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Chapter 6. Interest rates

Chapter 6. Interest rates - Arizona State University...

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Chapter 6: Interest Rates 1 Arizona State University FINANCE 300 Fundamentals of Finance Chapter 6: Interest rates Instructor: Christian Ramirez Introduction In the previous chapter we discussed the time value of money and analyzed the effects that interest rates have on investments over time. The main objective of this chapter is to introduce you to world of interest rates. In this chapter you will primarily learn how interest rates are set, and what factors determine these interest rates. Since interest is the cost of debt money, you will learn how the supply and demand of capital affect the cost of money. The Cost of Money Money has a cost. If you want to invest in a new business venture you would probably finance this venture either with your own money or with borrowed money. If you don’t have the enough funds to carry out this business venture, you would probably have to obtain a loan from the bank for example. How much is this loan going to “cost” you? Well, this will depend on the interest rate they will charge you on these borrowed funds. Again, during this chapter, every time we refer to cost of money , we will be referring to the cost of debt which equals the interest rate to be paid. In the next chapter, we will learn how the cost of equity is determined, but for now, we will only focus on interest as the cost of money for debt. Four variables affect the cost of money. (1) Production opportunities (investment opportunities) (2) time preferences for consumption, (3) risk, and (4) inflation. To better understand these four variables, assume that your friend Mark is a scalper; he specializes in selling National League playoff tickets. You really want two tickets for the D-Backs - Rookies playoff series. Mark is willing to offer these two tickets if you are willing to give him back these 2 playoff tickets plus an extra 2 playoffs tickets next season for forgoing the use of the tickets he will loan to you today. Then, Mark’s time preference for consumption is 100%. Now, another reason for this high rate of preference could be because of inflation ( Mark knows that the tickets may be higher next year and he wants to be protected ) . Another factor has to do with the fact that Mike is taking a big risk with you and even though he wants to get something in return he may end up with nothing if you don’t come through with the 4 tickets next playoff season. Lastly, the investment in the playoff tickets by mark is the investment opportunity by which he expects a return. In conclusion, interest paid to investors/savers depends on (1) rate of return investors expect to earn on invested capital (aka investment opportunities), (2) saver’s time

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Chapter 6: Interest Rates 2 preferences for current vs. future consumption, (3) risk of the loan, and (4) and expected rate of inflation. Also, we have said that interest is the cost of debt. In other words, interest is what it is charged when someone foregoes the use of money today (saver) to give it to someone (borrower) with the promise to be compensated by a greater amount in
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Chapter 6. Interest rates - Arizona State University...

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