Chapter 2The Financial Environment

MarketsInstitutionsInterest Rates

Fin 220Dr. Batool AsiriSept 2010

© 2005 Thomson/South-Western

Four factors that affect the cost of money

The Cost of Money

Production opportunities Time preferences for consumption Risk Expected inflation

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The Cost of Money

What do we call the price, or cost, of debt capital?The Interest Rate

What do we call the price, or cost, of equity capital?Return on Equity =Dividends +Capital Gains

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k = Quoted or nominal ratek* = Real risk-free rate (“k-star”)IP = Inflation premiumkRF = Real risk-free rate plus a

premium for expected inflation kRF = k* + IP

DRP = Default risk premiumLP = Liquidity premiumMRP = Maturity risk premium

The Determinants of Market Interest RatesQuoted Interest Rate = k = k* + IP + DRP + LP + MRP

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IP = Inflation premiumDRP = Default risk premiumLP = Liquidity premiumMRP = Maturity risk premium

Premiums Added to k* forDifferent Types of Debt

Short-Term (S-T) Treasury: only IP for S-T inflationLong-Term (L-T) Treasury: IP for L-T inflation, MRPShort-Term corporate: Short-Term IP, DRP, LPLong-Term corporate: IP, DRP, MRP, LP

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The Term Structure of Interest Rates

Term structure: the relationship between interest rates (or yields) and maturities

A graph of the term structure is called the yield curve.

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U.S. Treasury Bond Interest Rates on Different Dates

Interest RateTerm to March July July Maturity 1980 2000 2003 3 months 16.0% 6.1% 0.9%1 year 14.0 6.1 1.05 years 13.5 6.2 2.310 years 12.8 6.1 3.320 years 12.3 6.2 4.3

Short Term Intermediate Term Long Term

1 5 10 20

16

14

12

10

8

6

4

2

0

Interest Rate (%)

March 1980

July 2000

July 2003

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Three Explanations for the

Shape of the Yield Curve

Liquidity Preference Theory Expectations Theory Market Segmentation Theory

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Expectations Theory

Shape of curve depends on investors’ expectations about future inflation rates.

If inflation is expected to increase, S-T rates will be low, L-T rates high, and vice versa. Thus, the yield curve can slope up OR down.

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Liquidity Preference Theory

Lenders prefer S-T securities because they are less subject to interest rate risk and are thus more easily bought or sold in the market.

Thus, S-T rates should be low, and the yield curve should be slope upward.

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Market Segmentation Theory

Borrowers and lenders have preferred maturities

Slope of yield curve depends on supply and demand for funds in both the L-T and S-T markets (curve could be flat, upward, or downward sloping)

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Interest Rate Levels and Stock Prices

The higher the rate of interest, the lower a firm’s profits

Interest rates affect the level of economic activity, and economic activity affects corporate profits

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