3.4 Interest Rates
3 min read•june 18, 2024
Interest rates and inflation are closely intertwined in finance. Nominal rates include both the and an , while the explains their relationship. Understanding this connection is crucial for making informed financial decisions.
Real interest rates, calculated using expected or actual inflation, measure the true cost of borrowing. Positive real rates benefit lenders, while negative rates favor borrowers. This concept helps investors and borrowers assess the actual value of their investments and loans over time.
Interest Rates and Inflation
Nominal rates and inflation connection
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- consist of two components:
- represents the true cost of borrowing determined by supply and demand for loanable funds in the market
- Inflation premium compensates lenders for expected loss of purchasing power due to inflation increases as expected inflation rises
- states nominal interest rate = Real interest rate + Expected inflation rate
- , where is nominal interest rate, is real interest rate, and is expected inflation rate
- When expected inflation increases, nominal interest rates tend to rise to compensate lenders for loss of purchasing power (higher inflation premium)
- When expected inflation decreases, nominal interest rates tend to fall as inflation premium decreases (lower inflation expectations)
Calculation of real interest rates
- Real interest rate measures true cost of borrowing after adjusting for inflation
- calculated using expected inflation
- , where is real interest rate, is nominal interest rate, and is expected inflation rate
- calculated using actual inflation
- , where is real interest rate, is nominal interest rate, and is actual inflation rate
- Positive real interest rates indicate nominal interest rate is higher than inflation rate (lenders gain purchasing power)
- Negative real interest rates indicate inflation rate is higher than nominal interest rate resulting in loss of purchasing power for lenders (borrowers benefit)
Risk and Interest Rates
Risk impact on interest rates
- is risk that borrower will not repay loan
- Higher leads to higher interest rates to compensate lenders for increased risk (subprime mortgages)
- Credit ratings assess creditworthiness of borrowers and help determine interest rates (AAA, AA, A, BBB, etc.)
- is risk that investor may not be able to sell security quickly at fair price
- Less liquid securities tend to have higher interest rates to compensate investors for lack of liquidity (corporate bonds vs government bonds)
- is risk associated with length of time until bond matures
- Longer-term bonds typically have higher interest rates than shorter-term bonds
- Investors demand higher return for locking up funds for longer period (10-year Treasury vs 2-year Treasury)
- Longer-term bonds are more sensitive to changes in interest rates ()
- Longer-term bonds typically have higher interest rates than shorter-term bonds
- is risk of changes in interest rates due to economic conditions and market sentiment
- When market interest rates rise, value of existing fixed-rate securities falls (bond prices move inversely with yields)
- When market interest rates fall, value of existing fixed-rate securities rises (refinancing opportunities)
Time Value of Money and Interest Rates
- concept states that money available now is worth more than the same amount in the future due to its potential earning capacity
- Interest rates reflect the of using money for one purpose instead of another
- shows the relationship between interest rates and time to maturity for bonds of similar credit quality
- Upward sloping (normal) indicates higher long-term rates
- Inverted yield curve may signal economic slowdown
- is the interest rate at which banks lend money to each other overnight
- Influences other short-term interest rates and indirectly affects long-term rates
- is the interest rate that commercial banks charge their most creditworthy customers
- Often used as a benchmark for other types of loans
- is a unit of measurement for interest rates, equal to 1/100th of a percentage point
- Used to describe small changes in interest rates
Key Terms to Review (25)
Basis Point: A basis point (bps) is a unit of measurement used in finance to describe the percentage change in the value or rate of a financial instrument. One basis point is equal to 0.01% or 0.0001, and is commonly used to quantify changes in interest rates, bond yields, and other financial metrics.
Default risk: Default risk is the possibility that a bond issuer will fail to make required payments of interest or principal. This risk can affect the bond's value and the return expected by investors.
Default Risk: Default risk is the risk that a borrower will be unable to make the required payments on a debt obligation, resulting in a default. It is a critical consideration in the pricing and management of various financial instruments, particularly bonds and loans.
Duration Risk: Duration risk refers to the sensitivity of a fixed-income security's price to changes in interest rates. It measures the potential change in the value of a bond or other fixed-income investment when interest rates fluctuate, providing insight into the investment's interest rate risk exposure.
Ex-Ante Real Interest Rate: The ex-ante real interest rate, also known as the expected real interest rate, is the nominal interest rate adjusted for expected inflation. It represents the real return an investor expects to earn on their investment before the actual inflation rate is known.
Ex-Post Real Interest Rate: The ex-post real interest rate is the actual real interest rate that is realized after the fact, taking into account the actual inflation rate over the period. It represents the true purchasing power of the interest earned on an investment or loan, as it accounts for the impact of inflation.
Federal Funds Rate: The federal funds rate is the interest rate at which depository institutions (such as banks and credit unions) lend reserve balances to other depository institutions on an overnight basis. It is a key interest rate that influences the broader set of interest rates in the U.S. economy, including those for loans, mortgages, and savings accounts.
Federal Reserve funds rate (federal funds rate): The Federal Reserve funds rate (federal funds rate) is the interest rate at which depository institutions lend reserve balances to other depository institutions overnight. It is a crucial tool used by the Federal Reserve to control monetary policy and influence economic activity.
Fisher effect: The Fisher Effect describes the relationship between real interest rates, nominal interest rates, and inflation. According to this theory, nominal interest rates adjust to expected inflation to maintain a constant real rate of return.
Fisher Effect: The Fisher effect is a concept in economics that describes the relationship between interest rates, inflation, and real interest rates. It states that the nominal interest rate adjusts to changes in expected inflation to leave the real interest rate unchanged.
Inflation Premium: The inflation premium is the additional interest rate that lenders demand to compensate for the expected loss in the purchasing power of money due to inflation. It represents the extra yield investors require to offset the anticipated decline in the real value of their investment over the life of the loan or bond.
Liquidity risk: Liquidity risk is the risk that an investor will not be able to buy or sell a bond quickly enough in the market to prevent or minimize a loss. It arises when there is insufficient market demand for selling the asset at its current value.
Liquidity Risk: Liquidity risk is the risk that an asset or security cannot be converted into cash quickly enough to meet financial obligations. It is the risk of being unable to sell an asset or security at its fair market value due to a lack of buyers in the market.
Market Risk: Market risk, also known as systematic risk, is the risk associated with the overall fluctuations in the financial markets. It is the uncertainty inherent in the performance of the market as a whole, which can impact the value of an investment or a portfolio of investments. Market risk arises from factors such as changes in interest rates, economic conditions, political events, and other macroeconomic factors that affect the entire market.
Maturity Risk: Maturity risk refers to the risk associated with the timing or duration of a financial instrument, particularly a bond or other fixed-income security. It is the risk that the value of a security will change as its maturity date approaches, due to changes in interest rates and other market factors.
Nominal Interest Rates: Nominal interest rates refer to the stated or advertised interest rate on a loan or investment, without considering the effects of inflation. They represent the face value of the interest rate before adjusting for the purchasing power of money over time.
Opportunity cost: Opportunity cost is the value of the next best alternative that is forgone when making a decision. It represents the benefits you could have received by taking an alternative action.
Opportunity Cost: Opportunity cost is the value of the next best alternative that must be forgone in order to pursue a certain action or decision. It represents the trade-offs involved in allocating limited resources to one use instead of another.
Prime Rate: The prime rate is the interest rate that commercial banks charge their most creditworthy customers, typically large corporations or individuals with excellent credit histories. It is a widely used benchmark for various types of lending and serves as a reference point for setting interest rates on other loans, mortgages, and credit products.
Real interest rate: Real interest rate is the interest rate that has been adjusted for inflation to reflect the true cost of borrowing. It represents the real purchasing power of money earned from an investment or paid on a loan.
Real Interest Rate: The real interest rate is the nominal interest rate adjusted for inflation. It represents the true cost of borrowing or the true return on saving, as it takes into account the erosion of purchasing power due to rising prices in the economy.
Time Value of Money: The time value of money is a fundamental concept in finance that recognizes the difference in value between a sum of money available today and the same sum available at a future point in time. It is based on the principle that money available at the present time is worth more than the identical sum in the future due to its potential to earn interest or be invested to generate a return.
Time value of money (TVM): Time Value of Money (TVM) is the concept that money available now is worth more than the same amount in the future due to its potential earning capacity. This principle underlines why receiving money today is preferable to receiving it later.
Yield curve: The yield curve is a graphical representation of the interest rates on debt for a range of maturities. It shows the relationship between short-term and long-term bond yields issued by the same entity.
Yield Curve: The yield curve is a graphical representation of the relationship between the yield (or interest rate) and the maturity of a set of similar debt instruments, typically government bonds. It provides a visual depiction of the term structure of interest rates, reflecting the market's expectations about future interest rates and economic conditions.