketability) premium. This is a premium charged by lenders to reflect the fact that some securities cannot be converted to cash on short notice and at a “reasonable” price.

8. MRP = maturity risk premium. Longer-term bonds, even Treasury bonds, are exposed to a significant risk of price declines due to increases in interest rates; and a maturity risk premium is charged by lenders to reflect the interest rate risk. MRP is paid to cover interest rate risk. • Interest rate risk: The risk of capital losses to which investors are exposed because of changing interest rates. While long term bonds are exposed to interest rate risk, short term bonds are exposed to reinvestment rate risk. • Reinvestment rate risk: The risk that a decline in interest rates will lead to lower income when bonds mature and funds are reinvested.

5. Term Structure of Interest Rates • Describes the relationship between long term and short term interest rates. • The term structure is important to corporate treasurers for deciding whether to borrow by issuing long- or short-term debt and to investors deciding whether to buy long- or short-term bonds. • Yield curve can best depict this relationship. • Yield curve is actually a graph showing relationship between bond yields and maturities. • Three different types of Yield Curves: • “Normal” Yield Curve • Upward sloping yield curve • Short term interest rates are low, long term interest rates are high. • Inverted (“Abnormal”) Yield Curve • Downward sloping yield curve • Short term interest rates are high, long term interest rates are low. • Humped yield curve • A yield curve where interest rates on medium-term maturities are higher than rates on both short-and long-term maturities.

6. What determines the shape of the yield curve? Factors affecting shape of treasury securities • Yield on a Treasury bond that matures in t years can be expressed as follows: • T-bond yield = K* +IPt + MRPt • It thus emerges that expected inflation levels and bond’s maturity are the main factors affecting shape of yield curve of treasury securities. (Value of real risk free rate of interest, K* varies somewhat over time because of changes in the economy and demographics, these changes are random rather than predictable, K* thus is assumed to remain constant.) • Inflation • Expected inflation has an important effect on the yield curve for treasury securities. If the market expects inflation to increase in the future, the inflation premium will be higher on a 3-year bond than on a 1-year bond. On the other hand, if the market expects inflation to decline in the future, long-term bonds will have a smaller inflation premium than will short-term bonds. • Maturity • Since investors consider long-term bonds to be riskier than short-term bonds because of interest rate risk, the maturity risk premium always increases with maturity.

Factors affecting shape of Corporate bonds • Corporate bonds include a default risk premium (DRP) and a liquidity premium (LP). Therefore, the yield on a corporate bond that matures in t years can be expressed as follows: • Corporate bond yield = K* +IPt+ DRPt+ LPt+ MRPt • The corporate bonds carry additional default and liquidity risks, this is the reason they pay premium for covering these risks which is why the ‘i’ (interest rate) paid on corporate bond, also called the yield, is always higher than that paid by treasury bonds.

Because of their additional default and liquidity risk, corporate bonds yield more than treasury bonds with the same maturity and BBB-rated bonds yield more than AA-rated bonds.

7. Risks associated with investment in overseas securities • Two main types of risks that an investor, looking to invest in foreign securities, faces are: country risk and exchange rate risk. • Country risk • Risk that arises from investing or doing business in a particular country • This risk depends on a country’s economic, social and political environment. • Countries with safer political, social and economic environment have less country risk and therefore are safe choices for overseas investment.

Exchange rate risk • Risk of losing money in local currency because of fluctuation in the value of foreign currency (in which investment was being made). • Recall example narrated in class (Pakistani earning US dollars and praying for weak Pakistani rupee relative to US dollar). • Suppose a US investor purchases Japanese bond. The US investor gets interest rate in Japanese currency (yen) which must then be converted into US dollars whenever he wants to make a purchase (as the investor resides in the US). Whenever yen strengthens in comparison to dollar it means yen can be converted into a larger number of US dollars and the investor will be better off. On the other hand if yen weakens relative to dollar, it would mean yen’s conversion into dollar will give off fewer dollars and the investor will have to suffer.

Interest rate determination • Formula for calculation of interest rate on short term treasury securities: • Quoted interest rate = Real risk free rate + inflation premium • K = K* + IPt • Formula for calculation of interest rate on long term treasury securities: • Quoted interest rate = Real risk free rate + inflation premium + maturity risk premium • K = K* + IPt + MRPt

Interest rate determination • Formula for calculation of interest rate on corporate securities: • K= K* +IPt+ DRPt+ LPt+ MRPt • Quoted interest rate = Real risk free rate + inflation premium + default risk premium + liquidity premium + maturity risk premium

Chapter 6: Interest Rates