Financial Markets - Interest Rates & Required Returns

• Interest Rate - It is usually applied to debt instruments such as bank loans or bonds
• Interest Rate - the compensation paid by the borrower of funds to the lender; from the borrower’s point of view, the cost of borrowing funds.
• Required Return - it is usually applied to equity instruments such as common stock.
• Required Return - the cost of funds obtained by selling an ownership interest.
• what are the several factors that can influence the equilibrium interest rate? Inflation, Risk, Liquidity preference
• Inflation – which a rising trend in the prices of most goods and services.
• Risk – which leads investors to expect a higher return on their investment.
• Liquidity Preference – which refers to the general tendency of investors to prefer short-term securities.
• Real rate of interest – is the 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.
• The real rate of interest changes with changing economic conditions, tastes, and preferences.
• Nominal Rate of Interest – is the actual rate of interest charged by the supplier of funds and paid by the demander.
• What are the two factors that differs the nominal rate from the real rate of interest?

  inflation premium (IP) & risk premium (RP)
• Inflationary expectations reflected in an inflation premium (IP)
• Issuer and issue characteristics such as default risks and contractual provisions as reflected in a risk premium (RP).
• The nominal rate of interest for security 1, r1, is given by the following equation: r1 = r* + IP + RP1
• What are the two basic components of nominal rate in equation? risk-free rate of return (RF) and a risk premium (RP1)
• The risk free rate can be represented as: RF = r* + IP
• The risk-free rate embodies the real rate of interest plus the expected inflation premium.
• The inflation premium is driven by investors’ expectations about inflation—the more inflation they expect, the higher will be the inflation premium and the higher will be the nominal interest rate.
• One of the disadvantages of bonds is that they usually offer a fixed interest rate.
• Fixed interest rate - This presents a serious risk to bond investors, because if inflation rises while the nominal rate on the bond remains fixed, the real rate of return falls.
• A Series-I bond earns interest through the application of a composite rate. The composite rate consists of a fixed rate that remains the same for the life of the bond and an adjustable rate equal to the actual rate of inflation.

   
• The adjustable rate changes twice per year and is based on movements in the Consumer Price Index for All Urban Consumers (CPI-U).
• Term structure of interest rates – is the relationship between the maturity and rate of return for bonds with similar levels of risk.
• Yield curve – is a graphic depiction of the term structure of interest rates.
• Yield of maturity – is the compound annual rate of return earned on a debt security purchased on a given day and held to maturity.
• Normal yield curve – is an upward-sloping yield curve indicates that long-term interest rates are generally higher than short-term interest rates.
• Inverted yield curve – is a downward-sloping yield curve indicates that short-term interest rates are generally higher than long-term interest rates.
• Flat yield curve – is a yield curve that indicates that interest rates do not vary much at different maturities.
• Expectations theory – is the theory that the 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.
• Liquidity preference theory – suggests 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. Borrowers must offer higher rates on long-term bonds to entice investors away from their preferred short-term securities.
• Market segmentation theory – suggests 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.
• 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 - That the longer the maturity, the more the value of a security will change in response to a given change in interest rates. If interest rates on otherwise similar-risk securities suddenly rise, 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 these 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.
• Corporate bond – is a long-term debt instrument indicating that a corporation has borrowed a certain amount of money and promises to repay it in the future under clearly defined terms.
• Coupon interest rate – is the percentage of a bond’s par value that will be paid annually, typically in two equal semiannual payments, as interest.
• The bond’s par value, or face value, is the amount borrowed by the company and the amount owed to the bond holder on the maturity date.
• The bond’s maturity date is the time at which a bond becomes due and the principal must be repaid.
• Bond indenture – is a legal document that specifies both the rights of the bondholders and the duties of the issuing corporation.