6 Inflation premium Investors are compensated for reduction in purchasing power

6 inflation premium investors are compensated for

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6. Inflation premium Investors are compensated for reduction in purchasing power of money. From point (1) the higher the inflation premium, the higher the market interest rate. 7. Default risk premium (DRP) This is the rate added to risk free rate for possibility of default in payment of loans. Usually, its added if two securities have equal maturity and marketability. Business cycle
Lesson Five 628. Liquidity premium This is premium added to equilibrium interest rate on a security if that security cannot be converted to cash on short notice and close to the original cost. 9. Maturity Risk Premium a premium reflecting interest rate risk i.e risk of capital losses which investors are exposed to because of hanging interest rate over time. INTEREST RATE LEVELS AND STOCK PRICES Interest rates have two effects on corporate profits: a) Because interest rate is a cost, the higher the rate of interest the lower the firm‟s profit other things held constant. b) Interest rates affect the level of economic activities which affect the level of corporate profit. Interest rates obviously affect stock prices because of the effect on profit but even more importantly they have an effect due to the competition in the market between shares and bonds. If interest rates rise sharply, investors can get higher returns in the bond (money) market which induces them to sell shares (stocks) and transfer the funds from stock market to money market (Treasury bills). Such transfers in response to increase in interest rates reduces demand for shares in the stock exchange and this obviously depresses the share prices e.g in mid and late 1993 the CBK intervened in the short term market where it floated Treasury Bills whose interest rate was as high as 88% well above the returns that can be expected from high yield stocks. Accordingly, investors removed (misdirected) their money (funds) from the stock market into Treasury Bills. The result was a stagnation of stock prices of quoted firms. Accordingly as CBK achieved its objective of reducing the money supply in the economy the interest rates declined well below 30% and the immediate effect was a rebuild in demand for shares and the share prices shot up instantaneously around February 1994. Importance of Interest Rates These are of a particular relevance to a finance manager because: i) They measure the cost of borrowing. ii) Interest rates in a country influence the foreign exchange rate of the country‟s currency.iii) Interest rates act as a guide to the sort of return that firm‟s shareholders might want hence changes in interest rates will affect rates for an approved creditworthy borrower. Interest may be a) Base lending rates Banks lend to individual and small firm‟s at certain margins above the base lending rates. It is therefore the rates for an approved creditworthy borrower.

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