CP

securities in Market A.^7 Borrowers whose credit is strong enough to borrow in this

market can obtain funds at a cost of 10 percent, and investors who want to put their

money to work without much risk can obtain a 10 percent return. Riskier borrowers

must obtain higher-cost funds in Market B. Investors who are more willing to take

risks invest in Market B, expecting to earn a 12 percent return but also realizing that

they might actually receive much less.

If the demand for funds declines, as it typically does during business recessions, the

demand curves will shift to the left, as shown in Curve D 2 in Market A. The market-

clearing, or equilibrium, interest rate in this example declines to 8 percent. Similarly,

you should be able to visualize what would happen if the Federal Reserve tightened

credit: The supply curve, S 1 , would shift to the left, and this would raise interest rates

and lower the level of borrowing in the economy.

Capital markets are interdependent. For example, if Markets A and B were in

equilibrium before the demand shift to D 2 in Market A, then investors were willing

to accept the higher risk in Market B in exchange for a risk premiumof 12% 
10% 

2%. After the shift to D 2 ,the risk premium would initially increase to 12%
8%

4%. Immediately, though, this much larger premium would induce some of the

lenders in Market A to shift to Market B, which would, in turn, cause the supply

curve in Market A to shift to the left (or up) and that in Market B to shift to the

right. The transfer of capital between markets would raise the interest rate in Mar-

ket A and lower it in Market B, thus bringing the risk premium back closer to the

original 2 percent.

There are many capital markets in the United States. U.S. firms also invest and

raise capital throughout the world, and foreigners both borrow and lend in the United

28 CHAPTER 1 An Overview of Corporate Finance and the Financial Environment

FIGURE 1-3 Interest Rates as a Function of Supply and Demand for Funds

r = 10A

8

D 1

D 2

S 1

Interest Rate, r

(%)

Market A: Low-Risk Securities

0 Dollars^0 Dollars

Interest Rate, r

(%)

r = 12B

Market B: High-Risk Securities

S 1

D 1

(^7) The letter “r” is the symbol we use for interest rates and the cost of equity, but “i” is used frequently today
because this term corresponds to the interest rate key on financial calculators, as described in Chapter 2.
Note also that “k” was used in the past, but “r” is the preferred term today.

26 An Overview of Corporate Finance and the Financial Environment