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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

BA 580 – Interest Rates

Why They Exist; Link with Decisions; Key Facts & Formulas

why interest
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
why credit markets
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
rates decisions
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
rates decisions5
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
bonds rates
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
a couple of discounting issues
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?
key rates markets
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