THE COST OF MONEY

Factors affecting the Cost of Money:

1. Production Opportunities opportunity to generate cash from assets
2. Time Preference for Consumption willingness to spend as opposed to
saving
3. Risk chance that there is low or negative return
4. Inflation amount by which prices increase over time

If the market is low,
Time preference for saving is high
Interest rate will be high (to encourage investment)
Capital formation is difficult

INTEREST RATE LEVELS
Supply curve (Market H)
- upward sloping which indicates that investors are willing to supply more
if the rate of return is also high

Demand curve (Market L)
- downward sloping, which indicates that borrowers will borrow more if the
interest rates are lower


INTEREST RATE LEVELS
Market rate (going rate)
- Point at which supply and demand curve in Market H and Market L
intersect
Example: 5% is the going rate

Risk premium
- the expected return in exchange of risk

Example: The suppliers will provide rate of return of 7% higher than going
rate to obtain more finances.
7% - 5% = 2% = Risk premium




DETERMINANTS OF MARKET INTEREST RATES
Market interest rates (Quoted)

r = r
*
+ IP + DRP + LP + MRP

r
RF
= (r
*
+ IP)
r* = real risk free rate (no inflation is expected) (ex. Treasury certificates)
r
RF
= quoted rate on a risk free security (ex. T-bond)
DRP = default risk premium (risk that investment will not be paid on time)
LP = liquidity premium (risk that investment cannot be converted to cash)
MRP = marturity risk premium (reflects interest rate risk)
THE TERM STRUCTURE OF INTEREST RATES
- relationship between long term and short term rates

Yield curve graph to show the structure

Long term rates are usually higher than short term rates due to maturity
risk premium

Normal yield curve - upward
Abnormal - downward
WHAT DETERMINES THE SHAPE OF THE YIELD
CURVE?

Long term rates are usually higher than short term rates due to maturity
risk premium

T-bond yield = r
t
+ IP
t
+ MRP
t

Corporate bond yield = r
t
+ IP
t
+ MRP
t
+ DRP
t
+ LRP
t

Corporate Bond yield premium = DRP + LRP




USING THE YIELD CURVE TO ESTIMATE FUTURE
INTEREST RATES
Pure expectations theory the yield curve depends on investors
expectation about future interest rates

Example: assume that a 1 year Treasury bond currently yields 5.00%, while
a 2 year bond yields 5.50%. Investors who want to invest for a two year
horizon has two options:
Option 1 - Buy a 2 year T-bond @ 5.50%
Option 2 Buy 1 year T-bond @ 5.00%

Future Value at end of year 2
Option 1 = $1 x (1.055)
2
= $1.113025




USING THE YIELD CURVE TO ESTIMATE FUTURE
INTEREST RATES

If the expectations theory is correct, such that
1.05 (1 + x) = 1.055

Future Value at
Option 2 = $1 x (1.055)
1
+ $1 x (1+x%)
1
= $?

1+x = (1.055)
2
/1.05
= 6.00238%

SAMPLE PROBLEMS
Given:
The real risk free rate of interest, r*, is 3% and it is expected to remain constant
over time.
Inflation is expected to be 2% per year for the next 3 years and 4% per year for
the next 5 years.
The maturity risk premium is equal to (0.1) x (t -1 )%, where t=bonds maturity
The default risk premium for a BBB-rated bond is 1.3%

Compute for the following :
a) What is the average expected inflation rates over the next 4 years.
b) What is the yield on a 4 year Treasury bond?
c) What is the yield on a 4 year BBB-rated corporate bond with a liquidity
premium of 0.5%?
d) What is the yield on an 8 year Treasury bond?
SAMPLE PROBLEMS