Towards a practical understanding of interest rate determination and the investment decision

Abstract

Investment risk is highly correlated with variations in market interest rates. This paper examines a fundamental determinant of interest rates, and therefore investment risk. Monetary policy directly impacts market interest rates. As such, it is important for risk managers and investment managers to understand the mechanics of this key macroeconomic policy. This is especially true of managers of firms that are highly capital intensive. Capital intensive firms have a relatively long planning horizon – it is thus essential for investment and risk managers to comprehend those factors that influence the cost of capital, including macroeconomic policy that affects market interest rates. The purpose of this paper is to explain the potential impact that monetary policy has on the long-run investment decision.