Ch 5: Interest Rates Flashcards
What is the cost of money?
The rate you pay the lender to borrow the money
What is an interest rate?
The rate of cost per year to use someone else’s money
Inflation
The decrease of the purchasing power of currency over time
What causes inflation to rise?
The demand for goods & services grows faster than supply of goods & services; an increase in the amount of money in circulation in an economy
What does the interest rate compensate the lender for?
The lost of the opportunity to use that money, the loss of the value over time due to inflation, and the chance that they won’t get the money back
Nominal or Quote Rate
r = r* + IP + RP + DRP + LP + MRP
r*
Real (risk free) rate which is the opportunity cost
IP
Inflation premium which compensates for inflation
RP
Risk premium which compensates for possible default; increases with lower credit score
What are the two basic types of interest?
Simple interest and compound interest
What are the major factors that affect the cost of money?
Opportunity cost, risk, expected inflation, federal reserve policy, business activity/state of the economy, federal deficits, and foreign trade balance
What components of an interest rate are the risk premium?
DRP, LP, MRP
How is IP computed?
The average expected inflation rate over the life of the loan
DRP
Default risk premium which compensates the lender for possible default
What is concerned a riskless asset?
30-Day Treasury Bill
What is the DRP of a 30-Day Treasury Bill?
0%
LP
Liquidity premium which accounts for the ability of a borrower to repay a load with the firm’s asset
When is LP higher?
When assets are not very liquid (i.e. real estate, buildings, equipment)
Liquid asset
Non cash asset that can be converted quickly into cash and without significant loss in value
Does the U.S. pay LP? Why or why not?
No because they have the ability to print cash which is the most liquid asset
MRP
Maturity Risk Premium which depends on how long you are borrowing
What does MRP compensate for?
Interest rate risk and reinvestment risk
Nominal Risk-Free Rate
r sub rf; Same as the interest rate on a 30-Day Treasury Bill, because there is no risk premium
How do you calculate r*?
Nominal Risk-Free Rate - Current Inflation Rate
Why do company’s hold little cash on hand?
Because cash invested makes more money than cash on hand
What is yield?
Rate of Return
How do you compute r for loans shorter than 1 year maturity?
r = nominal risk free rate + DRP + LP + MRP
How do you compute r for loans longer than 1 year maturity?
r = r* + IP + RP + DRP + LP + MRP
What is the difference between calculating r for short term and long term rates?
Short term rates do not have IP
How do you calculate IP for long term loans?
(Inflation year 1 + Inflation year 2 + Inflation year 3…)/number of years of maturity
Market Interest Rate
Equilibrium Rate
What factors tend to lower interest rates?
Banks wanting cash flow from your interest payments, trying to offer more attractive rates, and often entering into risky lending in pursuit of cash flow
The interest rate a borrow pays is equal to what?
The lenders rate of return
How do you calculate the ROR of stock?
r* + IP + RP
What is the required ROR for anything?
r* + IP + RP
Even if an investment is risk free, what does the ROR compensate for?
Opportunity cost and inflation
What component of r is the only thing that changes for different investments?
Compensation for risk
What is the opportunity cost of capital?
The best available expected return offered in the market on an investment of comparable risk and length
Capital
Wealth in the form of money or property that can be used to produce more wealth
Term Structure
The relationship between interest rates (yields) and different loan lengths (maturities)
Why do bonds of longer maturity have higher interest rates?
More uncertainty with all risk
Yield Curve
A graph of the term structure that tells you the relationship at a specific date
What does a yield curve not predict?
Future interest rates
Upward sloping yield curve
Smaller interest rates on short term bonds, markets expect inflation to rise
Downward sloping yield curve
Higher interest rates on short term bonds, markets expect inflation to decrease
What does the shape of the yield curve indicate?
What the bond markets think inflation (and thus interest rates) might do in the future
What do yield curves not take into account?
Actions by the Federal Reserve
Concave yield curves
Markets predict direction of inflation is about to change
Flat line yield curves
Markets uncertain about direction of inflation
How should you borrow if the yield curve is upward sloping?
Borrow now because interest rates are expected to rise; borrow long term because you will lock in that lower interest rate for longer
How should you borrow if the yield curve is downward sloping?
Borrow later because interest rates are expected to drop; if you have to borrow, borrow short term so you can refinance sooner when the rates are expected to be lower
How should you borrow if the yield curve has been downward and is now flat?
Borrow now, long term because it is very unlikely rates will get lower soon
Which part of the yield curve changes more drastically?
Short term
Which firms have higher interest rates?
Higher risk firms
