Chapter 7 Interest Rates

The interest rate is the cost of debt capital. Companies raise capital in two main forms: debt and equity. The interest rate is the price that lenders receive and borrowers pay for debt capital. Equity investors expect to receive dividends and capital gains, the sum of which represents the cost of equity. Fundamental factors affecting the cost of money: production opportunities, time preferences for consumption, risk, expected inflation.

“Nominal” vs. “Real” Rates r = represents any nominal rate r* = represents the “real” risk-free rate of interest. rRF = represents the rate of interest on Treasury securities. IP = inflation premium = 1 + inflation rate rRF = (1 + r*)(1 + IP) − 1 = r* + IP + r*∙IP ≈ r* + IP

Determinants of Interest Rates r = r* + IP + DRP + LP + MRP r = required return on a debt security r* = real risk-free rate of interest IP = inflation premium DRP = default risk premium LP = liquidity premium MRP = maturity risk premium

Determinants of Interest Rates IP: Inflation has a major impact on interest rates because it erodes the real value of what you receive from the investment. The inflation rate built into interest rate is the inflation rate expected in the future. DRP reflects the possibility that the issuer will not pay the promised interest or principal at the stated time. LP: Some securities cannot be converted to cash on short notice at a reasonable price. MRP: Long-term bonds are exposed to a significant risk of price changes due to fluctuations in interest rates.

Premiums Added to r* for Different Types of Debt IP MRP DRP LP S-T Treasury  L-T Treasury S-T Corporate L-T Corporate

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.

Relationship Between Treasury Yield Curve and 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. Since corporate yields include a default risk premium (DRP) and a liquidity premium (LP), the corporate bond yield spread can be calculated as:

Representative Interest Rates on 5-Year Bonds in May 2011

Macroeconomic Factors That Influence Interest Rate Levels Federal reserve policy Federal budget deficits or surpluses International factors Level of business activity