Introduction to Finance

LEARNING ACTIVITY
Go to the website of the Federal Reserve Bank of St. Louis, http://www.stlouisfed.org, 
and access the FRED database. Find current interest rates for long-term Treasury bonds 
as well as Aaa-rated and Baa-rated corporate bonds, and indicate the size of default risk 
premiums.
Applying Finance To...
• Institutions and Markets 
Depository institutions make profi ts by 
achieving a spread between the interest rates they pay individuals on 
savings accounts and the interest rates they charge businesses and 
other individuals for loans. Interest rates are also important to fi n-
ancial institutions, such as insurance companies and pension funds, 
which accumulate premiums and contributions and invest these pro-
ceeds in government and corporate securities for the benefi t of their 
policyholders and employees. The government depends on fi nancial 
institutions holding or owning an important portion of the U.S. Treas-
ury securities issued to fi nance the national debt.
• Investments 
Interest rates are set in the fi nancial markets based on 
the supply and demand for loanable funds. The cost, or price, of home 
mortgage loans depends on the supply and demand for such loans in 
the mortgage markets. Interest rates off ered on Treasury debt secur-
ities refl ect a real rate of interest and an expected infl ation premium. 
Corporate bond borrowers must pay a default risk premium above 
the interest rate being off ered on government debt securities. Corpor-
ate issuers of high-quality, investment grade bonds pay lower default 
risk premiums relative to issuers of lower-quality bonds. Observed 
interest rates may also refl ect a maturity risk premium and/or a liquid-
ity premium.
• Financial Management
The prevailing level of interest rates is 
particularly important to fi nancial managers. When interest rates are 
high, businesses will fi nd it less profi table to borrow from fi nancial 
institutions or in the securities markets because investment in inven-
tories, plant, and equipment will look less attractive. Likewise, when 
interest rates are relatively low, loans are generally readily available 
and stock prices are usually high. Thus, fi nancial managers often fi nd 
it attractive to grow their businesses during periods when funds to 
fi nance the expansion activities can be borrowed at relatively low 
interest rates, or when they can issue new shares of their common 
stocks at relatively high prices.
Summary