Interest Rate Risk
Fixed rate borrowing - risk that variable rates drop
Variable rate borrowing - risk that variable rates rise
Yield Curves (Return to debtholder)
Long term loans - higher yields (more risk)
Longer term loans - Less yield (upcoming recession)
Yields are same for short and long term loans
The shape of the curve depends on:
In a bit more detail, the shape of the yield curve and thus the expectations of what the interest rates will be depends on…
Investors want their cash back quickly therefore charge more for long term loans which tie up their cash for longer and thus expose it to more risk
Interest rates rise (like inflation) - so longer term more charged
NB. Recession expected means less inflation and less interest rates so producing an inverted curve
If demand for long-term loans is greater than the supply, interest rates in the long-term loan market will increase
Differing interest rates between markets for loans of different maturity can also explain why the yield curve may not be smooth, but kinked
Governments may act to increase short-term interest rates in order to reduce inflation
This can result in short-term interest rates being higher than long-term interest rates,
Why is yield curve important?
It predicts interest rates.
Normal curves are upward sloping.
Therefore, in these circumstances, use short term variable rate borrowing and long term fixed rate.
The risk of an adverse movement in the interest rates reducing a company’s cashflow