Chapter05InterestRates

Chapter05InterestRates - OEM 2009 Program Price or Cost of...

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OEM 2009 Program Interest Rates Page 1 CHAPTER 5 Interest Rates Price or Cost of Debt Capital ± What do we call the price, or cost, of debt capital? ² The interest rate or the cost of money. Price or Cost of Equity Capital ± What do we call the price, or cost, of equity capital? ² A “required return”, where, for stocks: Required Dividend Capital Return Yield Gain = + Cost of Money ² Factors affecting interest rates ² Macro: z Production opportunities z Time preference for consumption ² Micro: z Risk z Expected inflation S 1 S 2 r Interest Rates: Macro D 1 D 2 r * $ Supply and Demand ² Business cycle ² Monetary/fiscal policy z Open marke Open market z Fed-funds rate z Reserve requirements z Budget surplus or deficit
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OEM 2009 Program Interest Rates Page 2 Deposit Reserve Loanable 100.00 90.00 10.00 9.00 90.00 81.00 Reserve Requirements 81.00 72.90 8.10 7.29 100.00 72.90 65.61 1,000.00 Interest Rates: Micro r * = Real, risk-free rate T-bond rate if no inflation historically between 1% to 4% r = Any nominal rate (includes an adjustment for inflation) r RF = Rate on Treasury securities r * r * + IP + DRP + LP + MRP Nominal rate on debt Real, risk-free rate r r Interest Rates: Micro Real, risk free rate Inflation premium Default risk premium Liquidity premium Maturity risk premium MRP LP DRP IP Nominal, Risk-Free Rate Arithmetic : r RF,1 = r * 1 + I 1 r RF N = r * N + IP N RF,N r * N = [r * 1 + r * 2 + … + r * N ] / [N] IP N = [I 1 + I 2 + … + I N ] / [N] r = r RF + DRP + LP + MRP Nominal, Risk-Free Rate Geometric : r RF,1 = [(1+r * 1 )(1+I 1 )] - 1.0 r RF N = [(1+r * N )(1+ IP N )] - 1.0 RF,N r * N = [(1+r * 1 )(1+r * 2 )…(1+r * N )] 1/N -1.0 IP N = [(1+I 1 )(1+I 2 )…(1+I N )] 1/N -1.0 r = r RF + DRP + LP + MRP Example: Inflation Premium ± A representative bundle of goods and services currently costs $100. ± The expected inflation rate over the coming year is equal to 5%. ± You would like to earn a real rate of 2% on your $100 (buy 1.02 bundles at the end of the year) ² How much must you earn?
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OEM 2009 Program Interest Rates Page 3 Example: Inflation Premium You must invest at a rate that is high enough to cover both your desired real rate and the expected inflation rate.
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This note was uploaded on 05/12/2010 for the course FIN 5405 taught by Professor Tapley during the Summer '08 term at University of Florida.

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Chapter05InterestRates - OEM 2009 Program Price or Cost of...

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