1 What is the cost of money, and how is it determined? What factors affect interest rates? What is a yield curve? How do government actions and business activity affect interest rates? How does the level of interest rates affect the values of stocks and bonds? The Cost of Money

2 Realized Returns

3 Cost of Money Interest rates are based on: Production Opportunities—greater production opportunities, greater demand for funds Time Preference for Consumption—individuals save less if they have a great need for current consumption Risk—investors demand higher returns for riskier investments Inflation—investors save to increase their ability to purchase in the future

4 Interest Rates—Levels Function of supply and demand Dollars Interest Rate, r S1S1 D1D1 7.0 D2D2 8.5 Interest rates fluctuate continuously

5 Interest Rates—Determinants 0 Risk Return (r) r RF Risk-Free Return = r RF Risk Premium = RP r= r RF + RP

6 Interest Rates—Determinants r = r RF +RP =[r* + IP] r* = real risk-free rate IP= inflation premium DRP= default risk premium LP= liquidity (marketability) premium MRP= maturity risk premium r* = real risk-free rate IP= inflation premium = r RF DRP= default risk premium LP= liquidity (marketability) premium MRP= maturity risk premium = RP r = r RF +RP =[r* + IP]+[DRP + LP + MRP]

7 Premiums Added to r* for Different Types of Debt Short-Term Treasury: only IP for S-T inflation Long-Term Treasury: IP for L-T inflation, MRP Short-Term corporate: Short-Term IP, DRP, LP Long-Term corporate: IP, DRP, MRP, LP

8 Term Structure of Interest Rates— Yield Curve Rate (Yield) Maturity Rate (Yield) Upward sloping Downward sloping Flat Short-Term BondsLong-Term Bonds

9 U.S. Treasury Bond Interest Rates on Different Dates

10 Term Structure of Interest Rates Explanations for the shape of a yield curve: Expectations Theory—slope of yield curve is the same as expected interest movements Liquidity Preference Theory—investors prefer more liquidity to less Market Segmentation Theory—market is segmented by maturity (LT or ST)

11 Interest Rates Other Factors that Influence Interest Rates Federal Reserve Policy Federal Deficits Foreign Trade Balance Business Activity

12 Interest Rates Interest Rate Levels and Stock Prices: highly correlated Interest Rates and Business Decisions: a firm’s decisions concerning what types of financing should be used for invest- ments in assets is based on forecasts of future interest rates

13 Forecasting Interest Rates Exp Infl YearEach Yr Avg Inflation Per Yr, IP t 20x11%20x11%= 1%/1= 1% 20x25%= (1%+5%)/2= 3% 20x36%= (1%+5%+6%)/3= 4% 20x11%= 1%/1= 1% 20x25% 20x11%= 1%/1= 1% 20x25%= (1%+5%)/2= 3% 20x11%= 1%/1= 1% 20x25%= (1%+5%)/2= 3% 20x36%

14 Forecasting Interest Rates If the real risk-free rate, r*, is 3 percent, then the forecasted yields on bonds will be: Bond Typer*+IP t =Nominal Rate, r RF 1-year bond3%+1%=4% 2-year bond3%+3%=6% 3-year bond3%+4%=7%

15 Forecasting Interest Rates Expected Rate on a Year r*Annual Infl1-Year Bond 20x13%1%4% 20x23%5%8% 20x33%6%9% 1-year bond4%/1=4.0% 2-year bond(4% + 8%)/2=6.0% 3-year bond(4% + 8% + 9%)/3=7.0% Bond Type Average of 1-Year Ratesr RF 1-year bond(4% + 8%)/2=6.0% 3-year bond(4% + 8% + 9%)/3=7.0% 1-year bond(4% + 8%)/1=8.0% 3-year bond(4% + 8% + 9%)/3=7.0% 1-year bond(4% + 8%)/1=8.0% 2-year bond(4% + 8% + 9%)/3=7.0% 1-year bond(4% + 8%)/1=8.0% 2-year bond(4% + 8% + 9%)/2=8.5%

16 The Cost of Money as a Determinant of Value rrr r = required rate of return = expected cash flow in Period t

17 Answers to Questions What is the cost of money, and how is it determined? The interest rate that lenders charge borrowers. Determined by the supply of funds and the demand for those funds. What factors affect interest rates? Production opportunities, time preferences for consumption, risk, inflation.

18 Answers to Questions What is a yield curve? A snapshot of the relationship between short-term and long-term interest rates at a particular time. How do government actions and business activity affect interest rates? Government borrowing exerts pressure on the demand for funds and may inflate interest rates. How does the level of interest rates affect the values of stocks and bonds? When rates increase in the financial markets, the values of assets decrease.