1. Intro to Financial Management
Financial Markets and Interest Rates

2. 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?

3. 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

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

5. 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

6. 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

7. 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

8. 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.

9. 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.

10. 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?

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

12. 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.

13. 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?

14. 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

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

16. 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

17. 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?