Determinants of Interest Rates

r = r* + IP + DRP + LP + MRP

•r = required rate of return
•r* = real risk free rate of interest
•IP = inflation premium
•DRP = default risk premium
•LP = liquidity risk premium
•MRP = maturity risk premium


r = require rate of return

•The required rate of return (RRR) is the minimum annual percentage earned by an investment that will induce individuals or companies to put money into a particular security or project. The RRR is used in both equity valuation and in corporate finance. Investors use the RRR to decide where to put their money, and corporations use the RRR to decide if they should pursue a new project or business expansion.
•Using the RRR, 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 RRR to calculate net present value in discounted cash flow analysis.


i = inflation premium

•The primary market force causing an inflation premium is an expectation of inflation. When inflation is significant (as it has been to varying degrees since World War II), lenders know the money they will be repaid will be lower in value. They raise interest rates to compensate for the expected loss. A contributing factor is that borrowers, believing 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.
•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 U.S. Treasury Inflation Protected Securities (TIPS). TIPS carry virtually no risk and are inflation-protected, so their rate closely approximates a real-risk rate. Treasury T-Bills have similarly low risk, but are not inflation-protected. Simply subtract the TIIPS rate from the T-Bill rate to obtain an estimate of the inflation premium. Use securities of the same maturity (10-year securities are most often used).


DRP = default risk premium

•A default 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 U.S. government. However in tumultuous times, even the U.S. 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.

LP = liquidity risk premium

•Liquidity risk is the risk stemming from the lack of marketability of an investment that cannot be bought or sold quickly enough to prevent or minimize a loss. With liquidity risk, typically reflected in unusually 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 9/11 attacks and the 2007-2008 global credit crisis motivated many investors to sell their holdings at any price, causing widening bid-ask spreads and large price declines, which further contributed to market illiquidity.
•Investors, managers and creditors utilize liquidity measurement ratios when deciding 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.


MRP = maturity 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 percent on a one-year CD and 5 percent on a 5-year CD. You earn an extra 1 percent per year to tie your money up for the longer maturity. The market interest rates for Treasury securities of different maturities also indicate the maturity risk premium. At the time of publication, the yield on a 20-year Treasury was 2.13 percent. The yield for a 30-year government bond was 2.53 percent.





Última modificación: martes, 14 de agosto de 2018, 08:42