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Stock Valuations - Key Interest Rates Relationship

A relationship that is not always so well-defined between evaluations of stocks and interest rates exists.

Decision on the direction of the interest rates is taken by the Federal Reserve Board on one of its eight yearly meetings. Depending on the economic circumstances, the board may decide to raise the key interest rates, lower them or take no action with regards to their value.

Since interest rates have an effect on the cost of borrowing money, consumer spending and etc. investors are keen on finding out the decision of the Federal Reserve Board regarding the interest rates level. This is so, since interest rates are key players in economic activity.

When an investor decides that it is time to start investing s/he determines the amount s/he has available. Only after this the investor starts to make evaluation of the available stock opportunities.

Depending on the type of investing approach, the investor may decide that s/he is unwilling to take any risk. In such a case it is recommended to put the money in US Treasury Notes since it is guaranteed by the US government itself and represents the safest investment on the market.

Unfortunately, the higher the safety is the lower your returns are.

When you make considerations whether a particular stock is worth taking the risk, you compare it with a risk free investment such as US Treasury Note. The difference between the return of the stock and the yield of the US Treasury Note is commonly referred to as risk premium.

There is no one single method for calculating the value of a risk premium. Every method varies from expert to expert. No matter which method you will use, you should establish a risk premium that is in accordance with the type of stock in which you invest.

Every stock has its required rate of return, which consists of risk-free rate and the risk premium we just explained.

Now, the first component of the required rate of return, namely the risk-free rate, is directly related to the key interest rates that the Fed adjusts at its meetings. The relationship between the two is as follows:

  • A rise in the key interest rate leads to a rise in the risk-free rate. This leads to a decrease in the target price of the stock, since the required return is increased.
  • A decrease in the key interest rate leads to a decrease in the risk-free rate. This leads to an increase in the target price of the stock, since the required return is decreased.

The relationship between interest rates and valuation of stocks represent an illustration of the potential expectations regarding the investment in a particular stock.

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