Corporate Finance Chapter Six

"normal" yield curve

upward-sloping yield curve short-term rates had dropped below long-term rates

this interdependency limits the ability of the Federal Reserve to

use monetary policy to control economic activity in the United States.

liquidity of real assets

varies over time

average liquidity premiums

vary over time. During the recent financial crisis, the liquidity premiums on many assets soared. The market for many assets that were once highly liquid suddenly dried up as everyone rushed to sell them at the same time

most capital in the United States is allocated through the price system

where the interest rate is the price.

interest rate in each market is the point

where the supply and demand curves intersect.

The risk that a borrower will default

which means the borrower will not make scheduled interest or principal payments, also affects the market interest rate on a bond: The greater the bond's risk of default, the higher the market rate.

The difference between the quoted interest rate on a T-bond and that on a corporate bond

with similar maturity, liquidity, and other features is the default risk premium (DRP).

inverted or "abnormal" yield curve

yield curve that slopes downward short-term rates were higher than long-term rates

we assume that the default risk premium on Treasury securities is

zero

inflation

the amount by which prices increase over time`

Macroeconomic Factors That Influence Interest Rate Levels

(1)Federal Reserve policy, (2)the federal budget deficit or surplus, (3)international factors, including the foreign trade balance and interest rates in other countries, and (4)the level of business activity.

long-term bonds can have higher yields for two reasons:

(1)Inflation is expected to be higher in the future. (2)There is a positive maturity risk premium.

In the years ahead, we can be sure of two 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.

slope of the yield curve depends primarily on two factors:

(1)expectations about future inflation and (2)effects of maturity on bonds' risk.

The estimation process is straightforward provided we

(1)focus on Treasury bonds and (2)assume that Treasury bonds contain no maturity risk premiums

The effect of maturity risk premiums is to raise interest rates on long-term bonds relative to those on short-term bonds. This premium, like the others, is difficult to measure, but

(1)it varies somewhat over time, rising when interest rates are more volatile and uncertain, and then falling when interest rates are more stable; and (2)in recent years, the maturity risk premium on 20-year T-bonds has generally been in the range of one to two percentage points

interest rate paid to savers depends

(1)on the rate of return that producers expect to earn on invested capital, (2)on savers' time preferences for current versus future consumption, (3)on the riskiness of the loan, and (4)on the expected future rate of inflation.

The four most fundamental factors affecting the cost of money are

(1)production opportunities, (2)time preferences for consumption, (3)risk, and (4)inflation.

Federal Reserve policy

(1)the money supply has a significant effect on the level of economic activity, inflation, and interest rates. (2)In the United States, the Federal Reserve Board controls the money supply.

The real risk-free rate is not static—it changes over time, depending on economic conditions, especially on

(1)the rate of return that corporations and other borrowers expect to earn on productive assets and (2)people's time preferences for current versus future consumption.

most experts believe that r* typically fluctuates in the range of

1% to 3%.* Perhaps the best estimate of r* is the rate of return on indexed Treasury bonds, which are discussed later in the chapter

both borrowers and lenders should understand

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

Business Activity

1. Because inflation increased from 1972 to 1981, the general tendency during that period was toward higher interest rates. However, since the 1981 peak, the trend has generally been downward. 2. The shaded areas in the graph represent recessions, during which (a) the demand for money and the rate of inflation tended to fall and (b) the Federal Reserve tended to increase the money supply in an effort to stimulate the economy. As a result, there is a tendency for interest rates to decline during recessions. 3. During recessions, short-term rates decline more sharply than long-term rates. This occurs for two reasons: (a)The Fed operates mainly in the short-term sector, so its intervention has the strongest effect there. (b)Long-term rates reflect the average expected inflation rate over the next 20 to 30 years, and this expectation generally does not change much, even when the current inflation rate is low because of a recession or high because of a boom.

supply curve

A curve that shows the relationship between the price of a product and the quantity of the product supplied. upward sloping: indicates that investors are willing to supply more capital the higher the interest rate they receive on their capital downward-sloping: demand curve indicates that borrowers will borrow more if interest rates are lower.

Liquidity Premium (LP)

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. investors prefer assets that are more liquid

inflation premium (IP)

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

pure expectations theory

A theory that states that the shape of the yield curve depends on investors' expectations about future interest rates. assumes that bond traders establish bond prices and interest rates strictly on the basis of expectations for future interest rates and that they are indifferent to maturity because they do not view long-term bonds as being riskier than short-term bonds. If this were true, the maturity risk premium (MRP) would be zero, and long-term interest rates would simply be a weighted average of current and expected future short-term interest rates.

flight to quality

An increase in the demand for low-risk government bonds, coupled with a decrease in the demand for virtually every risky investment.

What Determines the Shape of the Yield Curve

Because maturity risk premiums are positive, if other things were held constant, long-term bonds would always have higher interest rates than short-term bonds. However, market interest rates also depend on expected inflation, default risk, and liquidity, each of which can vary with maturity.

yield on a corporate bond that matures in t years

Corporate Bond yield= r*t + IPt + MRPt + DRPt + LPt

Inflationary pressures

Demand and supply-side pressures that can cause a rise in the general price level. Demand-pull inflationary pressure is greatest when actual GDP exceeds potential GDP causing a positive output gap. Cost-push inflationary pressure can arise from increases in unit wage costs, rising import prices and an increase in the prices of raw materials, fuel and components used in production strongest during business booms, also exerting upward pressure on rates.

Federal Budget Deficits or Surpluses

If the federal government spends more than it takes in as taxes, it runs a deficit, and that deficit must be covered by additional borrowing (selling more Treasury bonds) or by printing money. If the government borrows, this increases the demand for funds and thus pushes up interest rates. If the government prints money, investors recognize that with "more money chasing a given amount of goods," the result will be increased inflation, which will also increase interest rates.

International Factors

If they buy more than they sell (that is, if there are more imports than exports), they are said to be running a foreign trade deficit. When trade deficits occur, they must be financed, and this generally means borrowing from nations with export surpluses.

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.

current real rate of interest

The current interest rate minus the current inflation rate (which is also the gap between the inflation bars and the interest rate curve) shows how much investors really earned after the effects of inflation are removed. generally been in the range of 1% to 4% since 1987.*

Default Risk Premium (DRP)

The difference between the interest rate on a U.S. Treasury bond and a corporate bond of equal maturity and marketability.

production opportunities

The investment opportunities in productive (cash-generating) assets.

nominal, or quoted, risk-free rate, rRF

The rate of interest on a security that is free of all risk; is proxied by the T-bill rate or the T-bond rate; includes an inflation premium. the real risk-free rate plus a premium for expected inflation: rRF=r*+IP. should be the interest rate on a totally risk-free security—one that has no default risk, no maturity risk, no liquidity risk, no risk of loss if inflation increases, and no risk of any other type (no such security; hence, there is no observable truly risk-free rate)

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. may be thought of as the rate of interest on short-term U.S. Treasury securities in an inflation-free world

we can get some sense of an asset's liquidity by

looking at its trading volume. Assets with higher trading volume are generally easier to sell and are therefore more liquid.

one security is free of most risks

a Treasury Inflation Protected Security (TIPS), whose value increases with inflation. Short-term TIPS are free of default, maturity, and liquidity risks and of risk due to changes in the general level of interest rates. However, they are not free of changes in the real rate

When short-term bills mature and the principal must be reinvested, or "rolled over,"

a decline in interest rates would necessitate reinvestment at a lower rate, which would result in a decline in interest income.

yield curve

a graph showing the relationship between bond yields and maturities

sound financial policy calls for using

a mix of long- and short-term debt as well as equity to position the firm so that it can survive in any interest rate environment. Further, the optimal financial policy depends in an important way on the nature of the firm's assets—the easier it is to sell assets to generate cash, the more feasible it is to use more short-term debt.

maturity risk premium (MRP)

a premium that reflects interest rate risk higher the greater the years to maturity, is included in the required interest rate.

the quoted (or nominal) interest rate on a debt security, r, is composed of

a real risk-free rate, r*, plus several premiums that reflect inflation, the security's risk, its liquidity (or marketability), and the years to its maturity.

risk premium

an expected return in excess of that on risk-free securities

long-term interest rates

are interest rates on financial assets that mature a number of years in the future

short-term interest rates

are the interest rates on financial assets that mature within less than a year especially volatile, rising rapidly during booms and falling equally rapidly during recessions

inflation rate reflected in the quoted interest rate on any security is the

average inflation rate expected over the security's life

For corporate bonds,

bond ratings are often used to measure default risk. The higher the bond's rating, the lower its default risk and, consequently, the lower its interest rate

Inflation Protected Securities (TIPS)

bonds that are indexed to inflation.

When the economy is expanding, firms need

capital, and this demand pushes rates up

assuming that Treasury securities have no default risk

carry the lowest interest rates on taxable securities in the United States.

consumer prices change with a lag following

changes at the producer level. Thus, if the price of oil increases this month, gasoline prices are likely to increase in the coming months. T

Interest Rates and Business Decisions

companies look carefully at the level of interest rates and the shape of the yield curve when making important business decisions.

A "liquid" asset can be

converted to cash quickly at a "fair market value."

corporate bond yield spread

corporate bond yield - tresurary bond yield = DRPt + LPt estimates that both the default risk premium and liquidity premium vary over time, and that the majority of the corporate bond yield spread can be attributed to default risk

definition of the risk-free rate assumes that

despite the recent downgrade, Treasury securities have no meaningful default risk

Expected inflation has an especially important effect on the yield curve's shape

especially the curve for U.S. Treasury securities. Treasuries have essentially no default or liquidity risk, so the yield on a Treasury bond that matures in t years can be expressed as follows: T-Bond Yield = r*t + IPt + MRPt

Using the Yield Curve to Estimate Future Interest Rates

look at the yield curve and use information embedded in it to estimate the market's expectations regarding future inflation, risk, and short-term interest rates

Longer-term corporate bonds also tend to be

ess liquid than shorter-term bonds. Because short-term debt has less default risk, someone can buy a short-term bond without doing as much credit checking as would be necessary for a long-term bond. Thus, people can move in and out of short-term corporate debt relatively rapidly. As a result, a corporation's short-term bonds are typically more liquid and thus have lower liquidity premiums than its long-term bonds.

Borrowers

expected returns on real assets set an upper limit on how much borrowers can afford to pay for funds

relationship between inflation and long-term interest rates

follows close correlation

generally assume that U.S. Treasury securities are

free of default risk in the sense that one can be virtually certain that the federal government will pay interest on its bonds and pay them off when they mature. Therefore, we assume that the default risk premium on Treasury securities is zero. Further, active markets exist for Treasury securities, so we assume that their liquidity premium is also zero

The average default risk premiums vary over time, and tend to

get larger when the economy is weaker and borrowers are more likely to have a hard time paying off their debts.

In general, we use the T-bill rate to approximate

he short-term risk-free rate and the T-bond rate to approximate the long-term risk-free rate. So whenever you see the term risk-free rate, assume that we are referring to the quoted U.S. T-bill rate or to the quoted T-bond rate.

risk

in a financial market context, the chance that an investment will provide a low or negative return

If the Fed wants to stimulate the economy

increases the money supply. The Fed buys and sells short-term securities, so the initial effect of a monetary easing would be to cause short-term rates to decline. However, a larger money supply might lead to an increase in expected future inflation, which would cause long-term rates to rise even as short-term rates fell

inflation rate built into interest rates is the

inflation rate expected in the future, not the rate experienced in the past

As a general rule, the bonds of any organization have more

interest rate risk the longer the maturity of the bond

although long-term bonds are heavily exposed to

interest rate risk, short-term bills are heavily exposed to reinvestment rate risk

the prices of long-term bonds decline whenever interest rates rise

interest rates can and do occasionally rise, all long-term bonds, even Treasury bonds, have an element of risk called interest rate risk.

supply and demand interact to determine

interest rates in two capital markets

the prices of long-term bonds decline whenever

interest rates rise, and because interest rates can and do occasionally rise, all long-term bonds, even Treasury bonds, have an element of risk called interest rate risk

yield curve humped

intermediate-term rates were higher than either short- or long-term rates.

Inflation has a major impact on interest rates because

it erodes the real value of what you receive from an investment.

although it is difficult to predict future interest rate levels,

it is easy to predict that interest rates will fluctuate—they always have, and they always will

Real assets are generally

less liquid than financial assets, but different financial assets vary in their liquidity.

if the market expects inflation to decline in the future

long-term bonds will have a smaller inflation premium than will short-term bonds

actions that lower short-term rates won't necessarily

long-term rates. Lower rates could cause foreigners to sell their holdings of U.S. bonds. These investors would be paid with dollars, which they would then sell to buy their own currencies. The sale of dollars and the purchase of other currencies would lower the value of the dollar relative to other currencies, which would make U.S. goods less expensive, which would help manufacturers and thus lower the trade deficit.

As a general rule, the bonds of any organization have more interest rate risk the

longer the maturity of the bond

capital markets

markets that exist where businesses are able to finance operations as well as large purchases over long periods of time Within each category, there are regional markets as well as different types of submarkets.

Expectations for future inflation are closely, but not perfectly, correlated with

past inflation rates. Therefore, if the inflation rate reported for last month increased, people would tend to raise their expectations for future inflation, and this change in expectations would increase current rates

If the term risk-free rate is used without the modifiers real or nominal

people generally mean the quoted (or nominal) rate, and we follow that convention in this book. when we use the term risk-free rate, rRF , we mean the nominal risk-free rate, which includes an inflation premium equal to the average expected inflation rate over the remaining life of the security

In recent years, inflation has been

quite low, averaging about 2% a year, and it was even negative in 2009, as prices fell in the midst of the deep recession. However, long-term interest rates have been volatile because investors are not sure if inflation is truly under control or is about to jump back to the higher levels of the 1980s

quoted interest rate

r = r* + IP + DRP + LP + MRP where; r = the quoted, or nominal, rate of interest on a given security.* r* = the real risk-free rate of interest, it is the rate that would exist on a riskless security in a world where no inflation was expected. rRF = r*+IP. It is the quoted rate on a risk-free security such as a U.S. Treasury bill, which is very liquid and is free of most types of risk. Note that the premium for expected inflation, IP, is included in rRF. IP = inflation premium. IP is equal to the average expected rate of inflation over the life of the security. The expected future inflation rate is not necessarily equal to the current inflation rate, so IP is not necessarily equal to current inflation, as shown in Figure 6.3. DRP = default risk premium. This premium reflects the possibility that the issuer will not pay the promised interest or principal at the stated time. DRP is zero for U.S. Treasury securities, but it rises as the riskiness of the issuer increases. LP = liquidity (or marketability) premium. This is a premium charged by lenders to reflect the fact that some securities cannot be converted to cash on short notice at a "reasonable" price. LP is very low for Treasury securities and for securities issued by large, strong firms, but it is relatively high on securities issued by small, privately held firms. MRP = maturity risk premium. As we will explain later, longer-term bonds, even Treasury bonds, are exposed to a significant risk of price declines due to increases in inflation and interest rates, and a maturity risk premium is charged by lenders to reflect this risk.

Nominal (or quoted) rate of interest

r = rRF + DRP + LP + MRP Because rRF=r*+IP

a decline in the supply of funds

raises interest rates, while an increase in the supply lowers rates

an increase in the demand for funds

raises rates, while a decline in demand lowers rates.

Historically, long-term rates are generally above

short-term rates because of the maturity risk premium; so all yield curves usually slope upward

Borrowers bid for the available supply of debt capital using interest rates:

the firms with the most profitable investment opportunities are willing and able to pay the most for capital, so they tend to attract it away from inefficient firms and firms whose products are not in demand. At the same time, government policy can also influence the allocation of capital and the level of interest rates.

the larger the federal deficit, other things held constant

the higher the level of interest rates.

At any rate, the larger the trade deficit

the higher the tendency to borrow. Note that foreigners will hold U.S. debt if and only if the rates on U.S. securities are competitive with rates in other countries. This causes U.S. interest rates to be highly dependent on rates in other parts of the world.

if the market expects inflation to increase in the future

the inflation premium will be higher on a 3-year bond than on a 1-year bond

although "investing short" preserves one's principal,

the interest income provided by short-term T-bills is less stable than that on long-term bonds.

because investors consider long-term bonds to be riskier than short-term bonds because of interest rate risk

the maturity risk premium always increases with maturity.

time preferences for consumption

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

the actual interest rate on a short-term default-free U.S. Treasury bill, rT-bill

the real risk-free rate, r*, plus the inflation premium (IP): rT.bill = rRF = r*+IP

term structure of interest rates

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

interest rate risk

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

reinvestment rate risk

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

active markets exist for Treasury securities, so we assume that

their liquidity premium is also zero

Although the real risk-free rate, r*, varies somewhat over time because of changes in the economy and demographics

these changes are random rather than predictable. Therefore, the best forecast for the future value of r* is its current value.

There is a price for each type of capital

these prices change over time as supply and demand conditions change.

savers

time preferences for consumption establish how much consumption savers will defer—hence, the amount of money they will lend at different interest rates.