CCH

MAS Handout No.2-1

Interest Rates

I. Fundamentals of Interest Rate:

Interest rate or the required rate of return represents the cost of money.
Interest rate is usually applied to debt instruments such as bonds and bank loans.
Required rate of Return is usually applied to equity investments such as common
stock capital (ordinary share capital)

II. Factors that Influence The Equilibrium Interest Rate

1. Inflation:
A rising trend in prices of goods and services. Typically, savers demand higher
interest returns (interest rates) when inflation is high because they want their
investments to more than keep pace with the rising prices.

2. Risk:
When people perceive that a particular investment is riskier, they will expect a
higher return on that investment as compensation for bearing the risk.
**Risk: In financial market context, the chance that a financial asset will bot earn
the return promised.

3. Liquidity Preference (Time Preference For Consumption):

The term liquidity preference pertains to the general tendency of investors to
prefer shot-term securities (more liquid)

4. Production Opportunity
The higher the expected return on the investment would be, the more the
investor could afford to offer potential investors their savings.

Real Rate of Interest – Rate that creates equilibrium between the supply of savings
and the demand for investment funds in a perfect world, without inflation, where
suppliers and demanders of funds have no liquidity preferences and there is no risk.

Nominal or Actual Rate of Interest (Return)

The actual rate of interest charged by supplier of funds and paid by the demander
(Just like in Intermediate/Financial Accounting, the Nominal Rate is the Stated Interest
which could be seen in the contract agreed upon by the debtor and the creditor)

The nominal rate of interest differs from the real rate of interest, r*, as a result of two
factors, inflation and risk.
When people save money and save it, they are sacrificing consumption today (that
is, they are spending less than they could) in return for higher future consumption.
When

Sources:
Fundamentals of Financial Management by Brigham and Houston 13th Edition
1
Financial Management by Gitman
Basic Finance by Besley and Brigham 2013-2015 Edition
investors expect inflation to occur, they believe that the price of consuming goods and
services will be higher in the future than in the present.

When investors expect inflation to occur, they believe that the price of consuming
goods and services will be higher in the future than the present. Therefore, they will be
reluctant to sacrifice today’s consumption unless the return they can earn on the
money they save (or invest) will be high enough to allow them to purchase the
goods and services they desire at higher future price.

(Meaning, Investors will require higher nominal rate of return if they expect
inflation, the higher rate of return is called INFLATION PREMIUM{IP})

Similarly, investors generally demand higher rates of return on risky investment as

compared to safe ones. Otherwise, there is little incentive for investors to bear the
additional risk. Therefore, investors will demand a higher nominal rate of return in
risky investment. This additional rate of return is called the RISK PREMIUM{RP}

Formula of Nominal Interest:

R1= R* + IP + RP1
NOMINAL INTEREST = NOMINAL RATE + INFLATION PREMIUM + RISK PREMIUM

Illustrative Problems:
Candy Corporation has a budget of P100,000 to buy its premium candies which are to
be resold to its consumers. Candy Corporation’s supplier offers them a price of 25
pesos for each candy. The accounting manager currently ponders if he is to invest the
P100,000 on a 1-year deposit, it will earn 7%. The current inflation rate is 4%.

Questions:
1. How many candies should Candy Corporation buy, if the accounting manager
decides not to invest the P100,000?

100,000 / 25 = 4,000

2. How much would Candy Corporation earn if the accounting manager opted to
save the P100,000 in the company’s deposit for a year?

(100,000 x 7%) x 100,000 = 170,000

3. How much would the candies cost after a year?

25 x 1.04 = 26

4. How much would be the effect of the inflation to the candies’ cost?

(26 – 25) / 25 = 0.04

5. What is the real rate of return? (Show two analysis)

a. [(107,000 / 26) – 4000] / 4,000 = 0.0288 / 3%

b. 7% - 4% = 3%

III. Term Structure of Interest Rates

Term Structure of Interest Rates
- The relationship between the maturity and rate of return for bonds with similar
levels of risk.
Yield Curve
- A graphic depiction of the term structure of interest rates.
Yield to maturity
- Compound annual rate of return earned on a debt security purchased on a
given day and held to maturity.
Inverted Yield Curve
- A downward-sloping yield curve indicates that short-term interest rates are
generally higher than long-term interest rates.
Normal Yield Curve
- An upward-sloping yield curve indicates that long-term interest rates are
generally higher than short-term interest rates.
Flat Yield Curve
- A yield curve that indicates that interest rates do not vary much at different
maturities.
Expectations Theory
- The theory that yield curve reflects investor expectations about future interest
rates; an expectation of rising interest rates results in an upward-sloping yield
curve, and an expectation of declining rates results in a downward-sloping
yield curve.

Theories of Term Structure

Three theories are frequently cited to explain the general shape of the yield curve:
1. The expectations theory
2. The liquidity preference theory
3. Market Segmentation Theory

Expectations Theory
- Suggests that the yield curve reflects investor expectations about future
interest rates. According to this theory, when investors expect short-term
interest rates to rise in the future (perhaps because investors believe that
inflation will rise in the future), today’s long-term rates will be higher than
current short-term rates, and the yield curve will be upward sloping. The
opposite is true when investors expect declining short-term rates- today’s
short-term rates will be higher than current long-term rates, and the yield
curve will be inverted.

Liquidity Preference Theory

- Theory suggesting that long-term rates are generally higher than short-term
rates (hence, the yield curve is upward sloping) because investors perceive
short-term investments to be more liquid and less risky than long-term
investments to be more liquid and less risky than long-term investments.
Borrowers must offer higher rates on long-term bonds to entice investors
away from their preferred short-term securities.
Market Segmentation Theory
- Theory suggesting that the market for loans is segmented on the basis of
maturity and that the supply of and demand for loans within each segment
determine its prevailing interest rate; the slope of the yield curve is
determined by the general relationship between the prevailing rates in each
market segment.

IV. RISK PREMIUMS: ISSUER AND ISSUE CHARACTERISTICS

R1= r* + IP +RP1
RP1 – the risk premium consists of a number of issuer and issue related components,
including business risk, financial risk, interest rate risk, liquidity risk, and tax risk, as well
as the purely debt-specific risks- default risk, maturity risk and contractual provision risk.

In general, the highest risk premiums and therefore the highest returns result from
securities issued by firms with a high risk of default and from long-term maturities that
have unfavorable contractual provisions.

Default Risk – The possibility that the issuer of debt will not pay the contractual interest
or principal as scheduled. The greater the uncertainty as to the borrower’s ability to
meet these payments, the greater the risk premium. High bond ratings reflect low
default risk, and low bond ratings reflect high default risk.

Maturity Risk – the fact that longer the maturity, the more the value of a security will
change in response to a given change in interest rates. If the interest rates on otherwise
similar-risk securities suddenly rise as a result of a change in the money supply, the
prices of long-term bonds will decline by more than the prices of short-term bonds, and
vice- versa.

Contractual Provision Risk – Conditions that are often included in a debt agreement
or a stock issue. Some of theses reduce risk, whereas others may increase risk. For
example, a provision allowing a bond issuer to retire its bonds prior to their maturity
under favorable terms increases the bond’s risk.