2-14
FINANCIAL MARKETS AND INTEREST RATES
Effect on Stock Prices
Impact on
corporate
profits
Interest rates indirectly impact stock prices through their effect on
corporate profits. The payment of interest is a cost to companies the
higher the level of interest rates, the lower the level of corporate
profits (other factors held constant). Interest rates affect the level of
economic activity which, in turn, affects corporate profits.
Even more directly, interest rates affect the competition for funds
(capital) between stocks and bonds. Higher interest rates mean that
investors receive a higher return on their bond investments. High
bond yields induce investors to sell their stock holdings and invest in
more bonds. The reverse occurs when interest rates fall.
The effect of interest rates on corporate profits is more important
for individual companies, especially those with high debt levels. The
direct competition for capital has a more widespread effect on the
general stock price level for the entire economy.
UNIT SUMMARY
In this unit, we discussed the types of financial markets -- money
markets and capital markets. There are two subsets of capital
markets -- bond (debt) and equity markets. Players in the markets
include investors / lenders, issuers / borrowers, brokers, and dealers.
We said that investors' expectations of return on investment and
consumers' preferences for saving versus spending are two market
characteristics that affect the level of interest rates.
Interest rates required by investors are the sum of three factors:
Risk-free real rate
(r
*
)
+ Premium for inflation
(IP)
+ Premium for risk (RP)
= Interest rate
(r)
r = r
*
+ IP + RP