Intro to Financial Management Financial Markets and Interest Rates

Review Homework What is the goal of the firm? Measured how? What affects this measure? True or false, a business must focus on profits. Explain the time value of money. True or false, all risk is rewarded. What is the Efficient Market Hypothesis? What are agency problems? What are the different corporate forms? What are spot and future markets? What is a spread?

Interest Rates Interest is the cost of money Expressed in percent “Basis points”, bps, or “beeps” Nominal rate – quoted rate Simple “yield” = interest payment / current price Real risk-free interest rate – required rate of return on a fixed-income security that has no risk with zero inflation How much you want to get above inflation Premiums – rate required to take on additional risks

Interest Rates Nominal interest rate = real risk-free interest rate + inflation risk premium + default risk premium + maturity premium + liquidity premium

Interest Rates Practical issues: Consider these: Which term security should be used for risk-free asset? How should we measure inflation? Consider these: 3-month T-Bill 30-year Treasury Bond Inflation rate 30-year Aaa bond 30-year TIPS How would you calculate: Real risk-free rate of return Inflation risk rate Default rate risk Maturity premium

Comparing Rates When you want to find out a rate or premium for which you don’t have a specific measure, find two other rates that differ only in that specific respect. (OK, I know that needs more explanation.) Example: You want to know the default risk premium on a 30-year bond No security shows that by itself Find two bonds that are similar in every respect except one has a default risk and the other does not See next slide

Comparing Rates Maturity Inflation Risk Default Risk 3-month T-Bill 3 months Yes No 30-year Treasury Bond 30 years 30-year Aaa bond 30-year TIPS

Comparing Rates - Example We want to know the default premium risk for 30 years. Look at the previous table and find 2 bonds that mature in 30 years that differ only by default risk. Notice that the Aaa and T-Bond have the same risk premiums except for default risk. So, the difference in rates between the two bonds must be because of the default risk premium. Subtract the two rates and you get the default risk premium.

Comparing Rates - Example We want to know the inflation risk in 30 years. Look at the previous table and find bonds that mature in 30 years. Notice that the TIPS and T-Bond have the same risk premiums the exception of inflation risk. The difference in rates between the two bonds must be because of the inflation risk premium. Subtract the two rates and you get the inflation risk premium.

Comparing Rates – You Do It How do we find the maturity risk premium for 30-year bonds? How would you find the default risk premium of a Aaa bond vs. an BB bond?

Interest Rates Do Chapter 2 “Can You Do It?” p. 37 Do Chapter 2 “Did You Get It?” p. 38

Nominal and Real Interest Rates (1 + nominal rate) = (1 + real rate)*(1 + inflation rate) or nominal rate = real rate + inflation rate + (real * inflation) In practice, often use approximation: nominal rate = real rate + inflation rate NOTE: the “real rate” is not risk free. It includes risk premiums.

Interest Rates Examples Want a real rate of return of 4%, inflation is 2%. What nominal rate do you need? Bond yields are 10%, inflation is 6%. What is real rate? 30-year TIPS yield 6%, 30-year Treasuries yield 4%. What is the expected rate of inflation?

Interest Rates Simple, one-period, future value The next period’s amount Your money back Plus interest FV = (1 + r) * PV Problems Calculate how much money you will have next year Calculate how much money you need now Calculate what interest rate you need

Term Structure of Interest Rates Relationship between interest rates and maturity “Yield to maturity” The Yield Curve

Yield Curve Why does it look the way it does? Unbiased expectations theory Structure determined by expectations of future interest rates Liquidity preference theory Investors require maturity-risk premiums to compensate for risk of varying interest rates Market segmentation theory Rates determined by supply and demand for different maturities

In Class Excel Exercise You have a portfolio of the following mutual funds Vanguard Index 500 Vanguard Small Cap Index Vanguard Total Bond Index Vanguard International Index You invest $5,000 in each fund Use the average return over the last 10 years Calculate you portfolio value in 5 years What if returns are 100 bps less in the future? 200 bps less in the future?