Understanding Interest Rates

1
Understanding Interest Rates

• Business and Financial Journalism (JMSC6004)
• Feb 18, 2002

2
Mother of All Markets

• Cost of Money
• Inflation
• Credit-worthiness

3
Bonds

• An IOU
• Interest-bearing securities
• Components
• Face value (principal)
• Maturity
• Coupon rates

4
Pricing of a new bond

• Inflation
• Investors must be compensated with a return
  higher than the rate of inflation
• U.S. Fed calls the shot, using interest rate
  levers to pace the economy
• Credit-worthiness (default risk)

5
Basic Fixed Income Math

• Simple vs Compound interest rate
• YIELD annual rate of return on an investment
  expressed as percentage
• Bond price goes up, yield goes down

6
Concept of Discounting

• Money has a time value.
• Present value the amount of money that must be
  invested in order to realize a given future
  value.
• Zero-coupon bond
• Higher the int, lower the Present Value
• Farther into the future, lower the PV

7
YIELD Curve

• A graph that plots the relationship between the
  int on short-term and long-term bonds.
• Normal curve slopes up

8
Yield Curve

• Normal - Upward slopping (how steep?)
• Inverted Curve
• Flat or Humped Curve

9
Credit-worthiness

• Rating Agencies
• Yield expressed as a spread over U.S. Treasury
  securities
• Junk bonds, a.k.a. Non-investment grade
  securities