Question

Everyone uses money, and it is important to understand what factors affect the cost of money. Consider the following scenario: Due to recent political and economic events, general prices of goods and services are expected to increase significantly over the next five years. You were about to purchase a five-year bond. You now require a higher return on the bond than you did before you found out about these expected price increases. Determine which of these fundamental factors is affecting the cost of money in the scenario described

Answer 1

Answer:

Following are the factors in the economy that affects the cost of money:

1. Inflation
2. Required return of the investors on the additional risk
3. Systematic risk in the economy
4. Duration of lending
5. Credit Spread

Explanation:

If the inflation rate increases then the required return would be compensation for inflation and required return.

The higher is the risk associated with the investment the higher would be the investor's required return.

According to the Capital Asset Pricing Model, the company compensates the investor for the systematic risk, not for the unsystematic risk that he faces because CAPM assumes that the investor has diversified portfolio of investment.

If the amount lend is for greater duration, then there is a risk that the borrower will default payments. There is another explanation which is that there is higher chances of loss of opportunity due to lending amount for greater duration.

Credit Spread is the measure of the risk that the company will be unable to pay interest on loan or principal amount or both. So as we know higher the risk associated with the investment, the higher is the Required return demanded by the investors.