Interest Rates

Empirical Properties
 The Nominal Interest Rate
 Suppose you take out a $1000 loan today. You
agree to repay the loan with a $1050 payment in
one year.
 Interest = Payment (Face Value) – Principal (Price)
 Interest = $1,050 - $1,000 = $50

 Interest Rate = (Interest/Principal)

 Interest Rate = ($50)/($1,000) = .05 (5%) Per Year
 This is the one year spot rate

 INTEREST RATES ALWAYS HAVE A TIME PERIOD

ASSOCIATED WITH THEM!!!
 Annualizing
 Suppose that you invest $1 at a quarterly
interest rate of 2%. What is your annual return?

$1 $1.02 $1.04 $1.06 $1.082

X (1.02) X (1.02) X (1.02) X (1.02)

(1.02)(1.02)(1.02)(1.02) = 1.082 = 8.2%

Note: It is generally a safe approximation to multiply by 4

 Annualizing
 Suppose you earn a cumulative interest rate of 5% over
a 4 year period. What is your annualized return?

$1 $?? $?? $?? $1.05

X (1+i) X (1+i) X (1+i) X (1+i)

(1+i)(1+i)(1+i)(1+i) = 1.05
(1+i) = (1.05)^(.25) = 1.012 = 1.2%

Note: Its generally a safe approximation to just divide by 4

 The Yield Curve

6
4
2
0
1 yr 2 yr 5yr 10 yr 20yr
 Spot Rates are interest rates charged for loans
contracted today: S(1), S(2), S(3), etc…
 The Yield curve is a listing of current spot rates for
different maturities (on an annualized basis)
 Forward Rates
 Forward rates are interest rates for contracts to be
written in the future. (F)

 F(1,1) = Interest rate on 1 year loans contracted 1

year from now
 F(1,2) = Interest rate on 2 yr loans contracted 1
year
 from now
 F(2,1) = interest rate on 1 year loans contracted 2
years from now
 S(1) = F(0,1)

 Forward rates are not explicitly stated, but are implied

through observed spot rates
 Calculating Forward Rates
 The current annual yield on a 1 yr Treasury is 2.0% while a
2 yr Treasury pays an annual rate of 2.6%

 $1(1.02) = $1.02 ($1 invested for 1 year)

 $1(1.026)(1.026) = $1.053 (invested for two years)

 ($1.02)(1+F(1,1)) = $1.053

 Therefore, the implied return from the 1 st year to the

second is
$1.053/$1.02 = 1.032 = F(1,1) = 3.2%
 Calculating Forward Rates
 The current annual yield on a 2 yr Treasury is 2.6% while
a 3 yr Treasury pays an annual rate of 2.9%

 $1(1.026)(1.026) = $1.053 (invested for two years)

 $1(1.029)(1.029)(1.029) = $1.09 (invested for 3 years)

 ($1.053)(1+F(2,1)) = $1.09

 Therefore, the implied return from the 2nd year to the

third is
$1.09/$1.053 = 1.035 = F(2,1) = 3.5%
 Spot Rates & Bond Prices
 Zero Coupon (Discount) Bonds are convenient
because they only involve one payment.
 Maturity date (Term)
 Face Value (Assume $100)

 A 90 Day T-Bill is currently selling for $99.70

 Yield (Yield to Maturity) = ($100 - $99.70)/$99.70 = .003
(.3%)
 Annualized YTM = (1.003)^(365/90) = 1.012 (1.2%)
 Spot Rates & Bond Prices
 STRIPS (Separately Traded Registered Interest
and Principal) were created by the Treasury
department in 1985.
 Maturity date (Term)
 Face Value (Assume $100)

 A 10 Yr. STRIP is selling for $63.69

 YTM = ($100 - $63.69)/$63.69 = .5701 (57.01%)
 Annual YTM = (1.5701)^(.1) = 1.0461 (4.61%)
Forward Rates and Bond Prices
 STRIP prices also imply forward rates…

 An August 2015 STRIP is currently selling for $63.55

while an August 2014 STRIP is selling for $68.07.
 F(9,1) = $68.07/$63.55 = 1.07 = 7%
 Interest Rates & Bond Prices
 Consider a 1 year, $100  Now, consider the same 1
discount bond with a price year, $100 discount bond
of $98.00 with a price of $94.00

i = ($100 – $98.00) *100 =2% i = ($100 – $94.00) *100 = 6.4%

$98.00 $94.00

Higher bond prices are associated with Lower

Returns!!
 Interest Rates & Bond Prices
 What’s the difference between a bond
price and an interest rate?
 They are both relative prices
 Interest Rate = Price of a current $ in terms of
foregone future dollars.
 Bond Price = Price of a Future $ in terms of
foregone current dollars
Interest Rates in the US (1984 – 2004)

14
12

10

8
6

0
1/1/84 1/1/89 1/1/94 1/1/99 1/1/04

1 YR TBILL
 1 Year Treasury Rate
18
16
14
12
10
8
6
4
2
0
1/1/59 1/1/64 1/1/69 1/1/74 1/1/79 1/1/84 1/1/89 1/1/94 1/1/99 1/1/04
 Interest Rates in the US
Term Federal 1Yr TBill 5 Yr. 10 Yr.
Funds TBill TBill
Mean 5.88

Std. Dev. 2.98

Corr (+1) .988

Corr (+2) .968

Corr (+3) .949

Corr (+4) .934

 Interest Rates in the US
16
14
12
10
8
6
4
2
0
1/1/84 1/1/89 1/1/94 1/1/99 1/1/04

1 YR 5 YR 10 YR Fed Funds
 Interest Rates in the US
Term Federal 1Yr 5 Yr. 10 Yr.
Funds
Mean 5.80 5.88 6.49 6.69

Std. Dev. 3.39 2.98 2.75 2.68

Corr (+1) .986 .988 .992 .994

Corr (+2) .961 .968 .979 .985

Corr (+3) .937 .949 .968 .976

Corr (+4) .915 .934 .957 .969

 Correlations

  1YRTB 5YRTB 10YRTB FF

1YRTB 1  
5YRTB 0.966104 1  
10YRTB 0.934983 0.993211 1  
FF 0.973375 0.914724 0.879391 1
 Interest Rates
 Mean reverting (stationary)
 Long term rates are less volatile than short
term rates
 Long term rates show more persistence
than short term rates
 High degree of persistence
 Highly correlated with one another (long
rates less correlated with shorter rates)
 Interest Rates & Inflation
14

12

10

0
1/1/84 1/1/89 1/1/94 1/1/99 1/1/04
 Interest Rates & Inflation
15

10

0
1/1/84 1/1/89 1/1/94 1/1/99 1/1/04

-5

-10

1 YR TBILL INFLATION
 Interest Rates & Inflation
MEAN (Inflation Rate) 3.90
STDEV (Inflation Rate) 3.6746435
Corr(FF) 0.5899089
Corr(1YRTB) 0.5552795
Corr(5YRTB) 0.4879992
Corr(10YRTB) 0.4666077

 Inflation rates are highly correlated with interest

rates (less so for longer term rates)
 Characteristics of Business
Cycles
 All recessions/expansions “look similar”, that is, there
seems to be consistent statistical relationships between
GDP and the behavior of other economic variables.
 Correlation (procyclical, countercyclical)
 Timing (leading, coincident, lagging)
 Relative Volatility
 Interest Rates vs. GDP
4 18
3 16
2 14
1
Annual Growth

12

Annual Yield
0
10 GDP
-1
8 1YR TBILL
-2
-3 6
-4 4
-5 2
-6 0

 Nominal Interest Rates tend to be Procyclical and lagging

 Interest Rates vs. Money
5 14
4
12
3
10
Annual Growth

Annual Yield
1 8
M1
0 6 1YR TBILL
1/1/1984

1/1/1986

1/1/1988

1/1/1990

1/1/1992

1/1/1994

1/1/1996

1/1/1998

1/1/2000

1/1/2002

1/1/2004
-1
4
-2
2
-3
-4 0

 Interest rates tend to be negatively correlated with

changes in money (in the short run)
Nominal vs. Real Interest Rates
 A $1000 investment at a 10% annual interest rate will
pay out $1100 in one year.

 Nominal Return (i) = ($1100 - $1000)/$1000 = .10 (10%)

or

(1+i) = $1100/$1000 = 1.10

Nominal vs. Real Interest Rates
 A $1000 investment at a 10% annual interest rate will
pay out $1100 in one year. To get a real (inflation
adjusted) returns, we must divide by the price level
(current and future)

 Real Return (r) = (($1100/P’) – ($1000/P))/($1000/P)

or

(1+r) = ($1100/$1000)/(P’/P)

(1+r) = (1+i) / (1+ inflation rate)

Nominal vs. Real Interest Rates
 A $1000 investment at a 10% annual interest rate will
pay out $1100 in one year. To get a real (inflation
adjusted), we must divide by the price level (current and
future).
 Suppose that the inflation rate is equal to 5% annually

 Real Return (1+r ) = (1.10) / (1.05) = 1.048%

 An Easy Approximation
 We have the following:

(1+i) = (1+r)(1+inflation)

(1+i) = 1 + r + inflation + r*inflation

i = r + inflation. + r*inflation ( usually r*inf is small)

Ex) r = 10% - 5% = 5%
Real Interest Rates: 1975-1985
20

15

10
1YR
5 5YR
10YR
0
1/1/1975 1/1/1977 1/1/1979 1/1/1981 1/1/1983 1/1/1985

-5

-10

 Why would anyone accept a negative real rate of return?

 Ex Ante. Vs. Ex Post
 Ex Ante real interest rates are the rates
investors expect based on anticipated
inflation rates
 Ex Post real interest rates are the rates
investors actually receive after the fact.
 The difference between the two depends
on the accuracy of inflationary
expectations
 Inflation Expectations
20

15

10
Expected
5 Actual
Real Rate
0

-5

-10
 Inflation Expectations and Real
Returns
 Inflation expectation tend to be quite
persistent (i.e. investors don’t seem to
update to new information). Therefore,
real interest rates also have a high degree
of persistence.