Silicon Valley Bank’s (SVB) rapid demise revealed an important fact that volatile interest rate change could significantly impact asset valuation and prices.
The historically low interest rates in the last two decades made financial securities an attractive asset - because risk-free securities yielded little return, and the cost of capital was low. The result is an inflated asset valuation and price.
As interest rates increase, especially compounded by economic uncertainties and gloomy outlook, investors may find risk-free investments more attractive because of the guaranteed low-risk and safe return.
A second fact is that rising interest rates increase firms’ borrowing costs, which eats into their profits because more profit is used to repay debt interests. It, in turn, reduces firms’ free cash flow and, consequently, reduced dividend payouts. The result? Reduced share prices.
References
- The Balance. (2023). Here’s Why Asset Prices Go Down When Rates Go Up. Available from: https://www.thebalancemoney.com/why-do-asset-prices-fall-when-interest-rates-increase-357150.