1 / 18

What is the cost of money, and how is it determined? What factors affect interest rates?

The Cost of Money. What is the cost of money, and how is it determined? What factors affect interest rates? What is a yield curve? How do government actions and business activity affect interest rates? How does the level of interest rates affect the values of stocks and bonds?.

leon
Download Presentation

What is the cost of money, and how is it determined? What factors affect interest rates?

An Image/Link below is provided (as is) to download presentation Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript

  1. The Cost of Money • What is the cost of money, and how is it determined? • What factors affect interest rates? • What is a yield curve? • How do government actions and business activity affect interest rates? • How does the level of interest rates affect the values of stocks and bonds?

  2. Realized Returns

  3. Cost of Money Interest rates are based on: • Production Opportunities—greater production opportunities, greater demand for funds • Time Preference for Consumption—individuals save less if they have a great need for current consumption • Risk—investors demand higher returns for riskier investments • Inflation—investors save to increase their ability to purchase in the future

  4. Interest Rate, r Dollars Interest Rates—Levels • Function of supply and demand S1 8.5 7.0 D2 D1 • Interest rates fluctuate continuously

  5. Return (r) Risk 0 Interest Rates—Determinants Risk Premium = RP r= rRF + RP rRF Risk-Free Return = rRF

  6. Interest Rates—Determinants r = rRF+RP =[r* + IP]+[DRP + LP + MRP] r = rRF+RP =[r* + IP] r* = real risk-free rate IP= inflation premium r* = real risk-free rate IP= inflation premium = rRF DRP= default risk premium LP= liquidity (marketability) premium MRP= maturity risk premium DRP= default risk premium LP= liquidity (marketability) premium MRP= maturity risk premium = RP

  7. Premiums Added to r* for Different Types of Debt • Short-Term Treasury: only IP for S-T inflation • Long-Term Treasury: IP for L-T inflation, MRP • Short-Term corporate: Short-Term IP, DRP, LP • Long-Term corporate: IP, DRP, MRP, LP

  8. Rate (Yield) Rate (Yield) Maturity Term Structure of Interest Rates—Yield Curve Upward sloping Flat Downward sloping Short-Term BondsLong-Term Bonds

  9. U.S. Treasury Bond Interest Rates on Different Dates

  10. Term Structure of Interest Rates Explanations for the shape of a yield curve: • Expectations Theory—slope of yield curve is the same as expected interest movements • Liquidity Preference Theory—investors prefer more liquidity to less • Market Segmentation Theory—market is segmented by maturity (LT or ST)

  11. Interest Rates Other Factors that Influence Interest Rates • Federal Reserve Policy • Federal Deficits • Foreign Trade Balance • Business Activity

  12. Interest Rates • Interest Rate Levels and Stock Prices: highly correlated • Interest Rates and Business Decisions: a firm’s decisions concerning what types of financing should be used for invest-ments in assets is based on forecasts of future interest rates

  13. Forecasting Interest Rates Exp Infl YearEach Yr Avg Inflation Per Yr, IPt 20x11% 20x11%= 1%/1= 1% 20x25%= (1%+5%)/2= 3% 20x36%= (1%+5%+6%)/3= 4% 20x11%= 1%/1= 1% 20x11%= 1%/1= 1% 20x25% 20x11%= 1%/1= 1% 20x25%= (1%+5%)/2= 3% 20x11%= 1%/1= 1% 20x25%= (1%+5%)/2= 3% 20x36%

  14. Forecasting Interest Rates If the real risk-free rate, r*, is 3 percent, then the forecasted yields on bonds will be: Bond Typer*+IPt=Nominal Rate, rRF 1-year bond3%+1%=4% 2-year bond3%+3%=6% 3-year bond3%+4%=7%

  15. Expected Rate on a Year r* Annual Infl 1-Year Bond 1-year bond (4% + 8%)/1 = 8.0% 2-year bond (4% + 8% + 9%)/2 = 8.5% Bond Type Average of 1-Year Rates rRF 1-year bond (4% + 8%)/1 = 8.0% 3-year bond (4% + 8% + 9%)/3 = 7.0% 1-year bond (4% + 8%)/1 = 8.0% 2-year bond (4% + 8% + 9%)/3 = 7.0% Forecasting Interest Rates 20x13%1%4% 20x23%5%8% 20x33%6%9% 1-year bond4%/1=4.0% 2-year bond(4% + 8%)/2=6.0% 3-year bond(4% + 8% + 9%)/3=7.0% 1-year bond(4% + 8%)/2=6.0% 3-year bond(4% + 8% + 9%)/3=7.0%

  16. r r r = expected cash flow in Period t The Cost of Money as a Determinant of Value r = required rate of return

  17. Answers to Questions • What is the cost of money, and how is it determined? • The interest rate that lenders charge borrowers. Determined by the supply of funds and the demand for those funds. • What factors affect interest rates? • Production opportunities, time preferences for consumption, risk, inflation.

  18. Answers to Questions • What is a yield curve? • A snapshot of the relationship between short-term and long-term interest rates at a particular time. • How do government actions and business activity affect interest rates? • Government borrowing exerts pressure on the demand for funds and may inflate interest rates. • How does the level of interest rates affect the values of stocks and bonds? • When rates increase in the financial markets, the values of assets decrease.

More Related