Capital Asset Pricing Model: Market Equities, Interest Rates And Debt Securities

Factors that determine market interest rates

Describe about The Capital Asset Pricing Model Market Equities?

Debts Securities

Interest Rates are one of the most important things in the world of finance and are determined on the basis of various factors collectively. The interest rates in the markets help in the valuation of the various financial assets in a country and thus reduce the ambiguity in the valuation concepts. The market rates of interest are collectively controlled by various factors that change with the situation to determine the market interest rates of a particular economy.  Some of the important determinants of the interest rates can be discussed here under as below:

Nominal Interest Rates- The nominal interest rates on the different securities are quite different from each other and thus the interest rates differ in the normal circumstances. The quoted interest rates of a treasury bill would be different from the corporate bonds due to the difference in assumptions of the market on both these securities.

Real Risk Free Rate- These rate also affects the interest rates on the securities as this the inflated protected rates. This rate is measured without the inflation effect and thus calculates the value at which the risk free securities are traded.

Inflation Rate in the economy- The inflation rates prevailing in an economy are being calculated over the life of the security and is assumed on an average basis over the life of the bonds so it is calculated at different rates for the different securities. This does not imply that the current inflation rates would be considered for the purpose of the market interest rates as the life of the securities are used to find the market interest rates of the stock or security. The inflation rates are higher in an economy where there are sudden changes in the fiscal policy affect the market interest as well.

Default Risk Premium- This is the premium charged for the counter party default risk that if the person fails to pay the principal and interest of the security then the same might be covered by this component of the interest rates. The default risk premium generally is higher in the case where there both the parties are not recognized under any law so the risk will be strong in that case otherwise the risk would be low and the market interest rates would go down as the default premium would be less. This risk premium had a good impact on the market interest rates and addresses the issues of the determination of the rates.

Liquidity premium- This the premium charged if the securities are not easily convertible into cash and therefore the lender charges such interest as an compensation against the low liquidity of the assets. The more the asset is liquid then it will be less interest rate as the investors can convert into cash. The premiums are high on those securities where the assets have a longer duration due which the liquidity of these assets all and there is a stronger effect on the interest rates. This premium is low for the securities issued by the larger companies and high for the securities issued by the small firms.

Nominal Interest Rates

Lastly one of the factors is the Maturity Risk Premium which is the premium for fall in the market value of the security at the time of redemption of the same. This is generally lower for the sort term instruments and higher for the long term instruments of the company.

In the world of finance yield is the term that is mostly used for the return on the assets at various interest rates for the time period of the asset. The yield curve generally shows the time period of the asset and the return that it will be giving. The interest rates that are being earned on the assets are being compared to the yield of a security. For example in case of a bond the term used is YTM that means yield to maturity which refers to the time period during which the asset would mature and what would be the return it will provide to the investor. It can be regarded as the hidden return in the outflows and the inflows of the asset. This curve in short shows the relation between the return and the time period of the assets.

The yield curve can be generally of three types with regards to the shape of the same. The three types of yield curve are as follows

Normal Yield Curve- This curve shows that the short term yields on the asset are lower than the long term yields and as the time increases the rate of yield goes up in such kind of assets so the investors should wait for a return in such type of assets and this is also known as positive yield curve with a higher return in the long term. This curve moves upward with the passage of time as below

Second variant of the curve is the inverted shaped curve which shows that the returns will be higher at the early period of security for the short period and this forms an inverted curve as the returns are higher at the downside and lower when the assets are held for a longer period of time. This curve is inverted shaped and is presented below.

The third and the final yield curve is in the form of Flat shape and is called the Flat Shaped Yield curve. In this the yield on the securities are the same irrespective of the time period for which the securities are being held by the investors. There is no difference in the long term and short term yields of the bonds as the time passes but the yield is same, This type of curve is horizontal in shape as shown below.

Debt Securities are mostly issued by those enterprises that don’t want to dilute the share of their equity holdings and also raise funds in order to finance the projects of the firm. The debt securities are majorly the financial instrument that serves as a debt to the enterprise.

The types of Debt Security can be classified as

Real Risk Free Rate

 Term Loans, Leases, Debentures and Bonds.

Term Loans is a monetary loan that is being paid at regular payments over a particular period of time.  These loans are being given on individual basis and for a particular purpose which is well defined and used for the extension of business very commonly. There are some criteria for which loans are being given to the various enterprises.  These term loans are given to the small sized firms and often to the large sized firms too with different conditions.

Leases are also under the debt security under which the lesser leases the right of the property to be used by the other person for a definite period of time by the paying on annual rates as the debt charges for the leased asset. This also facilitates the lease to expand the business with ease and also the assets are being utilized in a proper manner. The various types of tractions that take place are operating lease for a short period of the life of the asset, Financial Lease, Sale and Lease back and Leveraged Lease.

Debentures are also debt security which is issued as a loan instrument and the funds are collected as a debt from these debenture holders. These are issued in the physical form as well as dematerialized form. The types of debentures are Convertible and Non Convertible debentures, secured and non secured debentures, redeemable and irredeemable debentures also.

Lastly one of the common debt security are the bonds which are traded on behalf of the government as well as by the private players also and are traded in different forms across the globe. The various classes of binds that are commonly used in the debt market as follows.

On the basis of maturity they can be classified as callable bond, puttable bond and convertible bonds as well. On the basis of payment it can be classified as amortizing bond and bond with sinking fund provision. And on the basis of the coupon it can be classified as Zero coupon bonds and floating rate bonds.      

Valuation Of The Corporate Bond
FV of the Bond	$   100,000.00
Maturity	10 years
Coupon	6%
Coupon per semi annually	$        3,000.00

	Timeline Showing the Cash Flows
	3000	3000	3000	3000	3000	3000	3000	3000	3000	$      3,000.00
Semis	1st	2nd	3rd	4th	5th	6th	7th	8th	9th	10th
	3000	3000	3000	3000	3000	3000	3000	3000	3000	$  103,000.00
Semis	11th	12th	13th	14th	15th	16th	17th	18th	19th	20th

Valuation Of the Bond
Semis	Inflows	PV @ 4%
1	3000	2884.6
2	3000	2773.7
3	3000	2667.0
4	3000	2564.4
5	3000	2465.8
6	3000	2370.9
7	3000	2279.8
8	3000	2192.1
9	3000	2107.8
10	3000	2026.7
11	3000	1948.7
12	3000	1873.8
13	3000	1801.7
14	3000	1732.4
15	3000	1665.8
16	3000	1601.7
17	3000	1540.1
18	3000	1480.9
19	3000	1423.9
20	103000	47007.9
Value of Bond	$    86,410

Price Movements
At time = 2 years
5	3000	2884.6
6	3000	2773.7
7	3000	2667.0
8	3000	2564.4
9	3000	2465.8
10	3000	2370.9
11	3000	2279.8
12	3000	2192.1
13	3000	2107.8
14	3000	2026.7
15	3000	1948.7
16	3000	1873.8
17	3000	1801.7
18	3000	1732.4
19	3000	1665.8
20	103000	54992.5
Value of Bond	$    88,348

At time = 4 years
9	3000	2884.6
10	3000	2773.7
11	3000	2667.0
12	3000	2564.4
13	3000	2465.8
14	3000	2370.9
15	3000	2279.8
16	3000	2192.1
17	3000	2107.8
18	3000	2026.7
19	3000	1948.7
20	103000	64333.5
Value of Bond	$  90,615

At time = 6 years
13	3000	2884.6
14	3000	2773.7
15	3000	2667.0
16	3000	2564.4
17	3000	2465.8
18	3000	2370.9
19	3000	2279.8
20	103000	75261.1
Value of Bond	$          93,267

At time = 8years
17	3000	2884.6
18	3000	2773.7
19	3000	2667.0
20	103000	88044.8
Value of Bond	$  96,370

So it could be said that the with the increase in time the value of the bond is rising as the coupons are decreasing so the investors would like to pay less for the bond as time increases

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