Aasim Bin Bakr Roll: 12 Class 10

Risk Free Rate

1. Lower risk is associated with treasury bill, usually they reach maturity in 1 year

2. Comparatively higher risk is associated with treasury bond, they reach maturity in 5
years

Treasury bill is preferred for risk free rate, since all other risks are considered in market
premium.

Cost of capital, required rate of return, expected rate of return, minimum required rate of return,
discount rate – all refer to the same thing.

Pure Expectation Theory

Pure expectation theory states that the future rate will be higher. The mathematical proof takes
the short-term rate and calculated the forward rate.

Liquidity Preference Theory

Liquidity preference theory states that people prefer liquidity. Thus, incentive should be given in
the name of liquidity premium. It was first postulated by John Maynard Keynes.

There are 3 main reasons to hold cash:

1. Transactional (higher income leads to higher number of transactions)

2. Precautionary (cash is required for unforeseen events)

3. Speculative (cash is required to utilize opportunities)

There is an inverse relationship between interest rate and cash balance. A logical flow to prove
this is:

Bond price will decrease later -> interest rate will increase later -> interest rate will be low now -
> bonds will be cashed in right now

The higher the maturity the lesser liquid a bond becomes. An implication of the liquidity
preference theory is seen in policy making as money supply is used to impact interest rate.
Here, the supply curve is a perpendicular line, whereas the demand curve is a downward
sloping curve.

Another implication of this theory is seen in the tradeoff between the capital and the money
market. Assuming there 50% of funds are allocated to the capital market and the rest are
Aasim Bin Bakr Roll: 12 Class 10

allocated to the money market in a portfolio. The starting yield in the capital market is 11% and
the one in the money market is 7%. As the yield increases from 7% to 11% in the money
market, more funds will be allocated. This way, more bonds will be purchased until the yield
levels match again.

Capital market yield is the inverse of market PE.

In 2020, money market interest rates increased to as high as 9-10%. Subsequently, a stimulus
package was announced by the government, resulting in the drop of the interest rate in the
money market to 3-4%. This led to increase in returns in the capital market.

Differences between Economic Theories

● Classical economic theories focus on supply driven factors.

● Keynesian economic theories focus on demand driven factors.

● Freidman economic theories focus on both supply and demand factors as well as money
supply.

The 3 key reasons behind the popularity of John Maynard Keynes are:

- Forecasted WW2 in 1918

- Forecasted the Great Depression in 1924

- Gained significantly higher returns in a fund managed by him for Oxford University