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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? Th i t t t th t f 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? A “ i d t h f A “required return”, where, for stocks: Required Dividend Capital Return Yield Gain = + Cost of Money Factors affecting interest rates Macro: z Production opportunities z Time preference for consumption Micro: z Risk z Expected inflation S 1 S 2 r Interest Rates: Macro D 1 D 2 r * $ Supply and Demand Business cycle Monetary/fiscal policy z 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 IP 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 [(1 r )(1 IP )] 1.0 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 th i i l t 5% 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) How much must you earn?
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