© 2000 John Petroff
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© 2000 John Petroff |
D- General understanding of interest rates
The valuation process is predicated upon the choice of an appropriate discount rate i. That discount rate is also, as already noted, the required rate of return for that type of financial asset. This choice of a specific required rate of return is tied to opportunities available in financial markets. A complete discussion of market interest rates can be found in textbooks on financial markets and monetary policy. Modern portfolio theory offers the foundations for understanding how market rates of return are adjusted for the risk associated with a given company (see Section E). On the one hand, market rates require the knowledge of how to forecast interest rates in general, and on the other hand, personal analytical skills and judgment are necessary to assess company risk. Most of this manual is devoted to correctly assessing elements that relate to company risk. It is useful, nevertheless, to understand what affects market rates in order to correctly predict changes in these rates and thus changes in all prices. Note, however, that prices do not all change in the same manner. This gives rise to various trading strategies, which themselves, in turn, affect prices.
In subsequent chapters and Chapter 4, in particular, we will encounter many instances of financial strategies based primarily on anticipated changes in market interest rates. Knowing how to forecast correctly these changes can, therefore, be one of the most important tasks of an analyst. The following distinguishes the different components that influence interest rates. Additional guidelines for forecasting of interest rates can be found in Chapter 15 Section C-6.
Rates of return can be broken down
into 6 distinguishable components:
1- compensation for loss of purchasing power, i.e. inflation
2- compensation for the non-use of money
3- liquidity preference
4- length of contract
5- monetary policy impact
6- market risk premium.
The first 5 components affect all financial assets, the sixth
differs according to type of security and type of company and
is undertaken in Section
E.
See review questions Q-2D.1 and Q-2D.2.
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