Ch 6: Interest Rates

interest rate risk

- the risk of capital losses to which investors are exposed because of changing interest rates

Which factor determines how much will be saved at different interest rates?

-Consumers' time preferences for consumption establish how much consumption they are willing to defer and hence how much they will save at different interest rates

How do risk and iinflation impact interest rates in the economy?

-Higher risk and higher inflation lead to higher interest rates

How does the price of capital tend to change during a boom? During a recession?

-Inflationary pressures are strongest during business booms, also exerting upward pressure on rates. -Conditions are reversed during recessions: Slack business reduces the demand for credit, inflation falls, and the Federal Reserve increases the supply of funds to help stimulate the economy. The result is a decline in interest rates.

What role do interest rates play in allocating capital to different potential borrowers?

-Investors are willing to allocate more capital the higher the interest rates are -borrowers will borrow more the lower the interest rate

Which factor sets an upper limit on how much can be paid for saving?

-Producers' expected returns on their business investments set an upper limit to how much they can pay for savings

yield curve

-a graph showing the relationship betwenn bond yields and maturities -"normal" yield curve: an upward-sloping yield curve -"inverted (abnormal)" yield curve: a downward-sloping yield curve -humped yield curve: a yield curve where int rates on intermediate-term maturities are higher than on both shot- and long-term maturities

liquidity premium (LP)

-a premium added to the equilibrium interest rate on a security if that security cannot be converted to cash on short notice and at close to its "fair market price"

inflation premium (IP)

-a premium equal to the expected inflation that investors add to the real risk-free rate of return

maturity risk premium (MRP)

-a premium that reflects interest rate risk -this premium is higher the greater the years to maturity

risk premium

-a scenario in which investors are willing to accept a higher risk in exchange for a higher return

risk

-in a financial market context, the chance that an investment will provide a low or negative return -the higher the perceived risk, the higher the required rate of return

flight to quality

-in response to a change in market forces, when investors perceive a certain market has become relatively more risky, this changing perception will induce many investors to shift toward safer investments

at the end of this chapter, you should be able to:

-list the various factors that inluence the cost of money -discuss how market interest rates are affected by the borrowers' need fro capital, expected inflation different securities' risks, and securities' liquidity

types of markets:

-markets for home loans, farm loans, business loans, federal, state, and local government loans, and consumer loans -in eachcategory, there are regional markets as well as different types of submarkets

inflation

-the amount by which prices increase over time

default risk premium (DRP)

-the difference betweeen the interest rate on a US Treasury bond and a corporate bond of equal maturity and marketability

production opportunities

-the investment opportunities in productive (cash-generrating) assets

time preferences for consumption

-the preferences of consumers for current consumption as opposed to saving for future consumption

nominal (quoted) risk-free rate of interest, r(RF) = r* + IP

-the rate of interest on a secutiry that is free of all risk; r(RF) is proxied by the T-bill rate or the T-bond rate; r(RF) includes an inflation premium

real risk-free rate of interest, r*

-the rate of itnerest thet would exist on default-free US Treasury securities if no inflation were expected -may be thought of as the rate of interest on short-term US Treasury securities in an inflation-free world -changes based on certain economic conditions: 1. the ROI thatt corporations and other borrowers expect to earn on productive assets 2. people's time preferences for current vs. future consumption -r* usually fluctuates in the range of 1% to 3%

term structure of interest rates

-the relationship between bond yields and maturities-describes the relationship between long- and short-term rates

term structure of interest rates

-the relationship between long-term and short-term rates

reinvestment rate risk

-the risk that a decline in interest rates will lead to lower income when bonds mature and funds are reinvested

both borrowers and investors should understand:

1. how long- and short-term rates relate to each other 2. what causes shifts in their relative levels

in the years ahead, we can be sure of 2 things:

1. interest rates will vary 2. interest rates will increase if inflation appears to be headed higher or decrease if inflation is expected to decline

4 fundamental factors affecting the cost of money:

1. production opportunities 2. time prefences for consumption 3. risk 4. inflation

If inflation during the last 12 months was 3% and the interest rate during that period was 5%, what was the real rate of interest?

a. 4% b. 2% c. 1% d. 3% e. 5% Answer: b. 2%

Assume that the real risk-free rate is r* = 2.5% and the average expected inflation rate is 3% for each future year. The DRP and LP for Bond X are 1% each, and the applicable MRP is 1.5%. What is Bond X's interest rate?

a. 9.0% b. 10.5% c. 7.5% d. 4.5% e. 6.0% Answer: a. 9.0%

Which of the following factors would tend to be consistent with a downward-sloping yield curve?

a. A high and positive default risk premium. b. A high and positive maturity risk premium. c. The absence of a liquidity premium. d. Expected inflation is expected to decline in future years. Answer: d. Expected inflation is expected to decline in future years.

If the inflation rate is expected to remain constant at the current level in the future, say 3%, which of the following best describes the shape of the yield curve? Consider all factors that affect the yield curve, not just inflation.

a. Because of the existence of a positive maturity risk premium, and even though the inflation rate is expected to remain constant, the shape of the Treasury yield curve would be upward sloping. b. Because the expectation of future inflation is expected to remain constant, the shape of the Treasury yield curve would be horizontal. c. The Treasury yield curve would be downward sloping, as this is the normal shape of the Treasury yield curve. Answer: a. Because of the existence of a positive maturity risk premium, and even though the inflation rate is expected to remain constant, the shape of the Treasury yield curve would be upward sloping.

An increase in either risk or inflation would likely lead to which of the following results?

a. Higher interest rates. b. Unlikely to affect the level of interest rates. c. Lower interest rates. Answer: a. Higher interest rates.

What are the two items whose sum is the cost of equity?

a. Interest and inflation b. Dividends and interest c. Interest and capital gains d. Inflation and dividends e. Dividends and capital gains Answer: E. Dividends and capital gains

Which of the following is most likely to occur during a recession?

a. The demand for funds increases, leading to lower interest rates. b. The demand for funds declines, leading to lower interest rates. c. The demand for funds declines, leading to higher interest rates. d. The demand for funds increases, leading to higher interest rates. Answer: b. The demand for funds declines, leading to lower interest rates.

A positive maturity risk premium has the effect of raising interest rates on long-term bonds relative to those of short-term bonds. True or false?

a. True b. False Answer: a. true

An upward-sloping yield curve is often referred to as a "normal" yield curve, whereas a downward-sloping yield curve is often referred to as an inverted or "abnormal" yield curve. True or false?

a. True b. False Answer: a. true

The yield curve for corporate bonds tends to have a shape similar to that for Treasury securities, but interest rates on corporate bonds are at lower levels because corporate yields include smaller default risk and liquidity premiums than do Treasury yields. True or false?

a. True b. False Answer: b. false