Financial Management
Interest Rates
Interest Rate
Interest Rate is the cost of money that is relevant to debt capital. It
is also the price that lenders receive and borrowers pay for debt
capital.
There are four most fundamentals factors affecting the cost of
money:
1. Rate of return
2. Time preferences for Consumption
3. Risk
4. Inflation
Interest Rate Levels
Borrowers bid for the available supply of debt capital using interest rates: The firms
with the most profitable investment opportunities are willing and able to pay the
most for capital, so they tend to attract it away from inefficient firms and firms whose
products are not in demand.
Interest Rate Levels
There is a price for each type of capital, and these prices change over time as
supply and demand conditions change.
⮚Short-term interest rates are especially volatile, rising rapidly during booms
like when the economy is expanding, firms need capital; and this demand
pushes rates up. Also, inflationary pressures are strongest during business
booms, also exerting upward pressure on rates.
⮚Conditions are reversed during recessions : Slack business reduces the
demand for credit, inflation falls, and the Federal Reserve increases the
supply of funds to help stimulate the economy. The result is a decline in
interest rates.
The Determinants of Market Interest Rate
In general, the quoted (or nominal) interest rate on a given security, r, is composed of a real risk-
free rate, r*, plus several premiums that reflect inflation, the security’s risk, its liquidity (or
marketability), and the years to its maturity. This relationship can be expressed as follows:
or
▪ Real Risk-Free Rate of Interest (r*), It is the interest rate that would exist on a riskless security
if no inflation were expected. r* is not static which means it changes over time depending on
economic conditions.
The Determinants of Market Interest Rate
▪ The Nominal, or Quoted, Risk-Free Rate of Interest, rRF = r* + IP, the rate
of interest on a security that is free of all risk.
Generally, T-bill rate used to approximate short-term risk free rate while T-bond rate used
for long-term risk free rate.
▪ Inflation premium (IP), a premium that is equal to the average expected
future inflation rate that investors add to the real risk free rate of return.
▪ Default Risk Premium (DRP), the risk that a borrower will default, which
means the borrower will not scheduled interest or principal payments. It is
also the difference between the interest rate on a T-bond and a corporate
bond of equal maturity and marketability.
The Determinants of Market Interest Rate
▪ Liquidity (or marketability) Premium (LP), a premium added to the equilibrium
interest rate on a security if that security cannot be converted to cash on short
notice and at close to its “fair market value.”
▪ Maturity Risk Premium (MRP), a premium that reflects interest rate risk. The
effect of maturity risk premiums is to raise interest rates on long-term bonds
relative to those on short-term bonds.
We should note that although long-term bonds are heavily exposed to
interest rate risks, short-term bills are heavily exposed to reinvestment rate risk
*Interest rate risk- risk of capital losses to which investors are exposed because of changing interest rates
*Reinvestment rate risk - risk that a decline in interest rates will lead to lower income when bonds mature and
funds are reinvested
The Term Structure of Interest Rates
⮚Is the relationship between long and short-term rates and it reflects the
expectations of market participants about future changes in interest rates
and their assessment of monetary policy conditions.
⮚Is important to corporate treasurers deciding whether to borrow by issuing
long or short-term debt and to investors deciding whether to buy long or
short-term bonds.
When graphed, the term structure of interest rates is known as a yield
curve, and it plays a crucial role in identifying the current state of an economy.
The Term Structure of Interest Rates
Three primary shapes:
1. Upward Sloping “Normal” Yield Curve
- long-term yields are higher than short-
term yields. This signals that the
economy is in an expansionary mode.
2. Downward “Inverted” Yield Curve -
short-term yields are higher than long-
term yields. Signifies that the economy
is in, or about to enter, a recessive
period.
3. Humped Yield Curve - a yield curve that
results when interest rates on medium-
term maturities are higher than rates on
both short-and long-term maturities.
Determinants of The Shape of The Yield Curve
Expected inflation has an especially important effect on the yield curve’s shape.
Treasuries have essentially no default or liquidity risk, so the yield on a Treasury bond that matures in t
years can be expressed as follows:
• Real risk-free rate (r*) varies somewhat over time due to changes in the economy and demographics,
these changes are random rather than predictable. Therefore, the best forecast for the future value of
r* is its current value.
• Inflation premium, IP, varies significantly over time and in a somewhat predictable manner, it is also
the average level of expected inflation over the life of the bond.
So, If the market expects inflation to increase in the future, the inflation premium will be higher on long-term bond
than on shorter bond. On the other hand, if the market expects inflation to decline in the future, long-term bonds will
have a smaller inflation premium than will short-term bonds.
• Finally, since investors consider long-term bonds to be riskier than short-term bonds because of
interest rate risk, the maturity risk premium (MRP), always increases with maturity.
Determinants of The
Shape of The Yield Curve
Corporate bonds include a default risk
premium (DRP) and a liquidity premium
(LP). Therefore, the yield on a corporate
bond that matures in t years can be
expressed as follows:
Note that: The yield spread between corporate
and Treasury bonds is larger the longer the
maturity because longer-term corporate bonds
have more default and liquidity risk than shorter-
term bonds, and both of these premiums are
absent in Treasury bonds.
Using the Yield Curve to Estimate Future Interest Rates
When yield curve is applied to
U.S. treasury securities in respect
to interest rates, useful
information regarding projected
interest rates in the future over
time can be estimated.
This is carefully monitored by
many traders, and utilized as a
point of comparison
or benchmark for other
investments particularly in
valuation of bonds.
Using the Yield Curve to Estimate Future Interest
Rates
When it comes to interest rates specifically, yield curves are useful constructs in
projecting future behavior.
The pure expectations theory predicts future short-term interest rates based
on current long-term interest rates.
It suggests that an investor earns the same amount of interest by investing in
two consecutive one-year bond investments versus investing in one two-year
bond today.
In this theory, long-term rates can be used to indicate where rates of short-
term bonds will trade in the future.
Macroeconomic Factors that Influence Interest Rate
Levels
The primary macroeconomic factors that have an effect on both general level of
interest rates and the shape of yield curve are the following:
a) Federal Reserve Policy
Macroeconomic Factors that Influence Interest Rate
Levels
b) Federal Budget Deficit
c) International Factors
Macroeconomic Factors that Influence Interest Rate
Levels
d) Level of Business Activity
Short term interest rates are
especially volatile, rising rapidly during
boom and falling equally during
recessions
During recessions:
• The demand for money and the rate
of inflation tended to fall.
• The money supply increases in an
effort to stimulate the economy
• Interest rates decline further.
Interest Rates and Business Decisions
• High Interest Rates Lower Consumer Income
When interest rates rise, consumers with debts are going to have to pay more interest to
lenders.
• High Interest Rates Make It Difficult for Businesses to Obtain Loans
Nearly every small business has outstanding loans, and when interest rates rise, those loans
become more expensive.
• Low Interest Rates Can Spur Consumer Spending
When interest rates are low, consumers tend to borrow more money, and they put that
money back into the economy by spending more on products and services.
• Low Interest Rates Can Spur Business Expansion and Growth
Low interests rates make it much more beneficial for you to take out new loans to invest in
the expansion of your business. Locking in a lower interest rate means borrowers’ loan will
cost them less in the long run.
References:
• Fundamentals of Financial Management – Brigham & Houston - 13th Edition
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