COST OF MONEY AND ITS DETERMINANTS

In a free economy such as ours, the excess funds of lenders are allocated to borrowers in
the financial markets through a pricing system that is based on the supply of, and the
demand for, funds.
This system is represented by interest rates, or the cost of money, such that those
borrowers who are willing to pay the rates that prevail in the financial markets are able to
use funds provided by others.

Whether the investment instrument is debt or equity, the dollar return earned by an
investor can be divided into two categories:
1. Income paid by the issuer of the financial asset and
2. The change in value of the financial asset in the financial market (capital gains) over
some time period.

If the financial asset is debt, the income from the investment consists of the interest paid by
the borrower. If the financial asset is equity, the income from the investment is the dividend
paid by a corporation.

To determine an investment’s yield, we state the dollar return as a percentage of the dollar
amount that was originally invested. Thus, the yield is computed as follows:

To illustrate the concept of yield, consider the return earned if you purchased a bond on Jan
1 for $980 & sold it on Dec 31 for $990.25.
If the bond paid $100.00 interest on December 31, 2008, the total dollar return on your
investment would be $110.25; this amount includes $100.00 in interest income and $10.25
in capital gains.
In this example, if we assume that this is the same return that investors expected to earn
when they purchased the bond at the beginning, then this yield represents the investors
required rate of return to provide their funds to the company that issued the bond. In this
case, the cost of money for such a corporation was essentially 11.25%.

Four fundamental factors affect the cost of money:

1. Production opportunities
2. Time preferences for consumption
3. Risk and
4. Inflation.

Production Opportunity. The ability to turn a cost into a benefit. For example, an investor
who buys a stock has the production opportunity to make capital gains.
the higher the production opportunity—the higher his expected return on the investment
would be, and the more he could afford to offer potential investors for their savings.
Time preference for consumption- the preference that consumers have to
spend immediately rather than to save for future needs.

Note also that if the entire population is living at the subsistence level, time preferences
for current consumption would necessarily be high, aggregate savings would be low,
interest rates would be high, and capital formation would be difficult.

The higher the perceived risk, the higher the required rate of return.

That is, the higher the expected rate of inflation, the greater the required return.

This simple illustration shows that the interest rate paid to savers depends in a basic way on:
1. The rate of return that producers expect to earn on their invested capital
2. Savers’ time preferences for current versus future consumption
3. The riskiness of the loan and
4. The expected future rate of inflation.

The returns that borrowers expect to earn by investing borrowed funds (opportunities) set
an upper limit on how much they can pay for savings.
In turn, consumers’ time preferences for consumption establish how much consumption
they are willing to defer, and hence how much they will save at different levels of interest
offered by borrowers.
Higher risk and higher inflation also lead to higher interest rates.

Financial markets are interdependent

There are markets for short-term debt, long-term debt, home loans, student loans, business
loans, government loans, and so forth.

• Prices are established for each type of fund, and these prices change over time as
shifts occur in supply and demand conditions.
• Short-term interest rates are especially prone to rise during booms and then fall
during recessions.
• When the economy is expanding, firms need capital, and this demand for capital
pushes rates higher.
• Inflationary pressures are strongest during business booms, which also exert
upward pressure on

Rate of return r = Risk free rate + Risk premium or

Rate of return r = rRF + RP = rRF + (DRP + LP + MRP)

r = Quoted, or nominal, rate of interest on a given security.

rRF = Quoted risk-free rate on investment that has no risk, like T bills.
RP = Risk premium represents additional payment for the risk associated with an
investment. RP = DRP + LP + MRP.
DRP = Default risk premium, which reflects the chance that the borrower will not pay the
debt’s interest or principal on time.
LP = Liquidity premium reflects that some investments are more easily converted into cash
on short notice at a ‘‘reasonable price’’.
MRP = Maturity risk premium, which accounts for the fact that longer-term bonds
experience greater price reactions to interest rate changes than do short-term bonds.

The relationship between long & short-term rates, which is known as the term structure of
interest rates, is important to corporate treasurers, who must decide whether to borrow
long or short-term debt & to investors, who must decide whether to buy long or short-term
bonds. For these reasons, it is important to understand (1) how long- and short-term rates
are related and (2) what causes shifts in their relative positions.

The set of data for a given date, when plotted on a graph such as that in the figure, is called
the yield curve for that date. The yield curve provides a snapshot of the relationship
between short- and long-term rates on a particular date

Long-term rates have generally been higher than short-term rates, so the yield curve
normally has been upward sloping. For this reason, people refer an upward-sloping yield
curve as a ‘normal’ yield curve.
A downward-sloping yield curve is pretty rare & thus we normally refer to this type of curve
as an inverted, or abnormal yield curve.

real risk-free rate of return, r, is generally is relatively stable but when interest rates shift to
substantially different levels, it generally is because investors have changed either their
expectations concerning future inflation concerning risk.

investors generally prefer to hold short-term securities because such securities are less
sensitive to changes in interest rates and provide greater investment flexibility than longer-
term securities.

Borrowers, on the other hand, generally prefer long-term debt because short-term debt
exposes them to the risk of having to refinance the debt under adverse conditions.

Liquidity preference theory- as the liquidity preference theory, simply states that long-
term bonds normally yield more than short-term bonds.

Expectations theory- expectations theory, which states that the yield curve depends on
expectations concerning future inflation rates.

SEE SLIDE 28 AND 29 OF IBF LECTURE 3 (DID NOT UNDERSTAND)