The Cost of Money (Interest Rates)

Ø Explain what the cost of money means, and

describe factors that affect the cost of money
(interest rates).
Ø Describe how interest rates are determined.
Ø Describe a yield curve and discuss how a yield curve
might be used to determine future interest rates.
Ø Discuss how government actions and general
business activity affect interest rates.
Ø Describe how changes in interest rates (returns)
affect the values of stocks and bonds.

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Ø Interest rates represent the prices paid to
borrow funds
Ø Equity investors expect to receive dividends
and capital gains

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 Yield Total dollar return Dollar income + Capital gains
(% return) = Beginning value = Beginning value

Dollar income + (Ending value - Beginning value)

=
Beginning value

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1. Production opportunities
◦ Returns available within from investment in
productive assets

2. Time preferences for consumption

◦ The preferences of consumers for current
consumption as opposed to saving for future
consumption

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3. Risk
◦ The chance that a financial asset
will not earn the return promised

4. Inflation
◦ The tendency of prices to increase
over time

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Market A: Low-Risk Securities Market B: High-Risk Securities

Interest Rate, r Interest Rate, r

(%) (%) SB1

rB = 9

SA1
DB1
rA1 = 6
rA2 = 5

DA1
DA2

Dollars Dollars

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Long & Short-term USD interest rates
since 1980
Rate of return = r = Risk-free rate + Risk premium

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Rate of return = r = Risk-free rate + Risk premium
= rRF + RP
= rRF + [MRP + LP + DRP]

r = the quoted or nominal rate

rRF = quoted risk-free rate
RP = risk premium

MRP = maturity risk premium

DRP = default risk premium
LP = liquidity, or marketability, premium

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Ø rRF = r* + IP

Ø The rate of interest on a security that is

free of all risk, except inflation

Ø Proxied by the T-bill rate or T-bond rate

Ø rRF includes an inflation premium (IP)

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ØThe rate of interest that would exist on
default-free U. S. Treasury securities if no
inflation were expected

ØGenerally ranges from 2 to 4 percent in the

United States

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ØA premium for expected inflation that
investors add to the real risk-free rate of
return

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Inflation expectations since 2003
Ø Difference between the interest rate on a U.S.
Treasury bond and a corporate bond of equal
maturity and marketability
Ø Compensates for risk that a borrower will
default on a loan

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Credit spreads
since 1998
ØPremium 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

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An interpretation of liquidity spreads
since 2016
Ø Premium that reflects the interest rate risk
linked to maturity mismatch
Ø Bonds with longer maturities have greater
interest rate risk

Ø Risk of capital losses when investors are

exposed to longer horizon
Ø Reinvestment risk is greater for short- term
bonds

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10Y-2Y spread on Treasury yields
since 1975
Term premium on 10-Y Treasury yields
since 2009
ØRelationship between yields and maturities of
securities

ØA graph of the term structure of interest rates

is called a yield curve

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Interest Rate
(%)

January 2007

November 2006

March 2014

Years to
1 5 10 15 20 Maturity
Short term Intermediate term Long term

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US Treasury Yield Curve (November 2020)
Ø “Normal” Yield Curve
◦ Upward sloping yield curve

Ø Inverted (“Abnormal”) Yield Curve

◦ Downward sloping yield curve

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Ø Expectations theory
◦ Shape of the yield curve depends on investors’
expectations about future inflation rates

Ø Liquidity preference theory

◦ Lenders prefer to make short-term loans;
borrowers prefer long-term debt

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ØMarket 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

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 rTreasury = rRF + MRP = [r* + IP] + MRP

Inflation is Expected to Increase Inflation is Expected to Decrease

Interest Rate Interest Rate
(%) (%)

Maturity Risk Premium, MRP

Maturity Risk Premium, MRP

Inflation Premium, IP Inflation Premium, IP

Real Risk-Free Rate, r* Real Risk-Free Rate, r*

Years to Maturity Years to Maturity

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 Interest rates and risk
Risk Free + Credit Spread
r = Risk-free rate + Risk premium
Interest Rate
(%)
BBB-Rated Corporate Bonds

AAA-Rated Corporate Bonds

Treasury Bonds

Years to
Maturity

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Ø Federal Reserve policy

Ø Level of the federal budget deficit

Ø Foreign trade balance

Ø Level of business activity

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Ø Higher interest rates increase costs and
thus lower a firm’s profits

Ø Interest rates affect the level of economic

activity and corporate profits

Ø Interest rates affect investment competition

between stocks and bonds

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Ø What is the cost of money and how is it
determined?
◦ The interest rate that lenders charge borrowers
◦ Determined by the supply of funds and the demand for those
funds
Ø What factors affect interest rates?
◦ The rate of return that borrowers expect to earn on their
investments
◦ Savers’ preferences to spend income in the current period
rather than delay consumption until some future period
◦ The risks associated with investments/loans
◦ Expected inflation

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Ø How are interest rates determined?
◦ The rate on a loan includes a minimum payment for delaying
consumption until some future date and payment for the risk
associated with the investment/loan.
Ø What is the yield curve and how might it be
used to determine future interest rates?
◦ The yield curve is a snapshot of the relationship between
short- and long-term interest rates on a particular date
◦ The relationships among the yields of bonds with different
terms to maturity are used to attempt to forecast future
interest rates. For example, an upward-sloping yield curve
might indicate that rates are expected to increase in the future,
and vice versa.

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Ø How do government actions and business
activity affect interest rates?
◦ When government spends more than it earns, funds must be
borrowed—borrowing inflates interest rates
◦ When businesses demand additional loans, interest rates
increase
Ø How do changes in interest rates affect the
values of stocks and bonds?
◦ When rates increase, the values of assets decrease

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