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Interest Rates I:

Interest Rates I:. Money & Banking - ECO 473 - Dr. D. Foster. The Basics. What is interest?. Payment made to savers to compensate them for foregoing consumption. “The most powerful force in the universe is compound interest.” Interest rates embody our expectations of the future.

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Interest Rates I:

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  1. Interest Rates I: Money & Banking - ECO 473 - Dr. D. Foster The Basics

  2. What is interest? • Payment made to savers to compensate them for foregoing consumption. • “The most powerful force in the universe is compound interest.” • Interest rates embody our expectations of the future.

  3. What affects interest? Who cares? • Savers • Borrowers • Policymakers • Forecasters • Time value of money • Liquidity • Risk

  4. Calculating Interest • Nominal yield: iN = C/F • Current yield: iC = C/P • Yield to maturity (YTM) . . . interest return if bond held to maturity i = nominal interest rate

  5. Using interest rates to price bonds • Relates to discounting into present values • PV = $X/[(1+i)n] • PV is the market price, or . . . . .set equation = price and solve for i (which is the YTM) • Special case: Perpetuity Price = C/i YTM if P=$950, C=$60, n=3?

  6. $1 today is worth more than $1 tomorrow PV shows the “discounted” value of future $ FV show the “compounded” value of present $ $X today = $X·(1+i)n in n years You have $1000 now; i=5%, n=18. What is FV? You get $1000 in 9 years; i=7%. What is PV? Present & Future Values

  7. Price = PV (expected earnings): P = E1/(1+i) + E2/(1+i)2 + E3/(1+i)3 + ... Dividends = Earnings in the long run. P = PV(expected dividends) Using interest rates to price stocks Expectations: • “Rational Expectations” - use available information and understanding of markets. • P due to E and/or i.

  8. Interest Rates & Risk • Default risk • (Il)liquidity risk • “Risk premium” = i - iT-Bill • where the T-Bill is the riskless (“safe”) rate. • How do you distinguish default from liquidity risk?

  9.  Bond Price will  interest rate • Monetary policy: Fed buys bonds - price rises - interest rates fall - spending rises -  GDP Fed sells bonds - price falls - interest rates rise - spending falls -  Inflation

  10. Stock and Bond Returns, 1900-2007

  11. Quick Hits • A wide spectrum of interest rates: • Federal Funds rate • Prime rate • 30 year bond rate • Real interest rate (r)= i -  • Note, this can only be calculated for past. • Note, i = r + e (real return + exp. infl.)

  12. Real and Nominal InterestRates, 1960-2007

  13. Interest Rates I: Money & Banking - ECO 473 - Dr. D. Foster The Basics

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