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

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

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

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 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 & Decisions Financial Business Financial Business –Interest rate “spread” – paid v. received Non-financial Business 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) 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 A quick primer (also see website) A quick primer (also see website) –Bond price Price (current) = C/(1 + r) 1 + C/(1 + r) C/(1 + r) n + B/(1 + r) n Price (current) = C/(1 + r) 1 + C/(1 + r) 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 Present Value = (Revenue – Cost) 1 /(1 + r) 1 + (R-C) n /(1 + r) n 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 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 Short Term Short Term –Fed Funds; LIBOR; T-Bill; Commercial Paper Medium Term Medium Term –Prime; 1-3 yr. Treasury; Aaa Bond; Bbb Bond Long Term Long Term –30-year Mortgage; 10-year Treasury Government Set Government Set –Discount; Fed Funds Target See irates.xls on website for graphics See irates.xls on website for graphics

Fed Funds & Libor

3 Month T-bill & Commercial Paper Rates

1-Year Treasury & Prime Rates

10-Year Treasury & 30-year Mortagage