ALLOCATION OF FUNDS AND INTEREST RATES
The Allocation of funds in an economy occurs primarily on the basis of price, expressed in terms of expected return. Economic units in need of funds must outbid others for their use. Although the allocation process is affected by capital rationing , government restrictions, and institutional constraints, expected return constitutes the primary mechanism by which supply and demand are brought into balance for a particular financial instrument across financial markets.
If risk is held constant, economic units willing to pay the highest expected return are the ones entitled to the use of funds. If people are rational, the economic units bidding the highest prices will have the most promising investment opportunities. As a result, savings will tend to be allocated to the most efficient uses.
It is important to recognize that the process by which savings are allocated in an economy occurs not only on the basis of expected return but on the basis of risk as well. Different financial instruments have different degrees of risk. In order for them to compete for funds, these instruments must provide different expected returns, or yields.
The idea of the market imposed â€œtrade-offâ€? between risks and returns for securities that is, the higher the risk of a security, the higher the expected return that must be offered to the investor. If all securities had exactly the same risk characteristic, they would provide the same expected returns if markets were in balance. Because of differences in default risk, marketability, maturity, taxability there are different embedded options. However, different instruments pose different degrees of risk and provide different expected returns to the investor.
When we speak of default risk, we mean the danger that the borrower may not meet payments due on principal or interest. Investors demand a risk premium (or extra expected) to invest in securities that are not default free. The greater the possibility that the borrower will default, the greater the default risk and the premium demanded by the marketplace.
Because Treasury securities are usually regarded as default free, risk and return are judged in relation to them. The greater the default risk of a security issuer, the greater is the expected return or yield of the security, all other things remaining the same.
For the typical investor, default risk is not judged directly but rather in terms of quality rating assigned by the principal rating agencies, Moodyâ€™s Investors Service, CRISIL and Standard & Poorâ€™s . These investment agencies assign and publish letter grades for the use of investors, in their ratings, the agencies attempt to rank issues in order of the perceived probability of default. The highest-grade securities, judged to have negligible default risk, are rated triple-A or AAA.
Credit rating in the top four categories (for Moodyâ€™s, Aaa to Baa; for Standard and Poorâ€™s, AAA to BBB and CRISIL AAA+ etc.,) are considered â€œinvestment grade quality.â€? This term is used by regulatory agencies to identify securities that are eligible or investment by financial institutions such as commercial banks and insurance companies.
Securities rated below the top four categories are referred to as â€œspeculative gradeâ€? Because of the limited institutional demand for these securities and their higher default risk they must offer considerably higher expected returns than investment-grade securities.
The marketability (or liquidity) of a security relates to the ownerâ€™s ability to convert it into cash. There are two dimensions to marketability: the price realized and the time required to sell the asset. The two are interrelated in that it is often possible to sell an asset in a short period if enough price concession is given. For financial instruments, marketability is judged in relation to the ability to sell a significant volume of securities in a short period of time without significant price concession.
The higher is the marketability of the security, the greater is the ability to execute a large transaction near the quoted price. In general, the lower is the marketability of the security the greater will have to be the yield necessary to attract investors. Thus, the yield differential between different securities of the same maturity is caused not by differences in default risk alone, but also by differences in marketability.
Securities with about the same default risk, having similar marketability, and not faced with different tax implications can still trade at different yields because â€œtimeâ€? is also a factor. The maturity of a security can often have a powerful effect on expected return, or yield. The relationship between yield and maturity for securities differing only in the length of time (or term) to maturity is called the term structure of interest rates.