A Simple Way in Understanding Interest Rates

The topic of interest rates is not a topic which we usually use as an ice breaking. In fact, this topic is categorized as a dull and far from interesting that make most people will usually turn their heads away once they hear about interest rates as the interest does not interest them at all. But for those who want to learn more about investing, whether it is market neutral investment, hedge fund, etc., this topic is worth to know. Below is a brief explanation of interest rates which will come in handy when you need it.

Interest Rates: The Cost of Money

Interest rate can be best understood as the cost of borrowing money. So, the amount of your money will usually give birth to an amount of interest which the interest will usually produce more interest and so forth.

The investor will see your money as the Treasury note rate which will get full guarantee of security and credit by the Government. Moreover, it is important to know that stocks are risky assets, even riskier than bonds because bondholders are paid their capital before stockholders in the event of bankruptcy. Therefore, a higher return is required for taking on extra risk by investing in stocks instead of Treasury notes which is assumed more profitable. In this sense, investing in riskier stocks will produce you with higher returns.

So, how can interest rates affect companies? It affects companies through the raise of its cost of capital that is paid by any increase in the interest rates. This condition will make a company works harder to generate higher returns in a high interest environment before its profits has been ate away by the bloated interest expense.

Furthermore, survival may be threatened if interest rate costs rise sharply to such a level that the company cannot pay off its debt. In this case, investors will demand an even higher risk premium. Even though, as a return, the fair value will fall even further. In conclusion, high interest rates are normally in line with a stagnant economy. They will make companies reluctant to invest in growth opportunities and prevent people from buying things.

 

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