Business Finance - 1

Muslim Reza Mooman, CFA

Head of WM, SCB
Visiting Faculty, IBA

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The Cost of Money
(Interest Rates)
Chapter 5

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Chapter Deliverable

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The Cost of Money
 Interest rates represent the prices paid to borrow funds

 Equity investors expect to receive dividends and capital gains

Factors Affecting Cost of Money
Production opportunities
 returns available within an economy from investment in
productive assets
Time preferences for consumption
 the preferences of consumers for current consumption as
opposed to saving for future consumption
Risk
 the chance that a financial asset will not earn the return
promised
Inflation
 the tendency of prices to increase over time
Supply & Demand for Funds
Determinants of Market Interest Rates
Quoted interest rate =
k = (k* + IP) + DRP + LP + MRP
= kRF + DRP + LP + MRP

 k = the quoted or nominal rate

 k*= the real risk-free rate of interest
 IP= inflation premium
 kRF = the quoted, or nominal risk-free rate
 DRP= default risk premium
 LP= liquidity, or marketability, premium
 MRP = maturity risk premium
Risk-Free Rate of Interest
Real k*
 The rate of interest that would exist on default-free U. S. Treasury
securities if no inflation were expected
 Ranges from 2-4% in US & 6-8% in PK

Nominal kRF
 kRF = k* + IP
 Rate of interest on a security that is free of all risk, except inflation
 Proxied by the T-bill rate or T-bond rate
 kRF includes an inflation premium

Interest Rate Risk

 Risk of capital losses to which investors are exposed because of
changing interest rates
Premium
Inflation Premium (IP)
 Expected Inflation Premium that investors add to real risk-free rate of return.

Default Risk Premium (DRP)

 Difference between the interest rate on a U. S. Treasury bond and a
corporate bond of equal maturity and marketability
 Compensates for risk that a borrower will default on a loan

Liquidity Premium (LP)

 Premium added to the rate on a security if the security cannot be converted
to cash on short notice and at close to the original cost

Maturity Risk Premium (MRP)

 Premium that reflects the interest rate risk
 Bonds with longer maturities have greater interest rate risk
 Reinvestment rate risk is greater for short-term bonds
Term Structure of Interest Rates
 Relationship between yields and maturities of securities

 Points connecting the rates at various tenors are the Yield curve

“Normal” Yield Curve

 upward sloping yield curve

Inverted (“Abnormal”) Yield Curve

 downward sloping yield curve
Yield Curve
Why Do Yield Curves Differ?
 Expectations theory
 shape of the yield curve depends on investors’ expectations
about future inflation rates

 Liquidity preference theory

 lenders prefer to make short-term loans borrowers prefer long-
term debt

 Market segmentation theory

 each borrower has a preferred maturity and the slope of the yield
curve depends on the supply of and demand for funds in the
long-term market relative to the short-term market
Expectations Theory
 Shape of curve depends on investors’ expectations about future
inflation rates.

 If inflation is expected to increase ;the curve will be upward sloping

(normal yield curve)

 If the rate of inflation is expected to decline, the curve will be

downward sloping ( abnormal or inverted yield curve).

 Under the expectation theory, the MRP is assumed to be zero.

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Liquidity Preference Theory
 Lenders prefer S-T securities because they are less risky and
provide greater investment flexibility ( more liquid) than longer-T
securities. Investors will therefore accept lower yields on S-T
securities and this leads to relatively S-T interest rates.

 Borrowers prefer L-T debt ,because S-T debt exposes them to the
risk of having to repay the debt under adverse conditions.

 Thus both lender and borrower preferences operate to cause S-T

rates to be lower than L-T rates.

 The above two sets of preferences imply that a positive MRP exists
and it increases with years to maturity causing the yield curve to be
upward sloping .

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The Liquidity Preference Framework
 There are essentially two things you can do with your wealth:
 Spend it using money
 Save it by purchasing bonds
 Breaking down wealth into these two broad asset categories yields the
following identity:
o BS + MS = BD + MD

 Equilibrium in the bond market will be achieved when BS = BD.

 The interest rate will adjust until the quantity of bonds supplied is equal to the
quantity of bonds demanded.

 At the equilibrium interest rate, BS = BD

 Rearranging the identity above: BS – BD = MD – MS
 At equilibrium, BS – BD = 0, so…
 MS = MD

 When the bond market is in equilibrium, the supply of money is equal to the
demand for money

 We can find the equilibrium interest rate by looking only at the money
market!
Market Segmentation Theory
 Each borrower and lender has a preferred maturity.

 The slope of the yield curve depends on supply and demand for
funds in the L-T and S-T markets (curve could be flat, upward,
or downward sloping).

 An upward sloping yield curve would occur when there is a large

supply of S-T funds relative to demand ,but a shortage of L-T
funds.

 A downward sloping yield curve occurs when there is a

relatively strong demand for funds in the S-T market compared
to that in the L-T market.

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Other Factors Influencing Rate
 SBP Reserve policy
 Level of the Budget Deficit
 Larger budget deficits drive interest rates up due to
a) increased demand for loan-able funds ( if the govt. borrows money) or
b) expectations for future inflation ( if the govt. prints money) while surpluses drive rates down due to
increased supply of funds.

 Which term rates are more affected is driven by the deficit financing mechanism.

 Foreign Trade Balance

 trade deficits push interest rates because deficits must be financed from abroad.
 to draw foreign investors rates must be higher relative to world interest rates

 Level of Business Activity

 Demand for money & Rate of inflation tend to fall,
 Govt. tends to increase the money supply in an effort to stimulate the economy.
 Result is that there is a tendency for interest rates to decline during recessions.
 During recessions, S-T rates decline more rapidly than L-T rates

 GDP growth Rates

Interest Rates and Stock Prices
 Higher interest rates increase costs and thus lower a firm’s
profits

 Interest rates affect the level of economic activity and

corporate profits

 Interest rates affect investment competition between stocks

and bonds

 Use a mix of long & short-term debt ,as well as equity ,such
that the firm can survive in every interest rate environment.

 Optimal financial policy depends in an important way on the

nature of the firm’s assets. it is more feasible to finance
assets with high marketability with short- term debt
( eg. Finance current assets with short- term debt)