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Transcript of 1 What is the cost of money, and how is it determined? What factors affect interest rates? What is a...
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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
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Yield Dollar return
Beginning value
Dollar income + Capital gains
Beginning value
Dollar income + (Ending value -Beginning value)
Beginning value
Realized Returns
50.0%0.50$10
$5
$10
$10) - ($12 + $3
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Cost of Money
Interest rates are based on:Production Opportunities—greater production opportunities, greater demand for fundsTime Preference for Consumption—individuals save less if they have a great need for current consumptionRisk—investors demand higher returns for riskier investmentsInflation—investors save to increase their ability to purchase in the future
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Interest Rates—Levels
Function of supply and demand
Dollars
InterestRate, r
S1
D1
7.0
D2
8.5
Interest rates fluctuate continuously
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Interest Rates—Determinants
0 Risk
Return (r)
rRF
Risk-Free Return = rRF
Risk Premium = RP r = rRF + RP
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Interest Rates—Determinants
r = rRF + RP
=[r* + IP]
r* = real risk-free rateIP = inflation premiumDRP = default risk premium
LP = liquidity (marketability) premiumMRP = maturity risk premium
r* = real risk-free rateIP = inflation premium
= rRF
DRP = default risk premiumLP = liquidity (marketability) premiumMRP = maturity risk premium
= RP
r = rRF + RP
=[r* + IP] + [DRP + LP + MRP]
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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
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Term Structure of Interest Rates—Yield Curve
Rate(Yield)
Maturity
Rate(Yield)
Upward sloping
Downward sloping
Flat
Short-Term Bonds Long-Term Bonds
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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)
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Interest Rates
Other Factors that Influence Interest Rates
Federal Reserve Policy
Federal Deficits
Foreign Trade Balance
Business Activity
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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
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Forecasting Interest Rates
Exp Infl
Year Each Yr Avg Inflation Per Yr, IPt
20x1 1%20x1 1% = 1%/1 = 1%
20x2 5% = (1%+5%)/2 = 3%
20x3 6% = (1%+5%+6%)/3 = 4%
20x1 1% = 1%/1 = 1%20x1 1% = 1%/1 = 1%
20x2 5%
20x1 1% = 1%/1 = 1%
20x2 5% = (1%+5%)/2 = 3%
20x1 1% = 1%/1 = 1%
20x2 5% = (1%+5%)/2 = 3%
20x3 6%
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Forecasting Interest Rates
If the real risk-free rate, r*, is 3 percent, then the forecasted yields on bonds will be:
Bond Type r* + IPt = Nominal Rate,
rRF1-year bond 3% + 1% = 4%
2-year bond 3% + 3% = 6%
3-year bond 3% + 4% = 7%
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Forecasting Interest Rates
Expected Rate on aYear r* Annual Infl 1-Year Bond
20x1 3% 1% 4%20x2 3% 5% 8%20x3 3% 6% 9%
1-year bond 4%/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 Rates rRF
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%
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The Cost of Money as a Determinant of Value
nn
22
11
r)(1CF
r)(1CF
r)(1CF
Asset an of Value
r r r
r = required rate of return
tCF
= expected cash flow in Period t
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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.
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Answers to QuestionsWhat 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.