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 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: –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 buy 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 MaturityInflation Risk Default Risk Risk-free Return 3-month T-Bill 3 monthsYesNoYes 30-year Treasury Bond 30 yearsYesNoYes 30-year Aaa bond 30 yearsYes No 30-year TIPS 30 yearsNo Yes

Comparing Rates - Example We want to know the default risk in 30 years. Look at the previous table and find 3 bonds that mature in 30 years. Notice that the Aaa and T-Bond have the same risk premiums with the only exception being default risk. So, the difference in rates between the two bonds much 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 3 bonds that mature in 30 years. Notice that the TIPS and T-Bond have the same risk premiums with the only exception being inflation risk. So, the difference in rates between the two bonds much 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. 35

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

Interest Rates Examples 1.Want a real rate of return of 4%, inflation is 2%. What nominal rate do you need? 2.Bond yields are 10%, inflation is 6%. What is real rate? 3.30-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?