BA 580 – Interest BA 580 – Interest RatesRates

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

Why Interest?Why Interest?

Personal Values of Present v. FuturePersonal Values of Present v. Future– ““Rate of Time Preference”Rate of Time Preference”– Data from National Long. Study of YouthData from National Long. Study of Youth

Present v. Future Production Present v. Future Production CapabilityCapability– Uses for “saved” consumption = Long Uses for “saved” consumption = Long

term real gdp growth term real gdp growth

Why Credit Markets?Why Credit Markets?

Basis: differences (people, bus., …)Basis: differences (people, bus., …)– Valuation present & futureValuation present & future– Projected earnings/consumption streamsProjected earnings/consumption streams

Intermediaries (“middlemen”) Intermediaries (“middlemen”) – See website for Credit Market overviewSee website for Credit Market overview– ““Transactions costs” – esp. information Transactions costs” – esp. information – Create effectsCreate effects

Product development; market making; dynamic Product development; market making; dynamic elementelement

Rates & DecisionsRates & Decisions

Take 5 minutes and write down as Take 5 minutes and write down as many examples as you can of many examples as you can of ways that interest rates influence ways that interest rates influence business and personal decisions business and personal decisions or outcomesor outcomes

Rates & DecisionsRates & Decisions Financial BusinessFinancial Business

– Interest rate “spread” – paid v. receivedInterest rate “spread” – paid v. received Non-financial BusinessNon-financial Business

– Explicit interest payments Explicit interest payments – Implicit cost of funds (projects, …)Implicit cost of funds (projects, …)– Valuation of revenue or cost over timeValuation of revenue or cost over time

Extensive application of PV formula Extensive application of PV formula ((rates&pv.xlsrates&pv.xls on website) on website)

– Valuation of contingencies (options, …)Valuation of contingencies (options, …)– Some have said that Finance is Some have said that Finance is

economics with PV and Option formulaseconomics with PV and Option formulas

Bonds & RatesBonds & Rates A quick primer (also see website)A quick primer (also see website)

– Bond price Bond price Price (current) = C/(1 + r)Price (current) = C/(1 + r)11 + C/(1 + r) + C/(1 + r)22 + . . . + C/(1 + + . . . + C/(1 +

r)r)nn + + B/(1 + r) B/(1 + r)nn C = interest original issuer promises to pay (coupon rate)C = interest original issuer promises to pay (coupon rate)B = face value of bond if held to maturity (par value)B = face value of bond if held to maturity (par value)P = usually quoted as % of face value (e.g. 99 = 99%)P = usually quoted as % of face value (e.g. 99 = 99%)

Simple case: suppose 1 period bond selling at par Simple case: suppose 1 period bond selling at par (100%) with coupon payment of 5 %(100%) with coupon payment of 5 %100 = 5/(1+r) + 100/(1+r) = (105)/(1+r); r = 0.05 = 5%100 = 5/(1+r) + 100/(1+r) = (105)/(1+r); r = 0.05 = 5%If P = 95, then r = 10.5%If P = 95, then r = 10.5%

So does P falling cause r to rise or vise versa?So does P falling cause r to rise or vise versa? Neither, BUT A COMMON MISCOMMUNICATION IN MEDIANeither, BUT A COMMON MISCOMMUNICATION IN MEDIA Analogous to temp rising in F and equating that to CAnalogous to temp rising in F and equating that to C

A Couple of “Discounting” IssuesA Couple of “Discounting” Issues

Present Value = (Revenue – Cost)Present Value = (Revenue – Cost)11/(1 + r)/(1 + r)11 + (R-C) + (R-C)nn/(1 /(1 + r)+ r)nn

– Widely used formula to convert streams of payments into Widely used formula to convert streams of payments into a current dollar equivalent; also used to solve for r given a current dollar equivalent; also used to solve for r given current and future expenditures (See current and future expenditures (See tmv.xlstmv.xls on website) on website)

A powerful tool, but one that involves critical A powerful tool, but one that involves critical decisions, foremost, what discount rate (r) to usedecisions, foremost, what discount rate (r) to use– What level?What level?– Nominal or inflation adjusted? (if using inflation-adjusted, Nominal or inflation adjusted? (if using inflation-adjusted,

then revenues and costs need to be also, if nominal, all then revenues and costs need to be also, if nominal, all nominal)nominal)

– Pre-post tax value?Pre-post tax value?– How much to adjust level for risk of scenario; start at How much to adjust level for risk of scenario; start at

“risk free” rate, e.g. 3-month T-bill, and work upward, “risk free” rate, e.g. 3-month T-bill, and work upward, but how much? but how much?

Key Rates & MarketsKey Rates & Markets

Short TermShort Term– Fed Funds; LIBOR; T-Bill; Commercial PaperFed Funds; LIBOR; T-Bill; Commercial Paper

Medium TermMedium Term– Prime; 1-3 yr. Treasury; Aaa Bond; Bbb Prime; 1-3 yr. Treasury; Aaa Bond; Bbb

BondBond Long TermLong Term

– 30-year Mortgage; 10-year Treasury30-year Mortgage; 10-year Treasury Government SetGovernment Set

– Discount; Fed Funds TargetDiscount; Fed Funds Target See See irates.xlsirates.xls on website for graphics on website for graphics

Fed Funds & LiborFed Funds & Libor

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3 Month T-bill & Commercial Paper 3 Month T-bill & Commercial Paper RatesRates

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1-Year Treasury & Prime Rates1-Year Treasury & Prime Rates

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10-Year Treasury & 30-year 10-Year Treasury & 30-year MortagageMortagage

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