What investors should know about interest rates

If you ever find a subject to kill the conversation so you can be links alone to think your investments, start talking about interest rates. Your listener's eyes are guaranteed to glassy, and you'll quickly alone. If you have attachments, the theme is not as dry as you think. In fact it is understand some investors should try. Financial theory is that interest rates — that change all the time - are to the business valuation of fundamental importance, and an important role in how we put a price on shares. Here we take a look at the relationship between interest rates and stock price. (For background, the stock market affect reading, check out how interest rates.)

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Interest rates: the cost of money
Consider an interest rate costs money that - as well as the cost of production, labor and other expenses - a factor of a company's profitability.

The basic cost money to an investor is the Treasury Note rate, returning "full faith and credit is guaranteed by the" Government. Financial theory is that the share value proposition starts here: stocks are risky assets, even riskier than bonds, because bondholders your capital to shareholders in the event of bankruptcy are paid. Investors require therefore a higher return for the above additional risk by investing in stocks instead of Treasury notes, which are guaranteed to pay a certain return.

The extra return that investors can expect in theory held is called a "Risk premium". Historically, runs the risk premium to about 7%. This means that the risk-free interest rate (the Treasury Note rate) is 4%, then investors would require a return of 11% from a herd. Therefore the total return on a stock is the sum of two parts: the risk-free interest rate and the risk premium. If you want that higher yields, must invest in riskier stocks, because you a higher risk premium as, say, greater blue-chip companies offer. The theory select rational investors an investment with a return that is high enough for the lost opportunity to earn interest of guaranteed Treasury note and to compensate for taking on additional risk. (For more see the equity risk premium: more risk for higher returns.)

Risk and back: an inverse relationship
If the required increases return, the stock price falls, and vice versa. This makes sense: If nothing changes, the price must be lower for the investor, to have the required return. There is an inverse relationship between required return and share that assign a stock investors.

The required return may increase the risk premium or the risk-free interest rate increases. For example, may increase the risk premium for a company when you his top managers new members or when the company suddenly decides to cut its dividend payments. And the risk-free rate will increase if interest rates rise.

So, interest rate changes effects the theoretical value of the company and its shares: basically a share fair value is its projected future cash flows discounted to the present, by using the investor must rate of return. If interest rates fall, and everything else is held constant should increase the share value. This is why the market cheers when the Fed Announces a rate cut. Conversely, if the Fed (holding everything else constant) rates are the triggers, should share values fall.

How changes in interest rates on business
Interest rates impact a company's operations to. Any increase in interest rates that is worth it will increase its cost of capital. A company has therefore harder work to generate higher returns in an environment with high interest rates. Otherwise it is bloated interest expense way to eat your profits. Lower profits, lower cash inflows and a higher return for investors, all in depressed fair to translate value required for the company.

Moreover, if interest rate cost to such a level up shoot, the company pays has from its debt problems of cannot be threatened then its survival. In this case investors will demand that a higher risk premium. The fair value will fall this even further. (Find out which debts to your investment will corporate debt drag your stock below do?)

Finally, go high interest rates usually hand in hand with a sluggish economy. You prevent people buy things and companies invest in growth opportunities. As a result, revenues and earnings drop and so share prices.

Conclusion
Theoretically financial evaluation begins with a simple question: If you money in this business what are, the chances you will get back a better than if you invest something else? Interest rates play an important role in determining what this could be something else.

Ben McClure (Contact author |) (Biography)

Ben McClure is a long-time contribution to the Investopedia.com.

Ben is the Director of the Bay of Thermi limited, an independent research and consulting company which specialized in early stage ventures for new investments and markets prepare. He works with a variety of customers in North America, Europe and Latin America. Ben was a highly rated European equities analyst at London's old mutual securities, and introduced new venture development, a major technology commercialisation consulting group in Canada. He began his career as a writer/analyst at the Economist Group. Mr. McClure graduated from the University of Alberta's School of business with an MBA from.

Ben's investing hard and fast philosophy is that the Flock is always wrong, but heck, if it is worth it nothing is wrong with his sheep.

He lives in Thessaloniki, Greece. You can Bay of Thermi limited at www.bayofthermi.com more information.