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BA 580 – Interest Rates

BA 580 – Interest Rates. Why They Exist; Link with Decisions; Key Facts & Formulas. Why Interest?. Personal Values of Present v. Future “Rate of Time Preference” Data from National Long. Study of Youth Present v. Future Production Capability

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BA 580 – Interest Rates

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  1. BA 580 – Interest Rates Why They Exist; Link with Decisions; Key Facts & Formulas

  2. Why Interest? • Personal Values of Present v. Future • “Rate of Time Preference” • Data from National Long. Study of Youth • Present v. Future Production Capability • Uses for “saved” consumption = Long term real gdp growth

  3. Why Credit Markets? • Basis: differences (people, bus., …) • Valuation present & future • Projected earnings/consumption streams • Intermediaries (“middlemen”) • See website for Credit Market overview • “Transactions costs” – esp. information • Create effects • Product development; market making; dynamic element

  4. Rates & Decisions • Take 5 minutes and write down as many examples as you can of ways that interest rates influence business and personal decisions or outcomes

  5. Rates & Decisions • Financial Business • Interest rate “spread” – paid v. received • Non-financial Business • Explicit interest payments • Implicit cost of funds (projects, …) • Valuation of revenue or cost over time • Extensive application of PV formula (rates&pv.xls on website) • Valuation of contingencies (options, …) • Some have said that Finance is economics with PV and Option formulas

  6. Bonds & Rates • A quick primer (also see website) • Bond price • Price (current) = C/(1 + r)1 + C/(1 + r)2 + . . . + C/(1 + r)n + B/(1 + r)n C = interest original issuer promises to pay (coupon rate) B = face value of bond if held to maturity (par value) P = usually quoted as % of face value (e.g. 99 = 99%) • Simple case: suppose 1 period bond selling at par (100%) with coupon payment of 5 % 100 = 5/(1+r) + 100/(1+r) = (105)/(1+r); r = 0.05 = 5% If P = 95, then r = 10.5% • So does P falling cause r to rise or vise versa? • Neither, BUT A COMMON MISCOMMUNICATION IN MEDIA • Analogous to temp rising in F and equating that to C

  7. A Couple of “Discounting” Issues • Present Value = (Revenue – Cost)1/(1 + r)1 + (R-C)n/(1 + r)n • Widely used formula to convert streams of payments into a current dollar equivalent; also used to solve for r given current and future expenditures (See tmv.xls on website) • A powerful tool, but one that involves critical decisions, foremost, what discount rate (r) to use • What level? • Nominal or inflation adjusted? (if using inflation-adjusted, then revenues and costs need to be also, if nominal, all nominal) • Pre-post tax value? • How much to adjust level for risk of scenario; start at “risk free” rate, e.g. 3-month T-bill, and work upward, but how much?

  8. Key Rates & Markets • Short Term • Fed Funds; LIBOR; T-Bill; Commercial Paper • Medium Term • Prime; 1-3 yr. Treasury; Aaa Bond; Bbb Bond • Long Term • 30-year Mortgage; 10-year Treasury • Government Set • Discount; Fed Funds Target • See irates.xls on website for graphics

  9. Fed Funds & Libor

  10. 3 Month T-bill & Commercial Paper Rates

  11. 1-Year Treasury & Prime Rates

  12. 10-Year Treasury & 30-year Mortagage

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