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Chapter 5 The Cost of Money (Interest Rates)

Chapter 5 The Cost of Money (Interest Rates). Return. Risk. 0. Determinants of Market Interest Rates. Rate of return ( interest) = k = Risk-free rate + Premium for risk = k RF + RP. Risk Premium = RP. k = k RF + RP. k RF. Risk-Free Return = k RF.

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Chapter 5 The Cost of Money (Interest Rates)

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

  2. Return Risk 0 Determinants of Market Interest Rates • Rate of return (interest) = k = Risk-free rate + Premium for risk = kRF + RP Risk Premium = RP k = kRF + RP kRF Risk-Free Return = kRF

  3. Determinants of Market Interest Rates • Quoted rate = k = kRF + RP = [k* + IP] + [DRP + LP + MRP] k* = real risk-free rate IP = inflation premium k* = real risk-free rate IP = inflation premium = kRF 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

  4. Yield (%) Term to Maturity (years) The Term Structure of Interest Rates Relationship between yields and bond maturities Upward sloping (normal) Flat Downward sloping (inverted)

  5. The term structure of interest rates Explanations for the shape of the yield curve • Expectations theory • The shape of the yield curve is based on expectations about inflation in the future, i.e. inflation increases => yield curve upward sloping • Liquidity preference theory • Long-term bonds are considered less liquid than short-term bonds, i.e. long-term bonds must have higher yields to attract investors • Market segmentation theory • Borrowers and lenders prefer bonds with particular maturities.

  6. Interest rate Levels and Stock Prices Effects on corporate profits • Interest is a cost to business, so interest rate changes have a direct impact on business profits • Interest rates affect investment behavior, so when rates on bonds increase, money is taken out of the stock markets to invest in the bond markets => general prices of stocks are pushed down and the prices of bonds are pushed up

  7. Interest rates and business decisions A firm’s decision concerning what types of financing should be used for investments in assets is based on forecasts of future interest rates • Suppose that interest rates are expected to fall over the next period, then the firm would borrow short-term and “lock” into lower long-term rates when the rates fall

  8. Self – test problems Term structure of interest rates • If you have information that a recession is ending, and the economy is about to enter a boom, and your firm needs to borrow money, it should probably issue long-term rather than short-term debt • (a) TRUE • (b) FALSE

  9. Self – test problems Term structure of interest rates • And the right answer is….. • (a)

  10. Self – test problems Risk and return • Your uncle would like to restrict his interest rate risk and his default risk, but he still would like to invest in corporate bonds. Which of the possible bonds listed below best satisfies your uncle’s criteria? • (a) AAA bond with 10 years to maturity • (b) BBB bond with 10 years to maturity • (c) AAA bond with 5 years to maturity • (d) BBB bond with 5 years to maturity

  11. Self – test problems Risk and Return • And the right answer is….. • (c)

  12. Exam – type problems • Problem 2-7 (page 82) • Suppose the annual yield on a two-year Treasury bond is 11.5 percent, while that on a one-year bond is 10 percent; k* is 3 percent, and the maturity risk premium is zero. • Using the expectations theory, forecast the interest rate on a one-year bond during the second year • What is the expected inflation rate in Year 1? Year 2?

  13. Problem 2-7 Solution Given: One-year bond yield 10.0% Two-year bond yield 11.5% k* 3.0% MRP 0.0% One-year rate In Year 2

  14. Exam – type problems • Problem 2-10 (page 82) • Today is January 1, 2005, and according to the results of a recent survey, investors expect the annual interest rates for the years 2008 – 2010 to be: YearOne-Year Rate 2008 5% 2009 4% 2010 3% • The rates given here include the risk-free rate, kRF , and appropriate risk premiums. Today a three – year bond – that is, a bond that matures on December 31, 2007, has an interest rate equal to 6%. What is the yield to maturity for bonds that mature at the end of 2008, 2009 and 2010?

  15. Problem 2-10 – Solution YearOne-Year Rate 2008 5% 2009 4% 2010 3% Today = 1/1/05 3-yr yield = 6%

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