https://rb.gy/n89u77 Describe interest rate fundamentals, the term structure of interest rates, and risk premiums. Discuss the general features, yields, prices, ratings, popular types, and international issues of corporate bonds. Review the legal aspects of bond financing and bond cost.

1. Chapter 6: Gitman/Brigham
Interest Rates
Qasim Raza Khan
Lecturer in Department of Management Sciences
CUI-Lahore
YouTube Link for lecture:
https://shorte.be/LP?$=174133

2. Topics Covered
Part-1: Cost of Money (Introduction)
Part 2: Factors affecting cost of money
– Fundamental factors
– Macroeconomic factors
• Interest rate levels
Part 3: Determinants of market interest rates
Part 4: Risk associated with overseas security
investment

3. Interest Rates
Part-1
Cost of Money

4. 1. Cost of Money
Cost of money is the rental price of borrowing
money
Suppose you go to a bank to borrow $10,000 for paying off college
fees, you won’t be able to get this money for free.
The $10,000 come with a price tag attached, i.e. some rate of
interest, consider for example a 10% rate of interest.
This 10% interest rate is the cost of obtaining $10,000. This cost is
also known as the ‘cost of money’.

5. LENDERS BORROWERS
EXCESS FUNDS
PRICING SYSTEM (i)
Supply of funds
Demand of funds
$
i
i
In a free economy, excess funds of lenders are allocated to borrowers through a
pricing system based on the supply of and demand for funds. This pricing system is
represented by interest rates, ‘i’ or the cost of money.

6. So, Now we know!
• Supply and demand of
funds determines the
interest rates (i).
• Supply curve move
downwards
• Demand curves move
upwards

7. • Generally interest rates are believed to be the
cost of money.
• However, in case of equity capital,
– Cost of money is called ‘Cost of equity’ and it
consists of dividends and capital gains expected by
the share holders
– Cost of equity = Dividends + Capital Gains

8. Remember!
•Cost from fund
users’ perspective
Cost of
Money
•Return from fund
providers’
perspective
Cost of
Money

9. BANK
(PROVIDER)
CORPORATION
ABC
(USER)
DEBT
CAPITAL
MONEY
COST OF MONEY (i)
Return for the funds provider Cost for the user of funds
STOCK-HOLDERS
(PROVIDER)
CORPORATION
ABC
(USER)
MONEY
COST OF MONEY (D+C.G.)
Return for the funds provider Cost for the user of funds
EQUITY
CAPITAL

10. QUICK FLASHBACK!
• ‘i’ is the cost of obtaining money.
• Supply and demand of funds determines the
interest rates.

11. Interest Rates
Part-2
Factors affecting on cost of
money, ‘i’

12. 2. Factors affecting cost of money, ‘i’
The four most fundamental factors affecting the cost of money are:
1. Production opportunities
– Rate of return that producers expect to earn on invested capital.
2. Time preferences for consumption
– The preferences of consumers for current consumption as opposed to
saving for future consumption.
Preference for current consumption Supply of funds Interest rate
3. Riskiness of loan
– The chance that an investment will provide a low or negative return.
4. Inflation
– The amount by which prices increase over time.
Expected Inflation Demand of funds Interest rate
For highly risky loans
investors expect
high rate of return,
i.e. high ‘i’
i. Fundamental factors affecting cost of money, ‘i’

13. ii. Macroeconomic factors affecting
cost of money, ‘i’
1. Monetary policy tools
– Federal Reserve Policies
– Open Market Operations
2. Business boom
3. Business recession
4. Government budget deficit and surplus

14. Macroeconomic factors affecting cost
of money, ‘i’
1. Federal Reserve Policies
– An increase in required reserve ratio by central
bank means reduction in volume of deposits
which raises interest rates.
RRR Supply of funds Interest rate
– A decrease in required reserve ratio means
availability of excess deposits which decreases
interest rates.
RRR Supply of funds Interest rate

15. 2. Open Market Operations
– Central bank buys back securities from open
market thus injecting money into the system
(increasing supply of money) which decreases
interest rates.
– Central bank sells securities into open market
thus absorbs money from the system (decreasing
supply of money) which increases interest rates.

16. 3. Business booms
Increased demand of funds Inflationary pressures i
4. Business recession
Decreased demand of funds Inflationary pressures i
5. Government budget deficit
Government needs funds which means demand for funds i
6. Government budget surplus
Government does not need funds which means demand for funds i

17. 3. INTEREST RATE LEVELS
• Capital is allocated to borrowers according to interest rates, i.
– Most capital across the world is allocated through the price system (that is,
interest rate).
• As can be seen in the figure below the excess funds of lenders are
allocated to the borrowers through a price system that is the
interest rate.

18. 4. Determinants of Market
Interest Rates

19. Interest Rates
Part-3
Determinants of Market
Interest Rates

20. Determinants of Interest Rates
• The interest rate quoted on any debt security is
composed of a real risk-free rate, r* , plus
several premiums that reflect inflation, the
security’s risk, its liquidity (or marketability),
and the years to its maturity. This relationship
can be expressed as follows:
Quoted interest rate = r = r* + IP + DRP + LP + MRP

21. How is interest rate determined
on debt securities?
• Required Rate of Return
– Nominal rate of return an investor requires to
make an investment worthwhile.
– Made up of 3 components:
• Real risk free rate
• Inflation premium
• Risk premium

22. 1. Real risk-free rate of return, r*
• Definition
– r* is the minimum rate of return an investor
requires. This rate does not take into account
expected inflation.
• Changes in r*
• r* is equal to T-bill rate minus the inflation
premium.

23. 2. Inflation Premium
• Inflation
– Definition: Loss in purchasing power of money
because of increase in prices.
– As inflation increases every dollar we own buys a
smaller percentage of goods and services.
• Why is inflation premium given?
• Impact of inflation on treasury and corporate
securities

24. Risk Free Rate
• rRF = r* + IP. It is the quoted rate on a risk-free
security such as a Treasury bill and it includes
a premium for expected inflation.

25. Difference between Real Risk free interest
rate and Risk free interest rate
• Risk free interest rate = Real Risk free interest rate + Inflation premium
• Real Risk free interest rate = Risk free interest rate – Inflation premium
• What does the term ‘real’ means?
• What does the term ‘risk-free’ means?

26. 3. Risk Premiums
1. DRP = default risk premium:
This premium reflects the possibility that the
issuer will not pay the promised interest or
principal at the stated time.
1. Treasury securities have no chance of default hence
DRP isn’t paid on them.
2. For corporate bonds higher the bonds rating, lower
its default risk and lower will be the interest rates.

27. 3. Risk Premiums
2. LP: Liquidity Premium:
– Liquid asset: An asset that can be converted to
cash quickly at a fair market value.
– Liquidity premium is added to ROI on securities
that aren’t liquid.
– Liquidity premium for treasury and
corporate securities

28. 3. Risk Premiums
3. MRP = Maturity Risk Premium:
Longer-term bonds, even Treasury bonds, are exposed to a
significant risk of price declines due to increases in interest
rates; and a maturity risk premium is charged by lenders to
reflect the interest rate risk.
MRP is paid to cover interest rate risk.
– Interest rate risk: The risk of capital losses to which investors are
exposed because of changing interest rates.

29. Interest Rates
Part-4
Risks associated with investment
in overseas securities

30. Risks associated with investment in
overseas securities
• Two main types of risks that an investor, looking to
invest in foreign securities, faces are: country risk
and exchange rate risk.
1. Country risk:
– Risk that arises from investing or doing business in
a particular country
– This risk depends on a country’s economic, social
and political environment.
– Countries with safer political, social and economic
environment have less country risk and therefore
are safe choices for overseas investment.

31. 2. Exchange rate risk:
– Risk of losing money in local currency because of fluctuation
in the value of foreign currency (in which investment was
being made).
– Recall example narrated in class (Pakistani earning US dollars
and praying for weak Pakistani rupee relative to US dollar).
– Suppose a US investor purchases Japanese bond. The US
investor gets interest rate in Japanese currency (Yen) which
must then be converted into US dollars whenever he wants
to make a purchase (as the investor resides in the US).
Whenever Yen strengthens in comparison to dollar it means
Yen can be converted into a larger number of US dollars and
the investor will be better off. On the other hand if Yen
weakens relative to dollar, it would mean Yen’s conversion
into dollar will give off fewer dollars and the investor will
have to suffer.

32. Simple Problems
• If expected inflation during the next year is 2%
and currently the nominal interest rate on T-bills
is 5%, what is the real risk free rate of interest?
• If inflation is expected to average 4% during the
next year and the real risk free rate of interest is
3%, what should be the nominal rate of interest?
• Answers: 3% and 7%

33. Simple Problem
• Assume that the real risk free rate, r* = 2% and
the average expected inflation rate is 3% for each
future year. The DRP and LP for Bond X are each
1% and the applicable MRP is 2%.
– What is Bond X’s interest rate?
– Is Bond X a treasury bond or a corporate bond?
– Does Bond X more likely to have a 3 month or 20 year
maturity?
Answers: 9%, corporate, 20 year

34. When inflation is expected to increase
• Long term bonds have higher yields for 2
reasons:
– Inflation is expected to be higher in
future
• If market expects inflation to increase in
future, the inflation premium will be
higher the longer the term to maturity.
– Positive MRP
• MRP always increases with increasing
maturity of bond.
– Refer to table page 177

35. • When inflation is expected to
decrease
• If market expects inflation to
decline in future, long-term
bonds will have smaller inflation
premium (thus lower rates) than
short-term bonds.
• Such yield curves predict
economic downturn because
weaker economic conditions
generally lead to declining
inflation which leads to lower
long-term interest rates.

36. Factors affecting shape of Corporate bonds
• Corporate bonds include a default risk premium (DRP) and a
liquidity premium (LP). Therefore, the yield on a corporate
bond that matures in t years can be expressed as follows:
• Corporate bond yield = r* + IPt + DRPt + LPt + MRPt
• The corporate bonds carry additional default and liquidity
risks, this is the reason they pay premium for covering these
risks which is why the ‘i’ (interest rate) paid on corporate
bond, also called the yield, is always higher than that paid on
treasury bonds.

37. Because of their additional default and liquidity risk, corporate bonds yield more than treasury
bonds with the same maturity and BBB-rated bonds yield more than AA-rated bonds.

38. • Corporate bond yield can be calculated using the formula:
• r = r* + IPt + DRPt + LPt + MRPt
• LP and DRP of a corporate bond are affected by its maturity
• For example:
– Coca Cola's chances of defaulting on 10 years bond are less
as compared to defaulting on a 100 year bond, so higher
DRP is paid on the bond with ______ years to maturity?
• Long term bonds are also less liquid than short term bonds so
as maturity of bonds increases LP also increases.

39. Interest rate determination
• Formula for calculation of interest rate on
short term treasury securities:
– Quoted interest rate = Real risk free rate + inflation premium
– r = r* + IPt
• Formula for calculation of interest rate on long
term treasury securities:
– Quoted interest rate = Real risk free rate + inflation premium +
maturity risk premium
– r = r* + IPt + MRPt

40. Interest rate determination
• Formula for calculation of interest rate on
corporate securities:
– r = r* + IPt + DRPt + LPt + MRPt
– Quoted interest rate = Real risk free rate + inflation premium + default
risk premium + liquidity premium + maturity risk premium