CH 6: Interest Rates

ST interest rates are prone to ___ during booms

rise

inflationary pressure tries to ___ rates

increase

During recessions, ST interest rates normally___

fall

What does the Federal Reserve normally do in response to recessions

lowers interest rates to stimulate the economy

ST interest rates have a ____ correlation with Inflation than LT rates

higher

What was the average inflation % from 1913 to 2019

2.96 (about 3)

higher rates of return are expected from investors of

riskier investments

WACC =

cost of debt (1-t) + cost of equity

k=

k* + IP + DRP + LP + MRP

k is the

quoted (nominal) interest rate

k* is the

real risk-free rate of interest

kRF =

k* + IP

the nominal risk-free rate of interest

kRF

IP stands for

inflation premium

DRP stands for

default risk premium

US treasury has a DRP and LP of

0

LP stands for

liquidity premium

exists on all LT bonds because of interest rate risk

MRP

MRP stands for

maturity risk premium

the fluctuation of the price of a LT bond when interest rates change

interest rate risk

risk =

fluctuation

the risk of having to reinvest money at a new interest rate because of a short maturity

reinvestment rate risk

When the ST rate is lower than the LT; upward sloping

Normal Yield Curve

What was the last year that there was a balanced budget in the US?

1997

What determines the shape of the yield curve?

Inflation Expectations Theory (Pure Expectations theory)
Maturity Risk Premium

Theory that can push or pull down interest rates

Inflation expectations theory

theory that can only increase the interest rate

maturity risk premium

What are the 3 federal reserve policies?

Reserve Requirements
Discount Rates
Open Market Operations

Money that normal americans have access to

money supply

MS and i have a ___ relationship

inverse

If the reserve requirement increases:

MS decreases
i increases

If reserve requirement decreases:

MS increases
i decreases

interest rate on a loan from the Fed to banks

discount rate

If discount rate increases:

MS decreases
i increases

If Discount Rate decreases:

MS increases
i decreases

Fed buys and sells bonds on the market (actively happening all the time)

Open Market Operations

If the Fed SELLS treasury stock:

MS decreases
i increases
(they take your money)

If Fed BUYS Securities on open market:

MS increases
i decreases
(pay out money)

Federal Deficit =

Taxes
(Programs)

When fed rates drop dramatically it is called

firing the gun

when the Feds “fire the gun”, interest rates

drop to 0-.25%

When Fed interest rates are almost 0, it is a good time to:

buy stocks

When Federal interest rates rise, it is a good time to

sell stocks

When the Federal rate peaks, it is a good time to:

buy bonds

When the interest rates drop back down to 0, it is a good time to:

sell bonds at a premium

Foreign Trade Deficit =

Exports
(Imports)

The country with the highest rates will ensure that other countries invest there and will buy that currency

Interdependency of Nations Rates

risk that arises from investing or conducting business in a particular country; depends on country’s political, economical, and social environment

Country Risk

When country risk increases/is high:

there is a decrease in people investing in country and their currency loses value

risk that exchange rates will fluctuate

Exchange rate risk

What are the causes of exchange rate fluctuations:

changes in relative inflation rates
increase in country risk

increased country risk means:

decreased currency value

When interest rates are high, you should:

NOT borrow money
invest in ST investments and bonds

the interest rate that would exist on a riskless security if no inflation were expected

real risk-free rate of interest