BMAN Ch. 5 - The Cost of Money (interest rates)

The Cost of Money (interest rates)

Pricing system that is based on the supply of and the demand for funds. Used for excess of funds of lenders that is allocated to borrowers.

Dollar return an investor earns is divided into two categories:

1. income paid by the issuer of the financial asset (stock or bond)

2. change in the market value of the asset (capital gains) over some time period

1st Fundamental Factor that affects the Cost of Money

Production Opportunities

2nd Fundamental Factor that affects the Cost of Money

Time Preferences for Consumption

3rd Fundamental Factor that affects the Cost of Money

Risk

4th Fundamental Factor that affects the Cost of Money

Inflation

Beginning Value & Ending Value

Represents the market value of the investment at the beginning of the period that yield is computed.

Market Value at the end of the period.

Income from the investment consists of the interest paid by the borrower if …

financial asset is debt

Income from the investment is the dividend paid by a corporation if…

Financial asset is equity

Production Opportunity

The return available within an economy from investment in a productive (cash-generating) asset.

Time Preference for Consumption

The preference of a consumer for current consumption as opposed to saving for future consumption.

Risk 

In a financial market context, the chance that a financial asset will not earn the return promised.

Inflation

The tendency of prices to increase over time.

Nominal (quoted) risk-free rate ( r _RF )

Rate of interest on a security that is free of all risk; r _RF is proxied by the T-bill rate and includes an inflation premium. ( = r^* + Inflation premium) ← (adding risk free rate and inflation premium)

Real risk-free rate of interest (r *)

The rate of interest that would exist on default-free U.S. Treasury securities if no inflation were expected in the future 

Inflation Premium (IP)

Premium that investors add to the real risk-free rate of return to account for inflation that is expected to exist during the life of the an investment. 

Default Risk Premium (DRP)

Difference between the interest rate on a U.S. Treasury Bond and a corporate bond of equal maturity and marketability; compensation for the risk that a corporation will not meet its debt obligations

Liquidity Premium

A premium added to the rate on a security if the security cannot be converted to cash on short notice at a price that is close to the original cost.

Maturity Risk Premium (MRP)

A premium that reflects interest rate risk; bonds with longer maturities have greater interest rate risk.

Term Structure of Interest Rates

The relationship between yields and maturities of securities.

Yield Curve

A graph showing the relationship between yields and maturities of securities on a particular date.

Normal Yield Curve

An upward-slopping yield curve.

Inverted (abnormal) Yield Curve

A downward-sloping yield curve.

Liquidity Preference Theory

Theory that, all else being equal, lenders prefer to make short-term loans rather than long-term loans; hence, they will lend short-term funds at lower rates than they lend long-term funds.

Expectations Theory

Theory that the shape of the yield curve depends on investors’ expectations about future inflation rates.

Market Segmentation Theory

Theory that every borrower and every lender has a preferred maturity, and that the slope of the yield curve depends on the supply of and the demand for funds in the long-term market relative to the short-term market.

Open Market Operations

Operations in which the Federal Reserve buys or sells Treasury securities to expand or contract the U.S. money supply.

The interest rate (return affects the prices of …

investments

When rates in the financial market increase, …

the price (values) of financial assets decrease