ffm1007BV - 7-1 Interest rates & Bonds Valuation...

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Unformatted text preview: 7-1 Interest rates & Bonds Valuation Interest rate fundamentals Key features of bonds Bond valuation Measuring yield Assessing risk 7-2 Interest Rates & Required Returns: Interest Rate Fundamentals When funds are lent, the cost of borrowing is the interest rate. When funds are raised by issuing stocks or bonds, the cost the company must pay is called the required return, which reflects the suppliers expected level of return. 7-3 Interest Rates Interest rates represent the compensation that a demander of funds must pay a supplier. The rental price of money. The price changes over time as the demand and supply changes. 7-4 Factors That Determine the Level of Interest Rate Central Bank policy Level of the federal budget deficit Foreign trade balance Level of business activity Opportunities for investment Other factors, including inflation and other risk premiums 7-5 Factors That Determine the IR Level k = k rf + RP, where k = nominal rate of interest k rf = risk-free rate of interest RP = risk premium k rf = k* + IP, where k* = real risk-free rate interest IP = Inflation risk premium k = k* + IP + RP 7-6 Factors That Determine the IR Level k = k fr + LP + DRP + MRP k = nominal rate of interest k rf = nominal real rate of interest LP = liquidity premium DRP = default risk premium MRP = maturity risk premium 7-7 Inflation premium A premium for expected inflation that investors add to the real risk-free rate of return 7-8 Liquidity premium Premium added to the rate on a security if the security cannot be converted to cash on short notice and at close to the original cost 7-9 Default risk premium Difference between the interest rate on a Govt / Treasury bond and a corporate bond of equal maturity and marketability Compensates for risk that a borrower will default on a loan 7-10 Interest rate risk Risk of capital losses to which investors are exposed because of changing interest rates 7-11 Maturity risk premium Premium that reflects the interest rate risk Bonds with longer maturities have greater interest rate risk Reinvestment rate risk is greater for short-term bonds 7-12 Term Structure of Interest Rates The term structure of interest rates relates the interest rate to the time to maturity for securities with a common default risk profile....
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This note was uploaded on 12/12/2011 for the course ECONOMICS 101 taught by Professor Thoman during the Spring '09 term at Abu Dhabi University.

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ffm1007BV - 7-1 Interest rates & Bonds Valuation...

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