The Federal Funds Rate and You

By Financially Fit Staff

With the recent volatility in the markets stemming from the sub-prime debacle, investors are closely eyeing the moves of the Federal Reserve (the Fed) in hopes of lower rates. But why is this? What is the connection between the interest rates the Fed meets to discuss and the stocks in your equity portfolio? And more important, is it the Fed's job to bail out the financial markets?

The Fed has two main responsibilities: promoting a healthy economy, which entails maximum sustainable employment, stable prices and moderate long-term interest rates, and, second, maintaining the stability of the financial system. The latter explains why it cut the discount rate - the interest rate charged to commercial banks and other depository institutions on loans they receive from their regional Federal Reserve Bank's lending facility - on August 17.

For investors, the interest rate of primary concern is the Federal Funds Rate. This refers to the interest rate at which depository institutions lend their balances (federal funds) at the Federal Reserve to other depository institutions overnight in the event those institutions need additional money in order to keep their reserve at the Fed at the required level. An increase in the Federal Funds Rate is the Fed's attempt to lower the supply of money - making it more expensive to obtain, thereby curbing inflation.

So what does this mean for investors?

The prevailing method of valuing a company - discounted cash flow (DCF) - is to sum all expected future cash flows discounted back to the present. An increase in interest rates lowers the DCF valuation of a particular firm. Additionally, given the higher interest rates, firms are less inclined to borrow money to fund growth. This lowers the future cash flows of the firm, once again lowering the intrinsic value of a firm based on DCF.

As investors' perception of the value of a firm is lowered, so too will the price of the firm's stock. Investors want to see their invested money increase in value. To most, gains can come in the form of stock price appreciation, dividends, or both. With lowered expectations for both growth and future cash flows from a particular firm, investors stand to benefit less from stock appreciation, making owning stocks less desirable.

Investors always seek out the maximum return for a given amount of risk. When the Fed raises rates, government securities, such as Treasury bills and bonds, are often viewed as the safest investments. Specifically, the "risk-free" (the U.S. government is unlikely to default) rate of return goes up, making these investments more desirable than stocks, which are inherently risky. 

As the risk-free rate goes up, the total return required for investing in stocks usually increases. This occurs because investors need to be compensated for assuming the additional risk found in equities, or a premium above the risk-free rate, coined the "risk premium." If the required risk premium decreases (likely to occur because of expected lower cash flows) and the total return remains the same or lower, investors may feel that stocks have become too risky, and will put their money elsewhere --  the effect of which you're likely to see on your portfolio holdings when the Fed is meeting and is expected to raise rates.

Of course, it remains to be seen whether the Fed will lower rates after its next meeting on Sep. 18.   

This concludes this week's issue of Financially Fit.  We encourage you to visit our website to review past issues of Financially Fit:

http://www.brokeradviser.com/newsletter.cfm


Disclaimer & Important Information

Financially Fit is owned and published by Business Financial Publishing, LLC of Washington D.C.  Business Financial Publishing is neither a registered investment adviser nor a broker/dealer.  Readers are advised that this electronic publication is issued solely for information purposes and should not to be construed as an offer to sell or the solicitation of an offer to buy any security.

The views expressed herein are based upon our analysis of the issuer's public disclosures, and assumes both their accuracy and completeness.

The opinions and statements included herein are based on sources (including the companies discussed and public sources) believed to be reliable and in good faith, but no representation or warranty, express or implied, is made as to their accuracy, completeness or correctness. We have not independently verified the information contained herein. This information is not intended to be used as the sole basis of any investment decisions, nor should it be construed as advice designed to meet the investment needs of any particular investor. We encourage you to consult with independent financial advisors with respect to any investment in the securities mentioned herein. You should review a complete information package on all companies, which should include, but not be limited to, the Company's annual report, quarterly reports, press releases and all regulatory filings. All information contained in Financially Fit should be independently verified with the subject company. The foregoing discussion contains  statements which are based on current expectations, estimates and projections, and differences from such expectations, estimates and projections can be expected.

Financially Fit is intended only for residents of the United States. Financially Fit is not for residents of the United Kingdom and is not an approved publication by the Financial Services Authority in the UK.

The information contained in this newsletter is not intended to be a complete discussion of information regarding all of the current and/or intended business activities of the covered companies. Any opinions expressed in Financially Fit are statements of judgment as of the date of publication, are subject to change without further notice, and may not necessarily be reprinted in future publications or elsewhere.

Business Financial Publishing and its members, managers, writers and employees do not accept compensation from the companies discussed within Financially Fit, nor any of our individual newsletter publications (Growth Report, Rising Star Stocks, Supernova Stocks).

====================
====================

Financially Fit  is a free email newsletter from BrokerAdviser.com (http://www.brokeradviser.com)