1. Chapter 2 The Financial Environment Markets Institutions Interest Rates Fin 220 Dr. Batool Asiri Sept 2010 © 2005 Thomson/South-Western

2. Four factors that affect the cost of money The Cost of Money  Production opportunities  Time preferences for consumption  Risk  Expected inflation 2

3. The Cost of Money  What do we call the price, or cost, of debt capital? The Interest Rate  What do we call the price, or cost, of equity capital? Return on Equity =Dividends +Capital Gains 3

4. k= Quoted or nominal rate k*= Real risk-free rate (“k-star”) IP= Inflation premium kRF= Real risk-free rate plus a premium for expected inflation kRF = k* + IP DRP= Default risk premium LP= Liquidity premium MRP= Maturity risk premium The Determinants of Market Interest Rates Quoted Interest Rate = k = k* + IP + DRP + LP + MRP 4

5. IP= Inflation premium DRP= Default risk premium LP= Liquidity premium MRP= Maturity risk premium Premiums Added to k* for Different Types of Debt  Short-Term (S-T) Treasury: only IP for S-T inflation  Long-Term (L-T) Treasury: IP for L-T inflation, MRP  Short-Term corporate: Short-Term IP, DRP, LP  Long-Term corporate: IP, DRP, MRP, LP 5

6. The Term Structure of Interest Rates  Term structure: the relationship between interest rates (or yields) and maturities  A graph of the term structure is called the yield curve. 6

7. U.S. Treasury Bond Interest Rates on Different Dates Interest Rate Term to March July July Maturity1980 2000 2003 3 months 16.0% 6.1%0.9% 1 year 14.0 6.11.0 5 years 13.5 6.22.3 10 years 12.8 6.13.3 20 years 12.3 6.24.3 Short Term Intermediate Term Long Term 151020 16 14 12 10 8 6 4 2 0 Interest Rate (%) March 1980 July 2000 July 2003 7

8. Three Explanations for the Shape of the Yield Curve  Liquidity Preference Theory  Expectations Theory  Market Segmentation Theory 8

9. Expectations Theory  Shape of curve depends on investors’ expectations about future inflation rates.  If inflation is expected to increase, S-T rates will be low, L-T rates high, and vice versa. Thus, the yield curve can slope up OR down. 9

10. Liquidity Preference Theory  Lenders prefer S-T securities because they are less subject to interest rate risk and are thus more easily bought or sold in the market.  Thus, S-T rates should be low, and the yield curve should be slope upward. 10

11. Market Segmentation Theory  Borrowers and lenders have preferred maturities  Slope of yield curve depends on supply and demand for funds in both the L-T and S-T markets (curve could be flat, upward, or downward sloping) 11

12. Interest Rate Levels and Stock Prices  The higher the rate of interest, the lower a firm’s profits  Interest rates affect the level of economic activity, and economic activity affects corporate profits 12