Interest Rates PDF

III. INTEREST RATES Companies raise capital in two main forms: debt and equity. In a free economy, capital, like other items, is allocated through a market system, where funds are transferred and prices are established. The interest rate is the price that lenders receive, and borrowers pay...

III. INTEREST RATES Companies raise capital in two main forms: debt and equity. In a free economy, capital, like other items, is allocated through a market system, where funds are transferred and prices are established. The interest rate is the price that lenders receive, and borrowers pay for debt capital. Similarly, equity investors expect to receive dividends and capital gains, the sum of which represents the cost of equity. A. The Determinants of Market Interest Rates o The Real Risk-Free Rate of Interest, R* - the rate of interest that would exist on default- free US Treasury if no inflation were expected. o The Nominal, or Quoted, Risk-Free Rate of Interest – the rate of interest on a security that is free of all risk; rRF is proxied by the T-bill rate or the T-bond rate; rRF includes an inflation premium. o Inflation Premium (IP) – a premium equal to expected inflation that investors add to the real risk-free rate of return. o Default Risk Premium (DRP) – the di_erence between the interest rate on a US Treasury bond and a corporate bond of equal o Liquidity Premium (LP) – a premium added to the equilibrium interest rate on a security if that security cannot be converted to cash on short notice and at close to its “fair market value.” o Interest Rate Risk – the risk of capital losses to which investors are exposed because of changing interest rates. o Maturity Rate Premium – a premium that reflects interest rate risk. o Reinvestment Rate Risk – the risk that a decline in interest rates will lead to lower income when bonds mature and funds are reinvested. The Cost of Money 4 Most Fundamental Factors A_ecting the Cost of Money: 1. Production Opportunities – The investment opportunities in productive (cash- generating) assets. 2. Time Preferences for Consumption – The preferences of consumers for current consumption as opposed to saving for future consumption. 3. Risk – In a financial market context, the chance that an investment will provide a low or negative return. 4. Inflation – The amount by which prices increase over time. People use money as a medium of exchange. When money is used, its value in the future, which is a_ected by inflation, comes into play. The higher the expected rate of inflation, the larger the required dollar return. Interest rate paid to savers depends on: (1) the rate of return that producers expect to earn on invested capital (2) savers’ time preferences for current versus future consumption  (3) the riskiness of the loan, and (4) the expected future rate of inflation. Producers’ (borrowers) expected returns on their business investments set an upper limit to how much they can pay for savings, while consumers’ time preferences for consumption establish how much consumption they are willing to defer and hence how much they will save at di_erent interest rates. Higher risk and higher inflation also lead to higher interest rates. Interest Rate Levels Short-term rates are responsive to current economic conditions. Long-term rates primarily reflect long-run expectations for inflation. Term Structure of Interest Rates – the relationship between long-term and short-term rates. Term Structure of Interest Rates - The relationship between bond yields and maturities. - It describes the relationship between long- and short-term rates. - The term structure is important to corporate treasurers deciding whether to borrow by issuing long- or short-term debt and to investors who are deciding where to buy long- or short-term bonds. Yield Curve – a graph showing the relationship between bond yields and maturities. Normal Yield Curve – an upward-slopping yield curve. Inverted (Abnormal) Yield Curve – a downward-slopping yield curve. Humped Yield Curve – a yield curve where interest rates on intermediate-term maturities are higher than rates on both short- and long-term maturities. B. Interest Rate Risk Interest Rate Risk – is the risk of capital losses to which investors are exposed because of changing interest rates. Maturity Risk Premium (MRP) – a premium that reflects interest rate risk. Reinvestment Rate Risk – the risk that a decline in interest rate will lead to lower income when bonds mature and funds are reinvested. C. Interest Rate Derivatives The Real Risk-Free Rate of Interest, R* o Is the interest rate that would exist on a risk-less security if no inflation were expected. It may be thought of as the rate of interest on short-term U.S. Treasury securities in an inflation-free world. The real risk-free rate is not static—it changes over time, depending on economic conditions, especially on (1) the rate of return that corporations and other borrowers expect to earn on productive assets and (2) people’s time preferences for current versus  future consumption. Borrowers’ expected returns on real assets set an upper limit on how much borrowers can a_ord to pay for funds, whereas savers’ time preferences for consumption establish how much consumption savers will defer—hence, the amount of money they will lend at di_erent interest rates. The Nomimal, or Quoted, Risk-Free Rate of Interest, rRF = r* + IP o The rate of interest on a security that is free of all risk; rRF is proxied by the T-bill rate of the T-bond rate; rRF includes an inflation premium. o To be strictly correct, the risk-free rate should be the interest rate on a totally risk-free security—one that has no default risk, maturity risk, no liquidity risk, no risk of loss if inflation increases, and no risk of any other type. o If the term risk-free rate is used without the modifiers real or nominal, people generally mean the quoted (or nominal) rate; and we follow that convention in this book. Therefore, when we use the term risk-free rate, rRF, we mean the nominal risk-free rate, which includes an inflation premium equal to the average expected inflation rate over the remaining life of the security. Inflation Premium (IP) o A premium equal to expected inflation that investors add to the real risk free rate of return. Default Risk Premium (DRP) o The risk that a borrower will default, which means the borrower will not make scheduled interest or principal payments, also a_ects the market interest rate on a bond: The greater the bond’s risk of default, the higher the market rate. Liquidity Premium (LP) o A “liquid” asset can be converted to cash quickly at a "fair market value." Real assets are generally less liquid than financial assets, but di_erent financial assets vary in their liquidity. Because they prefer assets that are more liquid, investors include a liquidity premium (LP) in the rates charged on di_erent debt securities. D. Monetary Policy Monetary policy is a set of tools used by a nation’s central bank to control the overall money supply and promote economic growth and employ strategies such as revising interest rates and changing bank reserve requirements. Types of Monetary Policy Contractionary – is policy that increases interest rates and limits the outstanding money supply to slow growth and decrease inflation, where the prices of goods and services in an economy rise and reduce the purchasing power of money. Expansionary – during times of slowdown or a recession, an expansionary policy grows economic activity. By lowering interest rates, saving becomes less attractive, and consumer spending and borrowing increase. Goals of Monetary Policy Inflation - Contractionary monetary policy is used to temper inflation and reduce the level of money circulating in the economy. Expansionary monetary policy fosters inflationary pressure and increases the amount of money in circulation. Unemployment - An expansionary monetary policy decreases unemployment as a higher money supply and attractive interest rates stimulate business activities and expansion of the job market. Exchange Rates - The exchange rates between domestic and foreign currencies can be a_ected by monetary policy. With an increase in the money supply, the domestic currency becomes cheaper than its foreign exchange. Tools of Monetary Policy - Open Market Operations: In open market operations (OMO), the Federal Reserve Bank buys bonds from investors or sells additional bonds to investors to change the number of outstanding government securities and money available to the economy as a whole. The objective of OMOs is to adjust the level of reserve balances to manipulate the short-term interest rates and that a_ect other interest rates. - Interest Rates: The central bank may change the interest rates or the required collateral that it demands. In the U.S., this rate is known as the discount rate. Banks will loan more or less freely depending on this interest rate. - Reserve Requirements: Authorities can manipulate the reserve requirements, the funds that banks must retain as a proportion of the deposits made by their customers to ensure that they can meet their liabilities. Lowering this reserve requirement releases more capital for the banks to o_er loans or buy other assets. Increasing the requirement curtails bank lending and slows growth. E. Yield Curve A graph showing the relationship between bond yields and maturities. The yield curve changes in position and in slope over time. o “Normal” Yield Curve – an upward-sloping yield curve. o Inverted (“Abnormal”) Yield Curve – a downward-sloping yield curve. o Humped Yield Curve – a yield curve where interest rates on intermediate-term maturities are higher than rates on both short- and long-term maturities. What Determines the Shape of the Yield Curve? Because maturity risk premiums are positive, if other things were held constant, long-term bonds would always have higher interest rates than short-term bonds. F. Inflation and Interest Rates Interest rates tend to move in the same direction as inflation but with lags, because interest rates are the primary tool used by central banks to manage inflation.  In the U.S. the Federal Reserve targets an average inflation rate of 2% over time by setting a range of its benchmark federal funds rate, the interbank rate on overnight deposits. Higher interest rates are generally a policy response to rising inflation. Conversely, when inflation is falling and economic growth slowing, central banks may lower interest rates to stimulate the economy. How Changes in Interest Rates A_ect Inflation? In general, rising interest rates curb inflation while declining interest rates tend to speed inflation. When interest rates decline, consumers spend more as the cost of goods and services is cheaper because financing is cheaper. Increased consumer spending means an increase in demand and increases in demand increases prices. Conversely, when interest rates rise, consumer spending and demand decline, money-flows reverse, and inflation is somewhat tempered. How Do Interest Rates A_ect Stocks? In general, rising interest rates hurt the performance of stocks. If interest rates rise, that means individuals will see a higher return on their savings. This removes the need for individuals to take on added risk by investing in stocks, resulting in less demand for stocks. The Bottom Line Interest rates influence stocks, bond interest rates, consumer and business spending, inflation, and recessions. However, there is often a lag in the timing between an interest rate change and its e_ect on the economy. Some sectors may react quickly, such as the stock market, while the e_ect on other sectors such as mortgages and auto loans can take longer to be felt. By adjusting the federal funds rate, the Fed helps keep the economy in balance over the long term. Understanding the relationship between interest rates and the U.S. economy will allow investors to understand the big picture and make better investment decisions. Although the relationship between interest rates and the stock market is fairly indirect, the two tend to move in opposite directions. As a general rule of thumb, when the Federal Reserve cuts interest rates, it causes the stock market to go up; when the Federal Reserve raises interest rates, it causes the stock market to go down. But there is no guarantee as to how the market will react to any given interest rate change.