BA 2103

Financial Management

Interest Rates
BA 2103– Financial Management| RCDBadoy | CBA-USeP
 Intended Learning Outcomes
• Illustrate the cost of money and interest rate levels
• Identify the determinants of market interest rates
• Relate interest rates to financial management as well as
inflation and interest rates

BA 2103 – Financial Management| RCDBadoy | CBA-USeP

 Interest
• Interest is money paid (or earned) for the use of money

• Simple Interest
• lnterest paid (earned) on only the original amount, or
principal, borrowed (lent)

BA 2103 – Financial Management| RCDBadoy | CBA-USeP

 Interest
• Compound Interest
• lnterest paid (earned) on any previous interest earned, as well as
on the principal borrowed (lent)

BA 2103 – Financial Management| RCDBadoy | CBA-USeP

BA 2103 – Financial Management| RCDBadoy | CBA-USeP
BA 2103 – Financial Management| RCDBadoy | CBA-USeP
 Interest Rate
• the price that lenders receive and borrowers pay
for debt capital
• there is no single interest rate
• interest rates on different types of debt vary depending on the
borrower’s risk, the use of the funds borrowed, the type of collateral
used to back the loan, and the length of time the money is needed

BA 2103 – Financial Management| RCDBadoy | CBA-USeP

 Interest Rate
Interest rate paid to savers depends on:
• the rate of return that producers expect to earn on invested
capital
• savers’ time preferences for current versus future consumption
• riskiness of the loan
• expected future rate of inflation

BA 2103 – Financial Management| RCDBadoy | CBA-USeP

 Cost of Money
Four fundamental factors affecting the cost of money
(1) Production opportunities
– The investment opportunities in productive assets.
(2) Time preferences for consumption
– The preferences of consumers for current consumption as opposed to
saving for future consumption
(3) Risk
– In a financial market context, the chance that an investment will provide a
low or negative return
(4) Inflation
– The amount by which prices increase over time
BA 2103 – Financial Management| RCDBadoy | CBA-USeP
 Interest Rate Levels

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
• the economy is not completely free in the sense of being influenced
only by market forces

BA 2103 – Financial Management| RCDBadoy | CBA-USeP

 Interest Rate as a Function of Supply and Demand of Funds

BA 2103 – Financial Management| RCDBadoy | CBA-USeP

 Interest Rate as a Function of Supply and Demand of Funds

BA 2103 – Financial Management| RCDBadoy | CBA-USeP

 Nominal Interest Rate
• In general, the quoted (or nominal) interest rate
on a debt security is composed of a real risk-
free rate of interest plus several premiums that
reflect inflation, the risk of the security, and the
security’s marketability (or liquidity)
• The term nominal as it is used here means the
stated rate as opposed to the real rate, where
the real rate is adjusted to remove inflation's
effects

BA 2103 – Financial Management| RCDBadoy | CBA-USeP

BA 2103 – Financial Management| RCDBadoy | CBA-USeP
BA 2103 – Financial Management| RCDBadoy | CBA-USeP
 The Real Risk-Free Rate of Interest

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

expected, and it may be thought of as the rate of interest on short-
term Treasury securities in an inflation-free world
• 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
(2) people’s time preferences for current versus
future consumption
BA 2103 – Financial Management| RCDBadoy | CBA-USeP
 Inflation Premium (IP)
• Inflation has a major effect on interest rates because it erodes the
purchasing power of the currency and lowers the real rate of return on
investments
• IP is a premium equal to expected inflation that investors add to the real
risk-free rate of return

Suppose you invest $3,000 in a default-free zero coupon bond that matures
in 1 year and pays a 5% interest rate. At the end of the year, you will receive
$3,150 – your original $3,000 plus $150 of interest

BA 2103 – Financial Management| RCDBadoy | CBA-USeP

 Inflation Premium (IP)

Now suppose that the inflation rate during the year is 10% and that it
affects all items equally. If gas had cost $3 per gallon at the beginning of
the year, it would cost $3.30 at the end of the year.

Therefore, your $3,000 would have bought $3,000/$3 = 1,000 gallons at

the beginning of the year but only $3,150/$3.30 = 955 gallons at the end.

BA 2103 – Financial Management| RCDBadoy | CBA-USeP

 Inflation Premium (IP)
• In real terms, you would be worse off – you would receive $150 of interest,
but it would not be sufficient to offset inflation. You would thus be better off
buying 1,000 gallons of gas (or some other storable asset) than buying the
default-free bond.

• Investors are well aware of inflation’s effects on interest rates, so when they
lend money, they build in an inflation premium (IP) equal to the average
expected inflation rate over the life of the security

BA 2103 – Financial Management| RCDBadoy | CBA-USeP

 The Nominal, or Quoted, Risk-free Rate of Interest
• The nominal, or quoted, risk-free rate, is the real risk-free rate plus a
premium for expected inflation

• To be strictly correct, the risk-free rate should mean the interest rate on a
totally risk-free security—one that has no risk of default, no maturity risk,
no liquidity risk, no risk of loss if inflation increases, and no risk of any
other type
• There is no such security, so there is no observable truly
risk free rate
BA 2103 – Financial Management| RCDBadoy | CBA-USeP
 Default Risk Premium (DRP)
• If the issuer defaults on a payment, investors
receive less than the promised return on the
bond

• The quoted interest rate includes a default

risk premium
• The greater the default risk, the higher the
bond’s yield to maturity

BA 2103 – Financial Management| RCDBadoy | CBA-USeP

 Liquidity Premium (LP)
• A “liquid” asset can be converted to cash quickly
and at a “fair market value”
• Financial assets are generally more liquid than
real assets

• Because liquidity is important, investors include

liquidity premiums when market rates of
securities are established

BA 2103 – Financial Management| RCDBadoy | CBA-USeP

 Liquidity Premium (LP)
• Although it is difficult to measure liquidity
premiums accurately, a differential of at least
2 percentage points (and perhaps up to 4 or
5 percentage points) exists between the
least liquid and the most liquid financial
assets of similar default risk and maturity

BA 2103 – Financial Management| RCDBadoy | CBA-USeP

 Maturity Risk Premium (MRP)
• All bonds, even Treasury Bonds, are exposed to two additional
sources of risk: interest rate risk and reinvestment risk

• The net effect of these two sources of risk upon a bond’s yield is
called the maturity risk premium (MRP)

BA 2103 – Financial Management| RCDBadoy | CBA-USeP

 Interest Rate Risk
• The risk of capital losses to which
investors are exposed because of
changing interest rates
• 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

BA 2103 – Financial Management| RCDBadoy | CBA-USeP

 Reinvestment Rate Risk
• The risk of an income decline due
to a drop in interest rates is called
reinvestment rate risk.

• Reinvestment rate risk is obviously

high on callable bonds

BA 2103 – Financial Management| RCDBadoy | CBA-USeP

 Term Structure of Interest Rates
• Describes the relationship between long-term and short-term rates
• Term structure is important to corporate treasurers deciding whether
to borrow by issuing long-term or short-term debt and to investors
who are deciding whether to buy long-term or short-term bonds
• Both borrowers and lenders should understand how long-term and
short-term rates relate to each other and what causes shifts in their
relative levels

BA 2103 – Financial Management| RCDBadoy | CBA-USeP

 MacroEconomic Factors That Influence
Interest Rate Levels
Federal Reserve Policy
As you probably learned in your economics
courses:
(1) the money supply has a significant effect on the
level of economic activity, inflation, and interest
rates
(2) Monetary Reserve Board controls the money
supply. If they want to stimulate the economy, it
increases the money supply.

BA 2103 – Financial Management| RCDBadoy | CBA-USeP

 MacroEconomic Factors That Influence
Interest Rate Levels
Federal Reserve Policy
• The BSP 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. The reverse holds if the
BSP tightens the money supply

BA 2103 – Financial Management| RCDBadoy | CBA-USeP

 MacroEconomic Factors That Influence
Interest Rate Levels
Budget Deficits or Surpluses
• If the 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

BA 2103 – Financial Management| RCDBadoy | CBA-USeP

 MacroEconomic Factors That Influence
Interest Rate Levels
Budget Deficits or Surpluses
• 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
• So the larger the government deficit, other
things held constant, the higher the level of
interest rates

BA 2103 – Financial Management| RCDBadoy | CBA-USeP

 MacroEconomic Factors That Influence
Interest Rate Levels
International Factors
• Businesses and individuals in a country buy
from and sell to people and firms all around the
globe. 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

BA 2103 – Financial Management| RCDBadoy | CBA-USeP

 MacroEconomic Factors That Influence
Interest Rate Levels
Business Activity
• Business conditions influence interest rates
particularly when there are economic crises,
recession, or depression

BA 2103 – Financial Management| RCDBadoy | CBA-USeP

BA 2103 – Financial Management| RCDBadoy | CBA-USeP