The Understanding of Risk-Free Rate - Term Paper Example

The understanding of risk free rate Name Course Tutor Date The understanding of risk free rate Table of Contents The understanding of risk free rate 2 Table of Contents 2 1.0 Introduction 3 2.0 Concept of Risk Free Rate 3 2.1 Risk Free Asset 4 3.0 Effect of interest rates 6 4.0 Effect on the property market of recent changes to interest rates 8 5.0 Conclusion 10 6.0 References 11 7.0Appendix 13 1.0 Introduction Investors place their monies in places where they expect to reap return out of their investment. This implies that they have to place their bets on risk free assets. It is this concept of risk free assets that gives rise to the term risk free rates. Risk free rate implies to a situation where actual return equals expected return. This concept is integral in the investment arena as it is critical in determining cost of equity and capital. Based on this realisation, the core concern of this paper is to outline what the term ‘risk free rate’ is, its origin in the USA & changes that it has undergone over these periods, implications of interest rate on the same, implications for property market and macroeconomic effects. To contextualise this discussion in relation to implications, the paper will discuss the effect on the property market of recent changes to interest rates focusing on changes to long term interest rates. 2.0 Concept of Risk Free Rate The conceptualisation of risk free rates in the models of risk and return finance is highly embedded in within the context that there exists a risk free asset with a known expected return. Subsequently, the established expected return on a risky asset is subsequently approximated as the risk free rate (Paulo, 2010, p.470). In a nutshell, the term is used to imply return on the risk free asset. The same argument is corroborated by Damodaran (2008, p.3) who observes that, majority of risk and returns frameworks in finance base their presumptions on assets as being risk free. Thus, the expected return on the said asset is utilised as the risk free rate. To realise this, it integral to establish first what is risk free asset since it constitutes the building block for establishing risk free rates (return on risk free asset).Therefore, to be able to vividly conceptualise the term risk free rate the paper will have to establish what contributes to an asset being risk free? 2.1 Risk Free Asset This forms the basis/ building block of establishing risk free rate and thus it would be integral in conceptualising what risk free rate is. Damodaran (2008, p.3) indicates that there are two approaches that can be used to determine what risk free asset is and consequently risk free rate. The first parameter is the difference between the returns that is expected from an asset and the actual return realized. The second contextualisation is in the performance of the acquired asset in relation to other investments. Subsequently, Damodaran (2008, p.3) postulates that ‘the expected returns on risky investments are then measured relative to the risk free rate, with the risk creating an expected risk premium that is added on the risk free rate’. As per the first parameter (difference between expected return and actual return), Damodaran (2008, p.3); Damodaran (1999, p.3) observes that when an investor acquires an asset, based on various parameters, back in their mind they have returns that they expect to accrue over a given period of time they will be possessing that investment. Nevertheless, in the process that they are holding this property, the actual income they are able to generate may differ by being lower or higher as compared to their expected returns. It is from this difference that the concept of risk comes into play. In this perspective, risk is treated as the variation of actual returns from the expected returns over a period of time. Consequently, for an investment in an economy to be treated as risk free, the actual return has to be the same as expected return. To contextualise the discussion on what is meant by expected return being equal to actual return, Damodaran (2008, p.3-4); Damodaran (1999, p.3-4) utilises the example of default-free-one year bond such as Treasury bill. In his example, the investor has invested in 1 year Treasury bill with an expected return of 5% at the expiry of the term. At the end of the term of this investment, the investor realises a 5% actual return as projected in the expected return. From this brief discourse, it can be established adequately that the investment he made is risk free. The rationale for this argument is based on the fact that there is no variance around the expected return. Damodaran (2008, p.4) gives the second perspective on establishing risk free assets in the context of it operates in relation to other investments. In this regard a risk free investment must have returns that are not correlated to risky investments in a specific market/ economy. However, this definition only holds water if the first definition of expected return being equal to actual returns is applied. Damodaran (2008) notes that ‘investment that delivers the same return, no matter what the scenario should be uncorrelated with risky investments with returns that vary across scenarios’ (p.4). Apart from the mere definition, the next integral question would be to outline what parameters constitute a risk free investment. The first is on the basis that there can be no default risk. This parameter locks out the securities issued by private firm with the remaining exception being government securities. The rationale behind the said statement is anchored on the fact that even the largest firms have some measures of default risk. On the other hand from normative perspective, government securities have chance of being risk free since they control printing of currencies and thus are able to meet their obligations. The second premise is that there can be no reinvestment risk if it has to meet the condition that actual return and expected return have to be equal (Damodaran, 2008, p.6; Damodaran, 1999, p.4). 3.0 Effect of interest rates Interest can defined as the amount of money which lenders get at the time they make out a loan which the borrower pay back while the rate of interest is the profit on the loan amount which the lender charges to loan the money. The presence of interest enables borrowers to use money without more ado, rather than waiting to bank the money for sometimes before making a purchase. Hemert (2010, p.482) asserts that with the low the interest rate consumers are much more willing to borrow funds to make purchases, like real estate or automobiles. When people pay lower interest, this grants them much money to use that can make a ripple impact of increased expenditure all over the economy (Hemert 2010, p.472). Organizations, farmers, and businesses also take advantage from low interest rates, because it motivates them to purchases large equipment owing to the low rate of borrowing. This results to a state in which productivity and output increase. With each loan, there is the likelihood the borrower may not pay back the money. To pay lenders costs for their risk, there ought to be a reward. In this case it is interest. Malkiel (2008) argues the effects of change of interest rates have an unrelenting effect on the welfare of any given country. For this reason it is the thoughtful idea that every person in society ought to have a knowing of what these changes comes with or meant for the general economy. Property ownership is one of the desires for every person in their lifetime. In this context we refer real estate as the property that every individual wish to own. Changes in the interest make both bank managers and consumers to review their decisions. Owing to the rising volatility of interest rates in current society, bank managers are much more apprehensive about the interest rate risk (Malkiel, 2008). Current market volatility offers inspiration for bank managers to think about interest rate risk management approach cautiously (Richie, Mautz and 2010). It will result to a business failure if interest rate risk is managed properly. Thus, it is critical to reduce the risk which is caused by interest rate volatility (Barbarin, Launois & Devolder 2009, p.131). If a central bank raises the base rate, all key interest rates within the economy tend to increase. This implies interest rates in both side of borrowing and saving will increase. Increasing the base rate will result to an increase in the general cost of borrowing, all over the economy of the country (Malkiel, 2008). Then again, high interest rates raise the saving return in an account bearing the interest. Hence consumers’ willingness to borrow will be lowered e.g. on personal loans and credit cards. Also, customers having variable mortgages could bear the increase in their monthly payments; this will ultimately results to a decrease in their disposable income making spending and consumption in other areas to fall (Barbarin, Launois, & Devolder, 2009, p.142). Increase in the normally have a discouraging factor on the people who already have projects and would like to venture to other projects too. The impact of increasing interest rates can frequently last to 18 months to bear an impact. For instance, if a consumer have a project in which 50 percent is completed, he or she is likely to conclude it off. Though, the higher interest rates could discourage him or her from starting off a new project the subsequently year. Increasing interest rates have an effect on both firms and consumers (Malkiel, 2008). Consequently, the economy will possibly to face falls in investment and investment. In short, an increase in rates of interest daunts investment; it enables consumers and firms to be less willing to pull out risky purchases and investments. Due to the volatility of interest rate, various countries normally set up a body that come up with monetary policies including regulation of interest rate. Benjamin (2000) state that in the US there is the Federal Reserve that carries out monetary policies to ensure rate of interest is stable. This Federal Reserve's policy regarding the interest rates affects property markets on various ways. To keep interest rate stable. The Fed achieves this goal by changing the interest rates (Toma, 2010). When interest rates are high make money become more expensive and contract the money in banks and in circulation. Low rates leads to less money and raise the supply of money. RBA (2013) argues that in Australia, The Reserve Bank is charged with the responsibility of establishing monetary policy. This entails setting up the interest rate on quick loans in the Australian money market. The cash rate affects interest rates in the financial system, the behaviour of consumers in the property markets and eventually the inflation rate (RBA, 2013). 4.0 Effect on the property market of recent changes to interest rates The ever changing nature in the interest rates can bear both positive and negative impacts on the U.S. property markets. Benjamin (2000, p.61) argues that when Federal Reserve Board (Fed) alters or adjusts the rate in which money can be borrowed by the banks, this causes a ripple effect within the whole economy. Interest rates, particularly the rates on Treasury bills and interbank exchanges, encompass as weighty an impact on the income-producing real estate value just as on any property investment. Since the interest rates influence on a person’s capability to buy residential properties (by rising or lessening the property capital cost) are so thoughtful, many individuals wrongly imagine that the lone deciding element in property valuation is the loan rate (Richie, Mautz, David & Sackley, 2010, p.25). However, loan rates are just one interest-associated component affecting the values of the property. Since interest rates also influence capital flows, the demand and supply for investors' needed rates of return on investment and capital, the rate of interest will compel property costs in a number of ways (Christina, 2013). Many individuals have to acquire mortgage loans so as to own properties. Even if or not the mortgage loan bears an adjustable rate or fixed rate on a long term basis, one is required to pay out the interest. Christina (2013) argues that the rate at which one will pay the interest on their mortgage loans is reliant on several factors, like the type of loan, the duration of payment, or the down payment amount. These are reflecting the components that will affect the interest rate that the lender presents. The rate of Interest is also influenced by elements that the lender or the borrower cannot control, such as the policy set by the Federal Reserve or the status of the general economy (Christina, 2013). Since many individuals and families purchase properties through loans, the property market is extremely affected by the ever changing nature of interest rates. Usually, lower interest rates on loans draw more attention of the property buyers increasing the demand in the property market. Paying low interest implies that the general value of mortgage will become lower, so individuals will be able to save much money (Malkiel, 2008). When interest rates become low, property sales increase since many people can have enough money to take loans at a low cost. Property owners can refund their loan, and attempt to take a low interest rate loan to finance their property. Low rates of interest leads to an increase in demand for properties in the market, so the real estate construction sector is also boosted (Christina, 2013). However, when interest rates goes up, the demand for properties decreases since property loans turn out to be more costly, and many individuals can not have enough money to purchase them anymore or just do not qualify, or basically decide to rent property until interest rates falls again. Higher interest rates also bear impact real estate builders, while the demand for new properties also goes down. Malkiel (2008) maintains that interest rates have changed considerably all through history, affected by volatility in both local and international economy, recessions, and wars among other components. 5.0 Conclusion With the trends of investing, it can be noted that most people are willing to borrow money and pay out on a project that takes short time give the returns. Another thing for sure is that investors are willing to pay interest on only completely risk-free investment which they expect to see return over a certain period of time. If this does not work that way, they get discouraged. However due to fluctuations in interest the can only be advised that that property market will at all times have to increase prices or experience a decrease from such fluctuations in the rate of interests. Therefore analysing how these variations in the rate of interest affect the property market could assist them settle for better decisions. 6.0 References Benjamin, MF. (2000). "The role of interest rates in Federal Reserve policymaking." Conference Series ; [Proceedings], Federal Reserve Bank of Boston, issue Oct, pages 43-66. Barbarin, J,. De Launois, T., & Devolder, P. (2009). Risk minimization with inflation and interest rate risk: applications to non-life insurance. Taylor and Francis Ltd. Scandinavian Actuarial Journal, Vol. 2009, No. 2, pp. 119-151(33) Christina, R. 2013. Current Mortgage rate, viewed 23rd July 2013 from http://www.currentmortgageratestoday.org/mortgage/how-do-changes-in-interest-rates- affect-the-housing-market/ Damodaran, A. (2008). What is the riskfree rate? A Search for the Basic Building Block. A Search for the Basic Building Block (December 14, 2008). Damodaran, A. (1999). Estimating risk free rates. WP, Stern School of Business, New York. Hemert, OV.2010. Household Interest Rate Risk Management. Real Estate Economics, Vol. 38, No. 3, pp. 467-505, Fall 2010. Malkiel, BG. 2008. "Interest Rates". In David R. Henderson (ed.). Concise Encyclopedia of Economics (2nd ed.). Indianapolis: Library of Economics and Liberty. Paulo, S. (2010).The UK Companies Act of 2006, the Sarbanes-Oxley Act of 2002, and important reviews of 2009: Implications for the certainty equivalent coefficient net present value criterion. International Journal of Law and Management, 52 (6), p. 469- 480. Reserve bank of Australia. (2013). RBA monetary Policy, viewed 23rd July 2013 from http://www.rba.gov.au/monetary-policy/ Richie, NF., Mautz Jr., David, R., & Sackley, W. (2010). Duration and Convexity for Assessing Interest Rate Risk. Bank Accounting & Finance (08943958);Feb/Mar2010, Vol. 23, Issue 2, p25 Toma, M. 2010. "Federal Reserve System". EH. Net Encyclopedia. Economic History Association. Retrieved February 27, 2011. 7.0Appendix The figure1below show the current inflation rate in the US year Jan Feb Mar Apr May Jun Jul Aug Sept Oct Nov Dec 2010 2.6 2.1 2.3 2.2 2.0 1.1 1.2 1.1 1.1 1.2 1.1 1.5 2011 1.6 2.1 2.7 3.2 3.6 3.6 3.6 3.8 3.9 3.5 3.4 3.0 2012 2.9 2.9 2.7 2.3 1.7 1.7 1.4 1.7 2.0 2.2 1.8 1.7 2013 1.6 2.0 1.5 1.1 1.4 1.8 Figure1 Source: Bureau of Labour Statistics.2013. Rates of inflation. Retrieved from http://www.usinflationcalculator.com/inflation/historical-inflation-rates/ The figure 2 below show the current interest rate in the US Figure2: current interest rate in the US Source: Federal Reserve. 2013. Interest Rate. http://www.tradingeconomics.com/united-states/interest-rate Read More