Finance Chapter 6

Production Opportunities
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Terms in this set (46)
Interest Rate in Each Marketthe point where the supply and demand curves intersectFlight to Qualityshifting from riskier investments to safer investmentsShort Term Interest Rates-volatile, rising rapidly during booms and falling equally rapidly during recessions -inflationary pressures exert upward pressure on ratesCurrent Real Rate of Interest-current interest rate-current inflation rate -shows how much investors really earned after the effects of inflation are removedreal risk-free rate of interest-r=r*+IP+DRP+LP+MRP -rate of interest that would exist on default-free US Treasury securities if no inflation were expected -depends on the rate of return that corporation and other borrowers expect to earn on productive assets and people's time preferences for current versus future consumption -typically functions between 1-3%Nominal/Quoted Risk-Free Rate of Interest (rRF=r*+IP)-Rate of interest on a security that is free of all risk -rRF is proxied by the T-bill rate -rRF includes an inflation premium -Interest rate on a security that has no default risk, maturity risk, liquidity risk, or risk of loss if inflation increasesTreasury Inflation Protected Security (TIPS)security whose value increases with inflation and is free from default, maturity, liquidity risks and of risks due to changes in the general level of interest ratesInflation Premium-A premium equal to expected inflation that investors add to the real risk-free rate of return -rt-bill=rRF=r*+IP -IP is the inflation rate expected in the future not the current or past inflation rateDefault Risk Premium (DRP)-difference between the interest rate on a U.S. treasury bond and a corporate bond of equal maturity and marketability -Risk that the borrower will not make scheduled interest or principal payments -Greater the bond's risk of default, the higher the market rateLiquidity Premium (LP)Premiums that include the liquidity of certain assets and securitiesRate of Interest on a Treasury SecurityrRFWhat happens when long-term bonds decline in price?when interest rates riseInterest Rate Riskrisk of capital losses to which investors are exposed because of changing interest ratesMaturity Risk Premium (MRP)-a premium that reflects interest rate risk -varies somewhat over time, rising when interest rates are more volatile and uncertain and then falling when interest rates are more stable -MRP on 20 year T-bonds has generally been between 1-2%Reinvest Rate Risk-risk that a decline in interest rates will lead to lower income when bonds mature and funds are reinvested -investing short preserves one's principal but the interest income provided by short term T bills is less stable than that on long-term bondsTerm Structure of Interest Ratesrelationship between bond yields and maturitiesYield Curve-a graph showing the relationship between bond yields and maturities -Risker the corporation, the higher the yield curve -Usually slopes upwards since long-term rates are generally above short-term rates (normal yield curve) -Short term securities have less interest risk than long term securities creating smaller MRPsHumped Yield Curveinterest rates on intermediate-term maturities were higher than rates on both short/long term maturitiesT-Bond Yieldr*t+IPt+MRPtIP vs r*-r* is more random so the best forecast is its current value -IP is more predictable so increases in inflation will increase over longer periods of time as well as MRPWhat are higher yields due to?higher expected inflation and a positive MRPCorporate BondCorporate Bond Yield-Treasury Bond YieldCorporate Bond Yieldr*t+IPt+MRPt+DRPt+LPtWhy is the yield between corporate and t-bonds larger the longer the maturity?because long-term corporate bonds have more default and liquidity riskPure Expectations Theory-states the shape of the yield curve depends on investors' expectations about future interest rates -$1 x (1+yield rate)nHow to achieve equilibrium-borrow money for 2 years at the 2 year rate or invest in a 1 year security at current yield rate and at the future yield rate to gain the equilibrium rate -Bond traders rush to borrow money (demand funds) in the 2 year market and invest (or supply funds) in the 1 year marketWhen can the yield curve be used to estimate the short-term rate?When the MRP is correctWhat increases the money supply?-trading of short-term securities -short-term rates decline -long-term rates riseWhat do lower short term rates do?they cause foreigners to sell their holdings of U.S. bonds which would lower the value of the dollar making US good less expensive and lower the trade deficitWhy would short-term rates be changed by the fed?they may be driven below the long-run equilibrium level if the Fed is easing credit and above the equilibrium rate if they are tightening creditFederal Budget Deficits-Larger the deficit, the higher the level of interest rates -Borrowing leads to higher demand for funds -More printed money leads to increased inflationForeign Trade Deficit-when a country imports more than it exports -must be financed which means borrowing from nations with export surpluses -larger the trade deficit, the higher the tendency to borrow -hinders the Fed's ability to combat a recession by lowering interest ratesHighs/Lows of Business Activity-When inflation increases, interest rates increase -During recessions, the demand for money and the rate of inflation tend to fall -The Fed tries to increase the money supply in order to stimulate the economy causes the interest rates to decline during recessionsShort Term vs Long Term Rates-Short-term rates decline more sharply than long-term rates -Fed operates mainly in the short-term sector -Long-term rates reflect average expected inflation rate over the next 20-30 years which doesn't change muchWhat does the optimal financial policy depend on?the nature of the firm's assets -- the easier it is to sell assets to generate cash, the more feasible it is to use more short-term debtWhat do decisions for 401(k)s do?-Affects your annual interest income -Choice of maturity would have a major effect on your investment performance and your future income