Understanding the Dynamics of Interest Rates

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"Understanding the Dynamics of Interest Rates"

• By Professor Jermaine Whirl
• Community Education Seminar

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Interest Rates

• Interest- is the cost of borrowing money.
• Interest has been around since 30,000 BC.
• In ancient Biblical History, it was against the
  Law of Moses to charge interest in private loans.
• The Catholic Church argued charging interest is a
  sin in the terms of usury.
• Medieval times loans were a necessity because of
  a bad harvest season, and charging interest would
  be considered a reproach.
• Islamic civilizations also looked down upon
  charging interest.
• The School of Salamanca (Spanish Theologians)
  During the 16th century (1458-1603) Renaissance
  Era argued that interest for production use (as
  in investing in companies, instead of consumption
  use was not a sin).

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The Interest Equation

• I RRIPRP
• RR Risk Free Rate
• IP Inflation Premium
• RP Risk Premium
• RR IP are usually set already.
• RP is what you have to be concerned about!

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Interest Rates Defined

• RR Risk Free Rate is the rate of interest you
  would be offered if there were no risk involved
  in the transaction. (They are typically based off
  of US Treasury Bills)
• IP Inflation premium is always set above the
  current inflation rate to protect the lender from
  running in a negative real interest rate returns.

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Risk Premium

• Risk serves as a premium in finance.
• The more riskier an individual the more interest
  they must pay.
• Banks, Loan offices, etc.. are all risk adverse.
• Risk adverse means they try to stay away from
  risky investments as much as possible.
• The greater the risk the greater the pay-off to
  the individual. (For investment purposes)
• The greater the risk the higher the risk premium.
• How do we determine risk? How do firms get around
  it?

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Credit

• Where did credit come from?
• Believe it or not credit itself has been around
  for ages.
• In the US however, "Credit" was first issued in
  the 1850s and really developed during the
  industrial revolution.
• In the 1920s- Roaring twenty's you could be a
  Ford on Credit, or obtain a hotel room on credit!
• Credit Card Creation
• There have been credit tokens made from metal
  coins, metal plates, and celluloid, metal, fiber,
  paper, and now mostly plastic cards.
• First Bank Credit Card
• The inventor of the first bank issued credit card
  was John Biggins of the Flatbush National Bank of
  Brooklyn in New York. In 1946, Biggins invented
  the "Charge-It" program between bank customers
  and local merchants. Merchants could deposit
  sales slips into the bank and the bank billed the
  customer who used the card.

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US Savings
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Determining the Risk of Individuals

• FICO (Credit Rating)- Founded by Fair Isaac
  Corporation
• founded in 1956 by engineer Bill Fair and
  mathematician Earl Isaac, provides consulting
  services and enterprise decision management
  systems. They developed the FICO scores, a
  measure of credit risk, that are the most used
  credit scores in the world. FICO scores are
  available through all of the major consumer
  reporting agencies in the United States and
  Canada Equifax, Experian, TransUnion and PRBC

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Calculation of Credit Scores

• The final number is a composite of individual
  ratings in five categoriesPayment history (35
  of the rating)
• Length of credit history (15)
• New credit (10)
• Types of credit used (10)
• Debt (30)

• Only 13 of the population has FICO scores of 800
  or above the median is 723.
• Information obtain by MSN Money Online.

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Credit Suggestions

• Pay all bills on time
• Think twice before closing accounts
• Minimize credit-card applications
• Keep balances low

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FICO Score Analysis
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Key Points

• If you are in the 700 Club, you're RP should be
  zero, and you should only be paying RR IP.
• This shows that you're credit worthy, reliable,
  dependable, and responsible to the firm lending
  you money.

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Interest Rates Determination in Capital Markets

• How are interest rates determined for banks,
  finance companies, mortgage companies, auto
  loans, and education loans?

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Capital Financing

• Corporations can only obtain financing through
  issuing debt (loans, bonds, short-term
  securities, or selling stock (equity).
• Assets Debt Equity
• Let's focus on debt first.
• The Government also uses Debt Financing!

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Bond Market
                                                  
                                                  
                                                 
                                                  
                                                  
                     
               
Firms, Governments, and Individuals by bonds.
They receive interest payments and principal when
they sell bonds. Bond Prices and Interest
payments all depend on the riskiness of the
firm. Examples If a firm is risky and they are
trying to obtain capital, they must give an
incentive to prospective investors. By offering a
low bond price, but a high interest payment. If
a firm is non-risky and they are trying to obtain
capital, they don't have to give an incentive to
prospective investors. Therefore, they will have
a high bond price, and offer a low interest
payment.
BS
P
IR
P
BD
Quantity
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Determining the Riskiness of BusinessBond
Ratings

• Moody's
• Aaa- Highest Rating
• Aa- High Quality
• A- Upper Medium Grade
• Baa- Medium Grade
• Ba- Lower Medium Grade
• B- Speculative
• Caa- Poor
• Ca- Highly Speculative
• C- Lowest Grade

• Standard Poor's
• AAA- Highest Rating
• AA- High Quality
• A- Upper Medium Grade
• BBB- Medium Grade
• BB- Lower Medium Grade
• B- Speculative
• CCC, CC-Poor
• C- Highly Speculative
• D- Lowest Grade

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Understanding how interest rates are determine.
Yield Curve the yield curve is the relation
between the interest rate (or cost of borrowing)
and the time to maturity of the debt for a given
borrower in a given currency.
Banks base their lending on the yield curve. If
the curve begins to flatten then their "interest
spreads" are shorter and therefore they need more
liquidity.
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Understanding the Dangers of Inflation

• In the 1980's many thrift institutions went out
  of business, because of high inflation IP
• Example They would sell a mortgage at 12 but
  inflation being double digit, for example 18
  they were making a -6 return on their money. In
  fact the Fed under Paul Volker inverted the yield
  curve to amortize inflation. He successfully did
  this but it killed well over 1000 banks during
  this time period.
• Thus, ARMs came out in the late 80s to protect
  against this.

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The Role of the Federal Reserve Interest Rates

• The Federal Reserve targets, what is known as the
  Federal Funds Rate, which is the shortest
  interest rate given (usually very-short-term
  overnight). That banks charge to other banks.
• As an indirect effect it directs the interest
  rates of all other financial loans. (including
  mortgages, auto loans, education loans, etc)

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FOMC

• The Fed does this by buying or selling T-Bills.
• If the purchase T-Bills they are putting money
  into the economy, lowering the overall interest
  rates.
• If they sell T-Bills they are taking money out of
  the economy, increasing the overall interest
  rates.
• But it takes time for other interest rates in the
  economy to adjust.

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The Federal Government

• Typically when the government spends all of it's
  tax revenues, it must borrow the rest to finance
  government programs.
• They typically finance themselves by selling
  T-Bills through the US Treasury.
• Some argue that this can "crowd out" private
  investment by driving up the interest rates.

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Federal Government
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Macroeconomics of Saving Investment

• In a closed economy national savings funds
  investment spending.
• This is because the national government can only
  borrow from internal banks.
• The US national savings rate has been falling for
  years.
• If we were a closed economy this would have
  drastic effects on the domestic interest rates.

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Federal Government
IR
Many argue that there is no crowding out effect,
because the US economy can borrow from the world,
and real domestic interest rates aren't effected
or overstated as many believe.
WS
ID
Quantity
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Understanding how Debt Financing Works

• PV- Present Value
• I- Interest Rate
• N- Number of Periods
• FV- Value in the Future
• PMT- Payment

• Future value of a present sum
• FV PV(1I)N
• Example You purchase a bond for 1,000.00. You
  interest rate is 5, and your number of periods
  is one year.
• Therefore, you'll have
• 1,000(1.08)1
• 1,080.00 after one year.

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Debt Financing

• Calculating a home mortgage payment
• Example
• PV-225,550
• I- 8.5 Fix/12 months
• FV-0
• PMT ?
• N- Number of Payments
• 30 years or 1230360

• 225,550 .007(1.007)360
• (1.007)360-1
• PMT 1,734.28

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Investment Strategies (Equity of Stock Ownership)

• Key Points!!!!
• If you don't have the time or energy to
  understand and work the stock market your best
  option is to use
• Mutual Funds or Index Funds
• Work with a financial planner you trust and can
  question!
• Take on risk you feel comfortable with!
• Never invest money that you need to use in the
  short-run (1-6 years).

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Diversification!!!

• The ole saying goes to much of a good thing might
  just be bad for you is true!
• When you purchase stock you are purchasing the
  company.
• Check out the prospectus on the company before
  giving them a dime. Check out the management of
  the company and their financial statements.
• Once you've studied the company you need to
  determine two things
• Your required rate of return RRR (or how much
  money you require to make off the investment)
• Your expected rate of return ERR ( or how much
  money you expect to make off the investment.

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Market of Stocks

• Stock prices are determined by supply and demand.
• You are demanding a stock and you should not pay
  1 cent above what you think the company is worth.
  
• One of the most commonly used methods of
  determining a stock purchase is the Gordon Growth
  Model
• Do The most recent dividend paid
• G The expected constant growth rate in dividends
• Ke (RRR) The required return on an investment in
  equity

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McDonald's Example

• McDonald's Stock Price as of December 1, 2008 _at_
  1164AM stock price was 57.63
• Dividend Payment was .50
• Growth in dividend
• In Nov '08 .50
• In Nov '06 .375
• (.50-.375)/.375 .33

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Calculation of the Stock Price

• Given this information, we can now search for the
  ERR
• Searching for Ke we find it to be .3415 or 34-
  This represents the current required rate of
  return from investors in the market at this point
  in time for this stock. This assumes a constant
  growth rate in the dividend.
• Therefore, you must now determine whether or not
  you believe this stock is undervalued or
  overvalued.

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Determining if a Stock is Overvalued or
Undervalued

• Knowing the market for McDonald's stock is
  currently 34 you must decide whether or not the
  stock is buyable or not based of your required
  rate of return.
• Firms that typically have a very high Ke or
  RRR are usually firms that are in trouble.
  Therefore, for people to invest in them they
  require a higher rate of return than a not so
  risky investment. Their stock prices too will be
  low as an incentive to get investors.
• Firms that have low Ke or RRR are usually
  strong firms with very little risk, and you'll
  have to pay a premium to own their stock.

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Decision time to purchase stocks

• If your RRR is under 34 you consider this stock
  to be undervalued, because your stock price
  calculation will be higher with a smaller
  denominator. You would buy this stock under these
  circumstances.
• However if your RRR is over 34 you would
  consider this stock to be overvalued, because
  your stock price calculation would be lower with
  a higher denominator. You would not buy this
  stock under these circumstances.

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The Financial Crisis

• http//www.ega.edu/facweb/jwhirl/International20F
  inance.ppt