FINANCIAL
ASSETS & THE
CONCEPT OF
INTEREST RATES
J. T. PUNAYAN,
CPA
E-mail:
[Link]@[Link]
At the end of the report, you
AGENDA should be able to do the
following:
● Determine various factors that
influence the cost of money.
● Discuss how market interest
rates are affected by
borrowers’ need for capital,
expected inflation, different
securities’ risks, and securities’
liquidity.
● Explain what the yield curve
is, what determines its shape,
and how you can use the yield
curve to help forecast future
interest rates.
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INTRODUCTION
Companies raise capital in two main
forms: debt and equity. In a free economy,
capital, like other items, is allocated
through a market system, where funds are
transferred and prices are established.
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COST OF MONEY
The four most fundamental factors
affecting the cost of money are
(1) production opportunities, (2)
time preferences for
consumption, (3) risk, and (4)
inflation.
IR = F ( S + D)
5
L & S-T IR
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INFLATION & L-T IR
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THE DETERMINANTS
OF MARKET INTEREST
RATES
The quoted (or nominal) interest rate on a debt 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:
Quoted interest rate = r = r* + IP + DRP + LP + MRP
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YIELD CURVE
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PURE EXPECTATION
THEORY
A theory that states that the shape of the
yield curve depends on investors’
expectations about future interest rates
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ASSUME THAT A 1-YEAR TREASURY BOND CURRENTLY
YIELDS 5.00%, AND A 2-YEAR BOND YIELDS 5.50%.
Option 2: Buy a 1-
year security, hold
it for 1 year, and
Option 1: Buy a 2-
then at the end of
year security and
the year
hold it for 2 years.
reinvest the
proceeds in another
1-year security.
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ASSUME THAT A 1-YEAR TREASURY BOND CURRENTLY
YIELDS 5.00%, AND A 2-YEAR BOND YIELDS 5.50%.
Option 1, for every dollar they invest today, they
will have accumulated $1.113025 by the end of
Option 1: Buy a 2- Year 2:
year security and
hold it for 2 years.
Funds at end of Year 2 = $1 X = $1.113025
Or
Funds at end of Year 1 = $1 X (1.055) = $1.055
Funds at end of Year 2 = $1.055 X (1.055) =
$1.113025
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ASSUME THAT A 1-YEAR TREASURY BOND CURRENTLY
YIELDS 5.00%, AND A 2-YEAR BOND YIELDS 5.50%.
If they select Option 2, they should end up
with the same amount, but this equation is Option 2: Buy a 1-
used to find the ending amount: year security, hold
it for 1 year, and
Funds at end of Year 2 = $1 X (1.05) = (1 + then at the end of
X) the year
reinvest the
To find the interest rates which makes the proceeds in another
options indifferent: 1-year security.
(1.05)(1 + X) =
1 + X = 1.05
X = 6.00238%
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LET’S SUPPOSE THAT THE YIELD CURVE LOOKS AS
FOLLOWS:
1-YEAR T-BOND: 5.00%
2-YEAR T-BOND: 5.50%
4-YEAR T-BOND: 6.25%
An investor would like to purchase a 1-year T-bond today and then to invest in a 3-
year T-bond 1 year from now. What yield would this investor expect to earn on the
3-year T-bond 1 year from now?
(1.0625)^4 = (1.05) x (1 + X)^3
(1.0625)^4 /(1.05) = (1 + X)^3
1.213742 = (1 + X)^3
(1.213742)^1/3 = (1 + X)
X = 0.0667 or 6.67%
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MACROECONOMIC
FACTORS THAT
INFLUENCE
INTEREST RATE LEVELS
The primary factors are (1) Federal
Reserve policy, (2) the federal budget
deficit or surplus, (3) international factors,
including the foreign trade balance and
interest rates in other countries, and (4)
the level of business activity.
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THANK YOU
Jay T. Punayan, CPA
Email Address: [Link]@[Link]
Sample Footer Text 2/7/20XX 16