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Factors Affecting Cost of Money (4)
1) Production Opportunities
2) Time Preferences for Consumption
3) Risk
4) Inflation
Production Opportunities
Factors Affecting Cost of Money
Investment Opportunities in productive (cash-generating) Assets
Time Preferences for Consumption
Factors Affecting Cost of Money
Preferences of consumers for current consumption, as opposed to saving for future consumption
Risk
Factors Affecting Cost of Money
The chance that an investment will provide a low or negative return
Inflation
Factors Affecting Cost of Money
Amount by which Prices will increase over time
Determinants of Market Interest Rates (5)
1) Real Risk Free Rate
2) Inflation Premium
3) Default Risk Premium
4) Liquidity Premium
5) Maturity Risk Premium
Real Risk Free Rate
Determinants of Market Interest Rates
(r*) The real rate of interest that would exist on a certain security in a world without inflation
Inflation Premium
Determinants of Market Interest Rates
(IP) Rate equal to the average expected rate of Inflation over the life of the Security, which mitigates the losses that are incurred by inflation. It is not necessarily equal to the current inflation rate at the time
Default Risk Premium
Determinants of Market Interest Rates
(DRP) Premium that reflects the possibility that the issuer will not pay the promised interest or principle at the stated time - directly correlated with perceived risk of the security
Liquidity Premium
Determinants of Market Interest Rates
(LP) Premium that reflects the cost of conversion of some securities, as some are more difficult to sell quickly than others
Maturity Risk Premium
Determinants of Market Interest Rates
(MRP) Premium that reflects the risk of price declines due to increases in inflation and interest rates
Quoted Rate of Interest
Market Interest Rates
(r) Nominal Interest Rate of a Security as listed on the document
r(RF)
Market Interest Rates
r(RF) Quoted Rate of Interest for a Risk Free Security. Takes into account inflation
r(RF) = (r*)+(IP)
r(RF) Formula
Market Interest Rates
r(RF) = (r*)+(IP)
Interest Rate (Formula)
Quoted Interest Rate = r = r* + IP + DRP + LP + MRP
or (since r(RF) = r* + IP)
Nominal Rate = r = r(RF) + DRP + LP + MRP
Term Structure of Interest Rates
Relationship between bond yields and maturities
Yield Curve
Graph that depicts the relationship between Bond Yields and Maturities
Types of Yield Curves (3)
1) Normal
2) Inverted (Abnormal)
3) Humped
Normal Yield Curve
Yield Curve that is upward sloping (interest rates increase with length of time to maturity)
Inverted (Abnormal) Yield Curve
Yield Curve that is downward sloping (interest rates decrease with length of time to maturity)
Humped Yield Curve
Yield Curve that has highest interest rates on intermediate securities (interest rates are highest on intermediate securities as compared to short term and long term)
Yield of Treasury Bond
Benchmark of Security Yields, as T-Bonds have essentially no default or liquidity risk
Yield of Treasury Bond (Formula)
T Bond Yield = r*(t) + IP(t) + MRP(t)
where t = numbers of years to maturity
Yield of Corporate Bond
Measurement of Security Yields, as the range of securities issued by corporations
Yield of Corporate Bond (Formula)
C Bond Yield = r*(t) + IP(t) + MRP(t) + DRP(t) + LP(t)
where t = number of years to maturity
Corporate Bond Yield Spread
Measurement that compares the risks involved in Corporate issued Securities as compared to those issued by the US government
- Indicates that the increased Interest Rates on Corporate Securities is based upon their inherent risk of default and security, w
Corporate Bond Yield Spread (Formula)
C Bond Yield - T Bond Yield = DRP(t) + LP(t)
Pure Expectations Theory
Theory that states the shape of the Yield Curve depends on investor's expectations about Future Interest Rates
Macroeconomic Factors Affecting Interest Rates (4)
1) Federal Reserve Policy
2) Federal Budget Deficit/Surplus
3) International Factors
4) Business Decisions
Loading the Gun
When the Fed raises Interest Rates
Firing the Gun
When the Fed lowers Interest Rates
Federal Reserve Requirement
Government mandated minimum of capital all banks must keep on hand at all times, and therefore cannot lend out
- If Rate increased, it contracts Money Supply, and raises Interest Rates
- If Rate decreased, it expands Money Supply, and lowers Interest Rate
Discount Rate
Interest Rate charged by Banks to lend to other Banks
- Paid in advance (taken off purchase value)
- If Raised, it contracts Money Supply, and increases Interest Rates
- If Lowered, it expands Money Supply, and decreases Interest Rates
Open Market Operation
- If Fed sells Securities, it contracts the Money Supply, and increases Interest Rates
- If Fed buys Securities, it expands the Money Supply, and decreases Interest Rates
- Called "Quantitative Easing
Federal Reserve Goals (2)
1) Achieve Full Employment
- (defined as 5% or lower Unemployment)
2) Maintain Low Inflation
Trade Deficit
When a Nation Imports more Goods than it Exports
Interdependency of Nation's Rates
Capital will seek out the Nation with the highest interest rates available, to maximize returns
Country Risk
Risk that arises from investing in a foreign nation tied to their social, economic, natural, ect. risk of business disruption and default
Exchange Rate Risk
Risk that Exchange Rates between Currencies will fluctuate
- When that area destabilizes, capital flees, harming exchange rates
Business Decisions with Interest Rates
When I is up, Borrow Short Term, Invest Long Term
When I is down, Borrow Long Term, Invest Short Term
