Chapter 5: Interest Rates

The Cost of Money The cost to borrow money The interest rate you pay a lender It is what borrowers pay to use the (rent) the money

Inflation Definition – The decrease of the purchasing power of currency over time Cause – Demand for goods and services grows faster than the supply of goods and services; as time goes by goods and services become more valuable thus more expensive; thus reducing the purchasing power of the currency – An increase in the amount of money in circulation in an economy; as quantity of currency increase, value of currency decreases with respect to the value of goods & services; it takes more money to purchase goods & services, thus the purchasing power of currency is reduced

What is an Interest Rate? When someone decides to lend money, they want compensation for: – The loss of the opportunity to use that money while it is loaned out ( opportunity cost ) – The loss of value over time due to inflation – The chance they won’t get the money back The interest rate one pays for the privilege of using someone else’s money

What is an Interest Rate? (cont) Interest rates are usually expressed and quantified as a percentage of the principle (the amount borrowed) Symbols you will see: r, k, i Two basic types of interest – Simple interest: Paid all at once either upon initiating or closing the loan – Compound interest:

Major Factors that affect the demand for money Production (or service) Opportunities – The opportunity for money holder to invest internally rater than investing externally (lending) – When the demand to invest internally goes up the compensation that lenders must pay to keep money holders from investing internally goes up

Major Factors that affect the demand for money (cont) Time preference for Consumption – The demand or desire to spend money now versus investing it Risk – Uncertainty the borrower will pay back interest or pay back the principle – When uncertainty goes up, the cost goes up Expected inflation – The tendency for prices to increase over time

Other factor that influence Money S&D Federal reserve policy [S↓r↑] Controls the supply of money through buying / selling of US Treasury bonds; Sets target interest rates Business Activity / State of the Economy: [D ↑r ↑] – Recessions usually lower interest rates: less demand for money – Boom usually raises interest rates: greater demand for money

Other factor that influence Money S&D (cont) Federal Deficits: [D↑r ↑] Larger federal deficit means higher interest rates since the government must borrow money to cover debt obligations; higher overall demand for money Foreign Trade Balance: [D↑r ↑] Larger trade deficit means higher interest rates. This deficit must be financed; higher overall demand for money

The components of an interest Rate This is how the major factors that influence the cost of money are quantified and factored into interest rates r = r* + IP + DRP + LP + MRP

The components of an interest Rate (cont) r* = Real Interest Rate (Real Risk Free Rate) – No one actually knows what the real risk free rate is. – A commonly accepted value for the real risk free rate can be found by subtracting current inflation rate from the current 30 day treasury-bill rate – r* is not constant, it changes over time

The components of an interest Rate (cont) IP = Inflation Premium – Compensates the lender for loss in value over time due to inflation – This is computed as the average expected inflation rate over the life of the loan. – The IP that is often applied is derived from government economic forecasts. No one really knows what the current inflation rate is but the one the US Government reports is the commonly accepted value

The components of an interest Rate (cont) DRP = Default Risk Premium – Compensates the lender for possible default – This is kind of like an insurance payment – 30 day Treasury bills (T-Bill; $1000 Face value, very short term bond) Have a DRP of 0%. Why?

The components of an interest Rate (cont) LP = Liquidity Premium – Accounts for the availability of a borrower to repay a loan with the firm’s assets. – If these assets are not liquid (ie real-estate, buildings, equipment, etc.) LP will be higher – Although it is very difficult to calculate LP, it tends to differ 2 to 5 percent between the most liquid and least liquid financial assets.

The components of an interest Rate (cont) MRP = Maturity Risk Premium – “Maturity” is the length of the loan – Compensates for interest rate risk. The longer the term, the greater the interest rate risk, thus a higher MRP – Compensates for reinvestment rate risk When a loan matures the interest rate that you can invest in may be lower than when the loan was issued. Therefore the lender cannot reinvest the repaid principle at the same rate at which it was loaned out at.

The components of an interest Rate (cont) Example: Safari Outfitters, a local outdoor equipment retail store, wants a 1-year, $50k loan from your bank. You have already determined that this firm warrants a DRP of 5%, a LP of 1% and a MRP of.5%. Today's WSJ reports 30 day T-bills are currently yielding 2.3%. What is an appropriate interest rate for this loan?

The components of an interest Rate (cont) r = r RF + DRP + LP + MRP Note: We assumed that the inflation Premium (IP) will be the current inflation rate as implyed by the rate of a 30-day T-bill. This usually is acceptable only for relatively short- term loans (less than 1 year maturity).

The components of an interest Rate (cont) How do you compute IP for loans longer than 1 year? – Use r = r* + IP + DRP + LP + MRP – Find the yield on a 30-day T-bill – Compute r* (r* = r RF – Current Inflation Rate) – Find expected inflation for upcoming years – Compute the average value for expected inflation: This is IP IP = (I 1 + I 2 + I 3 ……I n )/n Where n is the number of years of maturity and I n is the expected inflation for a particular year.

The components of an interest Rate (cont) Example: Safari Travel Adventures, a new travel agency, wants a 3-year, $500k loan from your bank. You have already determined that this firm warrants a DRP of 10%, a LP of 3% and a MRP of 1.5%. Today is Jan 2. Inflation is expected to remain at 2%. Next years inflation is expected to be 2.5% and the following years inflation is expected to be 3%. Today’s WSJ reports 30-day T-bills are currently yielding 2.3%. What is an appropriate interest rate for this loan?

What factors tend to lower interest rates? Everyone in the lending business wants to lend you money. They want the cash from your interest payments. Very competitive – Lenders are always trying to offer more attractive rates than their competitors in order to get your to borrow from them (BE CAREFUL!) This is the root cause for many banking fiascoes: banks often enter into risky lending in pursuit of cash flow.

Why should you care about interest rates? As a lender it will enable you to determine an appropriate competitive rate As a borrower it will help you shop for money

Interest Rates and RoR The interest rate that a borrower pays is exactly equal to the lenders RoR; the lender is investing in the borrower When you invest in stock, you should expect a RoR that compensates for the same things associated with lending money; – Required RoR of Stock = r S = r* + IP + RP

Term Structure of Interest Rates The Term Structure of Interest Rates  Term Structure: the relationship between interest rates (yields) and different loan lengths (maturities). U.S. Treasury Bond Interest Rate Term Structure Term to Interest Rate Maturity Mar Mar Jan months 15.0% 4.6% 4.16% 1 year 14.0% 4.9% 4.23% 5 years 13.5% 5.2% 4.34% 10 years 12.8% 5.5% 4.38% 20 years 12.5% 5.9% 4.46% Why do bonds of longer maturity have higher interest rates?  A graph of the term structure is called a yield curve. It graphically portrays the relationship between interest rates and maturities

Yield Curve Comparison (US Treasury Bonds) Interest Rate (%) Short Term Intermediate Term Long Term Maturity Yield Curve for July 2003 (upward sloping) Yield Curve for July 2000 (flat)

Yield Curve Comparison (US Treasury Bonds) (cont)  The yield curve is a “snapshot” in time; it tells you what the relationship between maturities and interest rates are at a specific date  The yield curve does not tell you what interest rates will be in the future (more on this later)  Yield curves for different bond markets (i.e. U.S. Treasuries, investment grade, junk, etc.) usually have similar shapes  Yield curves change over time due changes in the factors that govern interest rate components (IP, DRP, LP & MRP).  Historically, yield curves have mostly been upward sloping (i.e. interest on shorter term bonds were lower than longer term bonds)

Yield Curve Comparison (US Treasury Bonds) (cont)  Expected inflation has the greatest influence on yield curve shape  yield curves slope downward (Mar 1980) when debt markets expect inflation to decrease  yield curves slope upward (Mar 1999) when bond markets expect inflation to rise  yield curves are concave (Feb 2002) when the direction of inflation change is about to change The Cost of Money: (continued)  The shape of the yield curve gives some indication about what bond markets think inflation (and thus, interest rates) might be in the future

Other Yield Curves The relative riskiness (factors that influence DRP, LP & MRP) of borrowers also influences the shape of the yield curve (see also Ch 6 p 186 Yield Curve Comparison (US Treasury Bonds) (cont)

Interest Rate (%) Short Term Intermediate Term Long Term Maturity High-risk Firms Low-risk Firms Moderate-risk Firms U.S Treasuries Yield Curve Comparison (US Treasury Bonds) (cont)

The shape of the yield curve influences decisions on issuing debt – Upward sloping: go with l-t debt instead of s-t debt; upward sloping means the market expects interest rates to rise in the future – Downward sloping: go with s-t debt instead of l-t debt; refinance later when interest rates are lower – Caution: the yield curve changes over time Yield Curve Comparison (US Treasury Bonds) (cont)

Expectation Theory Shape of the curve depends on investors expectations about future inflation rates.