Video Transcript: Determinants of Market Interest Rates

Hello, welcome. We're going to be discussing determinants of market interest  rates. So let's look at determinants of market interest rates. So we see that R is  our required rate of return, right our R with the asterisk represents our real risk  free rate of interest. So what would we consider as being a risk free rate of  interest? So the United States government issues instruments called treasury  bills, and treasury bills are backed by the confidence of the United States  government. So we know that because the United States government has the  ability to print money, that we will not the United States government will not  default on their debt payments. So the real risk free rate of interest is typically  bench marked to the 10 year treasury bill, because that is considered risk free.  Now the inflation premium will sometimes have to pay an inflation premium,  which is marked into interest rates automatically through the Federal Reserve,  they control interest rates based on inflationary figures, default risk premium that will also be factored in to your interest rate when you are borrowing. The default  risk premium is based is based off your credit worthiness, and if the bank, or  whoever the lender is, feels like that you are good candidate and that your ability to repay the loan will minimize your default risk premium. Let's talk about  liquidity risk premium. The liquidity risk liquidity is, how fast can we convert an  asset into cash? So are we able to convert assets into cash quickly the bank will decide that as they are going through, who or whoever the lender is will decide  that as they go through and determine if you are credit worthy. So then we'll also have a maturity risk premium, and sometimes you'll see that in the callable bond options now required rate of return. The required rate of return is the minimal  and annual percentage earned by an investment that will induce individuals or  companies to put money into a particular security or project. The required rate of return is used in both equity valuation and in corporate finance, investors use  the required rate of return to decide where to put their money, and corporations  use the required rate of return to decide if they should pursue a new project or  business expansion. So our return on our investment will help us decide which  area we should invest in using the required rate of return. Investors compare the return of an investment to all other available options, taking into consideration  the risk free rate of return, inflation and liquidity. Corporations also use required  rate of return to calculate net present value and the discounted cash flow  analysis, which we'll cover later. Inflation premium, let's discuss this. The  primary market force causing an inflation premium is an unexpected is an  expectation of inflation. When inflation is significant, as it has been to variance,  varying degrees since World War II lenders know the money they will be repaid  will be lower in value, because as inflation goes up, it deteriorates the  purchasing power of your dollar. They raise interest rates to compensate for the  expected loss. So your inflation premium will be based off of factors of inflation.  Will we see higher inflation? Then you will see higher interest rates from the  bank. And typically, you will see if inflation begins to rise that usually the Federal 

Reserve will lower interest rates to keep inflation under control, but as interest  rate rise, inflation rises at times, the Federal Reserve will have to raise rates,  therefore causing causing consumers to pay more and inflation premium, a  contributing factor is that borrowers believe prices will rise. Are more willing to  pay higher interest rates to purchase goods and services on credit sooner rather than later, when they believe prices will be higher. So when inflation sets in,  asset prices go higher, just like stocks, stocks are in assets. If we have high  inflation, stock prices should theoretically increase, because they are assets. So inflation increases. Asset prices interest rates have three components. The first  is the risk free return. This is the amount of interest that lenders charge for the  use of their money if there is no risk of not being repaid, the inflation premium is  added to the risk free rate to offset expected losses from the declining value of  money due to inflation. The third component is the amount lenders charge to  offset credit risks. It's impossible to precisely calculate the inflation premium,  since it depends on expectations about the future. However, it's fairly simple to  estimate the inflation premium. Typically, this is done by starting with the current  interest rate on US treasury inflation protected securities which are known as  tips. Tips carry virtually no risk and are inflation protected, so their rate closely  approximates a real risk rate Treasury T bills have similar similarly low risk, but  are not inflation protected. Simply subtract the tips rate from the T bill rate to  obtain an estimate on the inflation premium use securities of the same maturity,  for example, 10 year tips versus 10 year T bills. Use those as the basis for your  calculation. Default risk premium is the additional amount a borrower must pay  to compensate the lender for assuming default risk. A default premium is  generally paid by all companies or borrowers indirectly, through the rate at which they must repay their obligation. Typically, the only borrower in the United States which would not pay a default premium would be the US government. However,  in tumultuous times, even the US Treasury has had to offer higher yields in order to borrow. The default premium is paid by companies with lower grade bonds or  by individuals with poor credit. The liquidity risk premium is the risk stemming  from the lack of marketability of an investment that can be bought or sold quickly enough to prevent or minimize a loss with liquid lift, with liquidity risk typically  reflected in usually wide bid ask spreads or large price movements. The rule of  thumb is that the smaller the size of the security or its issuer, the larger the  liquidity risk drops in the value of stocks and other securities in the aftermath of  the 911 attacks and the 2007-8 global credit crisis motivated many investors to  sell their holdings at any price, causing widening bid ask spreads and large price declines further contributed to market illiquidity. You have a bunch of sellers on  the market, no buyers. These sellers can't sell their product because there's no  buyers, so it just drives the price down, making it illiquid, because no, you can't  convert the asset to cash because there's nobody to buy it. Investors, managers and creditors utilize liquidity measurement ratios when deciding in the level of 

liquidity risk within an organization, they often compare short term liabilities and  liquid assets listed on the company's financial statements. If a business has too  much liquidity risk, it must sell assets bring in additional revenue or find another  method of shrinking the difference between available cash and debt obligations.  Financial Institutions are also scrutinized as to whether they can meet their debt  obligations without realizing great losses. The institutions face heavy compliance 

issues and stress tests for remaining economically stable. Market risk premium.  Buying a bond with a longer time to maturity increases the likelihood that  interest rates could rise over that period. The maturity risk premium is the extra  yield you will earn from buying a bond with a longer time to maturity. Maturity  risk premium can be viewed by comparing the same investment with different  maturities. Your bank may pay 4% on a one year CD and a 5% on a five year  CD, you earn an extra 1% per year to tie your money up for the longer the  maturity the market interest rates for Treasury securities of different maturities  also indicate the maturity risk premium at the time of publication, that the yield  on a 20 year treasury was 2.13% the yield for a 30 year government Bond was  2.53% notice for 10 years longer. You do receive a higher interest rate because  of the maturity risk premium, because it's further out on the time horizon, 30  years, or longer than 20 years. So they pay you a premium for locking up your  money longer.