Money Rates - Textbook MediaFlow Present values ... The real rate of interest ... foreign currency...
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Chapter 4 Money Rates
Transcript of Money Rates - Textbook MediaFlow Present values ... The real rate of interest ... foreign currency...
Chapter 4
Money Rates
4-2 © 2002, 2012 Frank M. Werner and James A.F. Stoner
Money Rates
Introductory concepts – interest rates, present value, and time
The components of interest rates
The term structure of interest rates
Other interest rate structures
Exchange rate systems
Foreign exchange market quotations
Spot and forward rates
Business exposure to exchange rates
4-3 © 2002, 2012 Frank M. Werner and James A.F. Stoner
Money Rates
Introductory concepts – interest rates, present value, and time
The components of interest rates
The term structure of interest rates
Other interest rate structures
Exchange rate systems
Foreign exchange market quotations
Spot and forward rates
Business exposure to exchange rates
4-4 © 2002, 2012 Frank M. Werner and James A.F. Stoner
Present Value and Interest
Rates
Interest rates and present values move in
opposite directions
4-5 © 2002, 2012 Frank M. Werner and James A.F. Stoner
Present Value and Time to Cash
Flow
Present values become more volatile as
the time to receiving a cash flow
increases
– When interest rates change, the present value of
a near-term cash flow (e.g., 1-year in the future)
changes very little
– When interest rates change, the present value of
a long-term cash flow (e.g., 30-years in the
future) changes by a large amount
4-6 © 2002, 2012 Frank M. Werner and James A.F. Stoner
Money Rates
Introductory concepts – interest rates, present value, and time
The components of interest rates
The term structure of interest rates
Other interest rate structures
Exchange rate systems
Foreign exchange market quotations
Spot and forward rates
Business exposure to exchange rates
4-7 © 2002, 2012 Frank M. Werner and James A.F. Stoner
The Components of Interest
Rates
The Fisher Model
– rp = pure rate of interest
– ri = inflation premium
– rr = risk premium
1)r+)(1r+)(1r+(1=rate Nominalrip
4-8 © 2002, 2012 Frank M. Werner and James A.F. Stoner
The Components of Interest
Rates
The real rate of interest
The risk-free rate
The model can explain differences among interest rates in different countries
1)r+)(1r+(1=rate Realrp
1)r+)(1r+(1=rateRisk-free ip
4-9 © 2002, 2012 Frank M. Werner and James A.F. Stoner
Prices and Yields of U.S. Treasury
Securities
4-10 © 2002, 2012 Frank M. Werner and James A.F. Stoner
Money Rates
Introductory concepts – interest rates, present value, and time
The components of interest rates
The term structure of interest rates
Other interest rate structures
Exchange rate systems
Foreign exchange market quotations
Spot and forward rates
Business exposure to exchange rates
4-11 © 2002, 2012 Frank M. Werner and James A.F. Stoner
The Yield Curve in November
2010
4-12 © 2002, 2012 Frank M. Werner and James A.F. Stoner
Yield Curve Shapes
4-13 © 2002, 2012 Frank M. Werner and James A.F. Stoner
Term Structure of Interest Rates
The expectations hypothesis – the term structure reflects expectations of inflation
The liquidity preference hypothesis – liquidity risk increases with maturity, hence so does investors’ required rate of return
The segmentation or hedging hypothesis – each maturity is a separate market with its own supply and demand, hence its own interest rate
4-14 © 2002, 2012 Frank M. Werner and James A.F. Stoner
Money Rates
Introductory concepts – interest rates, present value, and time
The components of interest rates
The term structure of interest rates
Other interest rate structures
Exchange rate systems
Foreign exchange market quotations
Spot and forward rates
Business exposure to exchange rates
4-15 © 2002, 2012 Frank M. Werner and James A.F. Stoner
Risk Structure of Interest Rates
Default risk
Interest-rate risk
Reinvestment risk
Marketability risk
Call risk
4-16 © 2002, 2012 Frank M. Werner and James A.F. Stoner
Tax Structure of Interest Rates
– Who Taxes What?
Investors care about after-tax yields
4-17 © 2002, 2012 Frank M. Werner and James A.F. Stoner
Money Rates
Introductory concepts – interest rates, present value, and time
The components of interest rates
The term structure of interest rates
Other interest rate structures
Exchange rate systems
Foreign exchange market quotations
Spot and forward rates
Business exposure to exchange rates
4-18 © 2002, 2012 Frank M. Werner and James A.F. Stoner
Exchange Rate Systems
Historically – the gold standard
Bretton Woods (1944) – a fixed exchange rate system based on the U.S. dollar
Why Bretton Woods broke down – the underlying economics of countries changed relative to one another – Economies in Europe and Japan strengthened
– The U.S. ran balance of payments deficits in the mid-1960s
– U.S. holdings of gold fell significantly
4-19 © 2002, 2012 Frank M. Werner and James A.F. Stoner
Exchange Rate Systems
in Place Today
Floating exchange rate system – currency values adjust continuously in the public markets
Managed (dirty) float – government influences a floating exchange rate
Pegged float – a currency is fixed against another which floats
4-20 © 2002, 2012 Frank M. Werner and James A.F. Stoner
The Euro
Sixteen members of the European Union have replaced their currencies with the Euro, a common currency
4-21 © 2002, 2012 Frank M. Werner and James A.F. Stoner
Money Rates
Introductory concepts – interest rates, present value, and time
The components of interest rates
The term structure of interest rates
Other interest rate structures
Exchange rate systems
Foreign exchange market quotations
Spot and forward rates
Business exposure to exchange rates
4-22 © 2002, 2012 Frank M. Werner and James A.F. Stoner
Foreign Exchange Market
Quotations
Direct (American) rates – the price of a
foreign currency in domestic money
Reciprocal (European, Continental) rates
– the number of units of a foreign
currency needed to buy one unit of
domestic currency
Cross rates – the price of one foreign
currency in terms of another, calculated
via their relationships to a third currency
4-23 © 2002, 2012 Frank M. Werner and James A.F. Stoner
Exchange Rate Quotations
4-24 © 2002, 2012 Frank M. Werner and James A.F. Stoner
Money Rates
Introductory concepts – interest rates, present value, and time
The components of interest rates
The term structure of interest rates
Other interest rate structures
Exchange rate systems
Foreign exchange market quotations
Spot and forward rates
Business exposure to exchange rates
4-25 © 2002, 2012 Frank M. Werner and James A.F. Stoner
Spot and Forward Rates
Spot rate – a rate quoted for an immediate
trade
Forward rate – a rate quoted for a contract
to be entered into today binding the
parties to a trade to take place in the
future
4-26 © 2002, 2012 Frank M. Werner and James A.F. Stoner
Forward Discount or Premium
Forward discount – the amount by which
forward rates are less than spot rates
Forward premium – the amount by which
forward rates are greater than spot rates
Calculation
forward months
12
spot
spotforward
4-27 © 2002, 2012 Frank M. Werner and James A.F. Stoner
Money Rates
Introductory concepts – interest rates, present value, and time
The components of interest rates
The term structure of interest rates
Other interest rate structures
Exchange rate systems
Foreign exchange market quotations
Spot and forward rates
Business exposure to exchange rates
4-28 © 2002, 2012 Frank M. Werner and James A.F. Stoner
Business Exposure to
Exchange Rates
Transaction exposure – exposure to losses
on day-to-day transactions
Translation exposure – exposure to losses
of accounting income and book values
Economic exposure – exposure to
changes in the value of monetary assets
and liabilities and to reduction in cash
flow
4-29 © 2002, 2012 Frank M. Werner and James A.F. Stoner
Economic Exposure
