Financial Management Fundamentals

12th Edition (Philippine Edition)

CHAPTER SIX

INTEREST RATES

Reported by: Sherinne Christie Ann Z. Albao

January 2013, Financial Management
 A BRIEF BACKGROUND
The US economy 1990-2007
Economic growth was positive
Unemployment was fairly low
Inflation remained under control

Reasons for the economy’s good performance:

Low level of interest rates
Treasury bills/bonds are low
The low interest rates reduced the capital for cost of capital for
business which encourage corporate investment, stimulate
consumer spending and helped produce massive growth in the
market.
 A BRIEF BACKGROUND
Because corporations and individuals are greatly
affected by interest rates, we take a closer look
at the major factors that determine those rates.

It will be interesting to see if interest rates can

continue to remain low and if not, whether the
economy can continue to perform as well as it
has in the past.
PUTTING THINGS IN PERSPECTIVE
Companies raise capital in
two main forms:
DEBT and EQUITY
INTEREST RATES
Is the price that lenders received
and borrowers pay for debt
capital
The cost of debt is a key
determinant of bond and stock
prices, it is also an important
component of the cost of
corporate capital.
CAPITAL
Is allocated through a market
system, where funds are
transferred and prices are
established.
Equity investors expect to
receive DIVIDENDS+CAPITAL
GAINS, the sum of which
represent the cost of equity.
Interest rates are different depending
upon:
1. Borrower’s Risks
2. Use of Funds Borrowed
3. Type of Collateral Used
4. Time
 THE COST OF MONEY
There are (4) most FUNDAMENTAL FACTORS
affecting the cost of money:
Production Opportunities
Time Preferences for Consumption
Risk
Inflation
E.g. Isolated Island where people live on FISH.
 THE COST OF MONEY
Interest rate paid to savers depends:
1. On the rate of return that producers expect
to earn on invested capital
2. On savers’ time preferences on current vs.
future consumption.
3. Riskiness of the loan.
4. Expected Future rate of inflation.
 SELF TEST
What is the price paid to borrow debt capital called?
>>> INTEREST

What are the two items whose sum is the cost of equity?
>>> DIVIDENDS & CAPITAL GAINS

What (4) Fundamental factors affect the cost of money?

>>> Production Opportunities, Time Preferences for
Consumption, Risk and Inflation.
INTEREST RATE LEVELS

Flight to
Quality

RISK PREMIUM
= 7% - 5% = 2%
Current Real
Rate of
Interest
We can be sure of two things:
1. Interest rates will vary
2. They will increase if inflation appears to be
headed higher or decrease if inflation is
expected to decline.

We don’t know where interest rates will go, but

we do know they will vary.
 SELF TEST
What role do interest rates play in allocating capital to different
potential borrowers?
>>> It allows borrowers to bid for available supply of debt
capital.

What happens to market-clearing, or equilibrium, interest rates

in a capital market when the supply of funds declines? What
happens when expected inflation increases or decreases?
>>> If supply funds declines, it causes the supply line to move backward
causing the interest rate to increase. If inflation is expected to increase,
people buy or borrow early expecting that interest rates will increase
tomorrow while inflation decreases it makes interest rates decrease as
well.
 SELF TEST
How does the price of capital tend to change during a boom?
During a recession?
>>> During a booming period in the economy it causes the price
of the capital to increase since this is when firms have a high
demand for capital pushing interest rates to increase hence also
increasing capital price. Also, when recession occurs it reduces
the demand for credit, inflation falls, interest rates decreases
and Government reserves increase the supply of funds to
stimulate the economy hence decreasing the price of capital.
 SELF TEST
If inflation during the last 12 months was 2% and the interest
rate during that period was 5% what was the real rate of
interest? If inflation is expected to average 4% during the next
year and the real rate is 3%, what should the current interest be?

Real Rate of Interest = Current Interest Rate – Inflation Rate

= 5% - 2% = 3%

Current Interest Rate = Real Rate + Inflation Rate

= 3% + 4% = 7%
 DETERMINANTS OF MARKET
INTEREST RATES
Quoted (Nominal) Interest Rate
r = r*+IP+DRP+LP+MRP also, r=rRF+DRP+LP+MRP
Notes:
r The quoted/nominal, rate of interest on a given security

r* (r-star) the real risk-free rate of interest. The rate that would exist on a riskless security in a world no
inflation is expected

rRF r*+IP. It is a quoted rate on a risk free security which is very liquid and is free of most type of risk. (IP is
included)
IP Inflation Premium. It is equal to the average expected rate of inflation over the life of the security. The
expected future inflation rate is not necessarily equal to the current inflation rate, so IP is not
necessarily equal to current inflation shown in Figure 6-3.
DRP Default Risk Premium. This reflects the possibility that the issuer will not pay the promised interest or
principal at the stated time.
LP Liquidity(Marketability) premium. This is charged by lenders to reflect that some securities cannot be
converted to cash on short notice at a “reasonable” price.
MRP Maturity Risk Premium. Charged by lenders to reflect this risk.
REAL RISK-FREE RATE OF INTEREST
r*
The interest rate that would exist on a riskless
security of no inflation were expected.
It is not static – it changes depending on the
conditions of the economy, especially on (1) rate of
return and (2) time preferences for current vs. future
consumption.
The best estimate of r* is the rate of return on
indexed Treasury bonds, that will be discussed later.
 THE NOMINAL RISK FREE RATE OF
INTEREST
rRF = r*+IP
Real risk-free rate plus a premium for expected
inflation rate over the remaining life of the security.
The risk-free rate should be the interest rate on a
totally risk free security – but there is no such
security, therefore, there is no truly observable risk-
free rate.
Proxied by the T-bill rate or the T-bond rate.
 INFLATION PREMIUM
Inflation has a major impact on interest rates because it
erodes the real value of what you receive from the
investment.
Investors are well aware of the risks of inflation so when they
lend money they build an inflation premium – equal to the
average expected inflation rate over the life of the security
into the rate they charge.
It is important to note that the inflation rate built into interest
rates is the inflation rate expected in the future, not on the
past.
Note that the inflation rate reflected in the quoted interest
rate on any security is the average inflation rate expected
over the security’s life.
DEFAULT RISK PREMIUM (DRP)
The risk that a borrower will default, which means the
borrower will not make scheduled interest or principal
payments, also affects the market interest rate on a bond: The
greater the bond’s risk of default, the higher the market rate.
DRP = Quoted Interest Rate on a T-bond (-) Interest rate of a
corporate bond of equal maturity and marketability.
 LIQUIDITY PREMIUM (LP)
It is added to the equilibrium of interest rate on a security if
that security cannot be converted to cash on a short notice
and at close to it’s fair market value.
Real Assets are generally less liquid than financial assets, but
different financial assets vary in liquidity.
Investors included LP, because it is important in the rates
charged on different debt securities.
It is difficult to measure liquidity premiums accurately, a
differential of at least two and probably four to five
percentage points exists between the least liquid and the
most liquid financial assets of similar default risk and maturity.
 INTEREST RATE RISK & MRP
The prices of long-term bonds decline whenever interest rates
rise and because interest rates can and do occasionally rise, all
long-term bonds have an element of risk called interest rate risk.
As a general rule, the bonds of any organization have more
interest rate risk the longer the maturity of the bond. Therefore
a maturity risk premium (MRP) which is higher the greater the
years to maturity, is included in the required interest rate.
Maturity risk premiums effects is to raise interest rates on long-
term bonds relative to those on short-term bonds. It is difficult
to measure but (!) it varies overtime and (2) MSP on a 20-year T-
bond has generally been in the range of one to two percentage
points.
 INTEREST RATE RISK & MRP
Also note that long-term bonds are heavily exposed to interest
rate risk, short term bills are heavily exposed to reinvestment
rate risk. When short-term bonds mature and the principal
must be reinvested or “rolled over” a decline in interest rates
would necessitate reinvestment at a lower rate which would
result in a decline in interest income.
 SELF TEST
Write an equation for the nominal interest rate on any security.
>>> r = r*+IP+DRP+LP+MRP

Distinguish between the real risk-free rate of interest, r*, and the
nominal or quoted, risk-free rate of interest, rRF.
>>> Real risk free rate of interest is an interest rate on which we
expected no inflation while quoted, risk free rate includes the
inflation premium to tell that there is no such risk-free security.
 SELF TEST
How do investors deal with inflation when they determine
interest rates in the financial markets?
>>> They take analyze if inflation would increase or decrease in
the following years, they take on the average expected inflation
rate then the build an inflation premium on what they charge.

Does the interest rate on a T-bond include a default risk

premium. Explain.
>>> Yes. Any bonds issued by both private
corporations/government is considered to have some default
risk. The amount of default risk is very important to pricing a
bond. Also, the formula of ‘r’ also include DRP if applicable.
 SELF TEST
Assume that the real interest rate is r*=2% and the average expected inflation
rate is 3% for each future year. The DRP and LP for Bond X are each 1% and
the applicable MRP is 2%. What is Bond X’s interest rate? Is Bond X (1) a
Treasury bond or a corporate bond and (2) more likely to have a 3-month or a
20-year maturity? (9%, corporate, 20-year)

r= r*+IP+DRP+LP+MRP
r= .02+.03+.01+.01+.02
r= .09, 9%

It is a corporate bond and more likely a 20 year maturity.

 SELF TEST
What effect would each of the ff. events likely have on the level
of nominal rates?
r = r*+IP+DRP+LP+MRP
a.) Households dramatically increase their savings rate.
IT WILL DECREASE
b.) Corporations increase their demand for funds following an
increase in investment opportunities.
IT WILL INCREASE
c.) There is an increase in expected inflation.
IT WILL INCREASE