FINANCIAL
MARKETS AND INTEREST RATES 2-5
Swaps are also used to hedge risk, but they differ from true derivative
instruments in that they are essentially an exchange of financial
assets. For this reason, they are not really traded among investors, but
they are often included in a discussion of derivatives. We will briefly
introduce options and swaps in Unit 10. For a
more thorough discussion of these instruments and their uses, we
recommend that you refer to the specific workbook covering each
instrument.
INTEREST RATES
Price paid for
use of capital
In a free economy, capital is allocated through the price system.
An interest rate is the price paid by a borrower for the use of an
investor's capital.
Interest rates provide the vehicle for allocating capital among firms. In
a perfect free-market economy, firms with the most profitable
investment opportunities attract capital away from companies with
less inviting investment opportunities arising from problems such as
inefficiency, low demand for products, poor management, etc.
However, a perfect free-market economy doesn't exist. There are
imperfections, usually introduced by governments, that lead to the
allocation of capital to firms that do not necessarily have the most
profitable investment opportunities.
An investor purchasing a debt security, such as a bond, receives an
interest payment for the period that the borrower uses the investor's
capital. In an equity investment, return to the investor takes two forms:
dividend payments and appreciation of the investment, also called a
capital gain.