Chapter4Interest Rate FundamentalsLawrence J. GitmanJeff MaduraFinancial management4-2 Copyriht ! 2""# $ddison-%esley&iscuss the components that influence the ris'-free interest rate at a i(en point in time.)*plain why the ris'-free interest rate chanes o(er time.)*plain why the ris'-free interest rate (aries amon possi+le maturities ,in(estment hori-ons..)*plain the relationship +etween ris' and nominal rate of interest.)*plain why re/uired returns of ris'y assets chane o(er time.Learning Goals4-0 Copyriht ! 2""# $ddison-%esleyRF 1 k2 3 IPInterest Rate Fundamentals4he interest rate represents the cost of money to a +orrower and the return on in(ested money to an in(estor ,or lender..4he real rate of interest ,k2. reflects the rate of interest that would e*ist if there was no e*pected inflation and no ris'.4he ris'-free rate of interest ,RF. reflects only the real rate of interest ,k2. plus a premium ,IP. to compensate in(estors for inflation ,risin prices..4-4 Copyriht ! 2""# $ddison-%esleyk5 1 k2 3 IP 3 RPInterest Rate Fundamentals4he nominal rate of interest ,k5. is the rate of interest actually chared+y the supplier of funds and paid +y the demander of funds.$ll nominal ,o+ser(ed. rates contain an inflation premium ,IP. to compensate in(estors for inflation and a ris' premium ,RP. to compensate in(estors for issuer ris' characteristics such as the ris' of default.4-6 Copyriht ! 2""# $ddison-%esleyInterest Rate FundamentalsFiure 4.#4-7 Copyriht ! 2""# $ddison-%esleyExplaining Changes in the Risk-Free RateIn this te*t8 we will use the rate of interest on 9.:. 4reasury ;ills ,4-;ills. as pro*y for the ris'-free rate of interest +ecause the return on this in(estment compensates in(estors only for the real rate of return plus an inflation premium.9nderstandin chanes in the ris'-free rate is important +ecause chanes in this rate are reflected in all other interest rates.4-< Copyriht ! 2""# $ddison-%esleyHow the Equilibrium Interest Rate Is Determined4he interest rate on +orrowed funds is determined +y the total ,areate. supply of funds +y in(estors and the total ,areate. demand for funds +y +orrowers.4he areate supply of funds is dependent on the interest rate offered to in(estors.$t low interest rates8 areate supply should +e low +ecause of the low reward to in(estors.4he opposite is true at hih interest rates.4-= Copyriht ! 2""# $ddison-%esleyHow the Equilibrium Interest Rate Is DeterminedLi'e areate supply8 the areate demand for funds also depends on the pre(ailin interest rate.If the nominal interest rate is low8 areate demand should +e hih +ecause the cost of funds is relati(ely low.4he opposite would +e true at hih interest rates.4he com+ined effect of areate supply and demand is demonstrated in Fiure 4.2 on the followin slide. 4-> Copyriht ! 2""# $ddison-%esleyHow the Equilibrium Interest Rate Is DeterminedFiure 4.24-#" Copyriht ! 2""# $ddison-%esleyHow hi!ts in uppl" #!!e$t Interest RatesFiure 4.04-## Copyriht ! 2""# $ddison-%esleyFa$tors that #!!e$t hi!ts in uppl":hift in sa(ins +y in(estors:hift in monetary policy?pen mar'et operations&iscount rate@ow the Fed uses monetary policy to reduce interest rates@ow the Fed uses monetary policy to increase interest rates4-#2 Copyriht ! 2""# $ddison-%esleyFa$tors that #!!e$t hi!ts in uppl"Fiure 4.44-#0 Copyriht ! 2""# $ddison-%esleyHow hi!ts in the Demand !or Funds #!!e$t Interest Rates:hift in the o(ernment demand for funds:hift in the +usiness demand for funds:hift in the household demand for fundsCom+inin shifts in supply and demand4-#4 Copyriht ! 2""# $ddison-%esleyHow hi!ts in the Demand !or Funds #!!e$t Interest RatesFiure 4.64-#6 Copyriht ! 2""# $ddison-%esley%erm tru$ture o! Interest Rates4he term structure of interest rates relates the interest rate to the time to maturity for securities with a common default ris' profile.4ypically8 treasury securities are used to construct yield cur(es since all ha(e -ero ris' of default.@owe(er8 yield cur(es could also +e constructed with $$$ or ;;; corporate +onds or other types of similar ris' securities.4-#7 Copyriht ! 2""# $ddison-%esley&ield Cur'esFiure 4.74-#< Copyriht ! 2""# $ddison-%esley%heories o! %erm tru$ture)*pectations 4heory 4his theory suests that the shape of the yield cur(e reflects in(estorsA e*pectations a+out the future direction of inflation and interest rates.4herefore8 an upward-slopin yield cur(e reflects e*pectations of hiher future inflation and interest rates. In eneral8 the (ery stron relationship +etween inflation and interest rates supports this theory.4-#= Copyriht ! 2""# $ddison-%esley%heories o! %erm tru$tureLi/uid Breference 4heory4his theory contends that lon-term interest rates tend to +e hiher than short-term rates for two reasonsCD Lon-term securities are percei(ed to +e ris'ier than short-term securities.D ;orrowers are enerally willin to pay more for lon-term funds +ecause they can loc' in at a rate for a loner period of time and a(oid the need to roll o(er the de+t.4-#> Copyriht ! 2""# $ddison-%esley%heories o! %erm tru$tureMar'et :ementation 4heory 4his theory suests that the mar'et for de+t at any point in time is semented on the +asis of maturity.$s a result8 the shape of the yield cur(e will depend on the supply and demand for a i(en maturity at a i(en point in time.4-2" Copyriht ! 2""# $ddison-%esleyRis' Bremiums on &e+t :ecurities4he nominal rate of interest for a de+t security with a specific maturity ,k#. is e/ual to the ris'-free rate ,RF. for that same maturity8 plus the ris' premium ,RP#.. k# 1 RF 3 RP#4he ris' premium represents the additional amount re/uired +y in(estors to compensate them for uncertainty surroundin the return on the security and (aries with the ris' of the +orrower.Risk (remiums4-2# Copyriht ! 2""# $ddison-%esleyRisk (remiumsRis' Bremiums on &e+t :ecurities?ne of the most important reasons for the e*istence of a ris' premium on some de+t securities is default ris'.&efault ris' is the possi+ility that the issuer of the security will default on its payments to the in(estors holdin the de+t securities.?ther issue- and issuer-related ris's include li/uidity ris'8 contractual pro(isions8 maturity ris'8 and ta* pro(isions as summari-ed in 4a+le 4.#.4-22 Copyriht ! 2""# $ddison-%esley 4a+le 4.# ,Banel #.Risk (remiums on Debt e$urities4-20 Copyriht ! 2""# $ddison-%esley 4a+le 4.# ,Banel 2.Risk (remiums on Debt e$urities4-24 Copyriht ! 2""# $ddison-%esleyRisk (remiumsRis' Bremiums on )/uity :ecurities4he ris' premiums on e/uity securities are not as easy to determine as they are on de+t securities +ecause e/uities do not ha(e an o+ser(a+le interest rate that indicates the return to in(estors.In(estors will not necessarily aree on the e*act ris' premium that is re/uired for e(ery stoc'.4his e*plains why some in(estors will purchase a stoc' while others will not.4-26 Copyriht ! 2""# $ddison-%esleyRisk and ReturnFiure 4.4-2> Copyriht ! 2""# $ddison-%esleyExplaining hi!ts in Required Returns$ctual :hifts in Returns on )/uity :ecurities:hifts in the ris'-free rate:hifts in the ris' premium on e/uity securitiesChapter4)nd of ChapterLawrence J. GitmanJeff MaduraFinancial management