1.8 Interest Rates

Interest rates are the price of borrowing money - and they're one of the most important factors affecting securities prices. Understanding how rates work and how they impact investments is crucial for the SIE exam.

What Are Interest Rates?

An interest rate is the cost of borrowing money, expressed as a percentage of the principal. It's also the return earned by lenders for providing funds.

Key Interest Rates

Federal Funds Rate: Rate banks charge each other overnight; Set By - Federal Reserve (target)

Prime Rate: Rate banks charge their best customers; Set By - Banks (follows fed funds)

Discount Rate: Rate Fed charges banks for emergency loans; Set By - Federal Reserve

Treasury Rates: Yields on U.S. government securities; Set By - Market forces

The Federal Funds Rate

The federal funds rate is the benchmark for short-term interest rates in the U.S. economy. The Fed sets a target range, and banks trade reserves to stay within it.

How It Influences Other Rates

1. Fed sets federal funds target

2. Prime rate typically = Fed funds + 3%

3. Other rates adjust accordingly

4. Eventually affects mortgages, car loans, credit cards, and business loans

Example Rate Chain

If Fed funds target is 5.25-5.50%:

- Prime rate about 8.50%

- Credit cards about Prime + 10-15%

- Mortgages influenced by longer-term Treasury rates

Interest Rates and Bond Prices

This is one of the most important relationships in finance:

Bond prices and interest rates move in opposite directions.

Why the Inverse Relationship?

When interest rates rise:

1. New bonds are issued with higher coupon rates

2. Existing bonds (with lower coupons) become less attractive

3. Existing bond prices must fall to offer competitive yields

When interest rates fall:

1. New bonds are issued with lower coupon rates

2. Existing bonds (with higher coupons) become more attractive

3. Existing bond prices rise

Example

You own a bond paying 4% interest. If new bonds start paying 5%:

- Who would pay full price for your 4% bond?

- Your bond's price must drop until its yield matches 5%

Duration: Measuring Rate Sensitivity

Duration measures how sensitive a bond's price is to interest rate changes.

Short duration (1-3 years): Less sensitive

Intermediate duration (4-7 years): Moderate sensitivity

Long duration (10+ years): Most sensitive

Rule of Thumb

For every 1% change in interest rates, a bond's price changes approximately equal to its duration:

- 5-year duration bond: about 5% price change per 1% rate change

- 10-year duration bond: about 10% price change per 1% rate change

The Yield Curve

The yield curve plots interest rates across different maturities, typically using Treasury securities.

Types of Yield Curves

Normal (Upward): Long-term rates higher than short-term rates; Economic Signal - Economic growth expected

Flat: Rates similar across maturities; Economic Signal - Uncertainty or transition

Inverted: Short-term rates higher than long-term rates; Economic Signal - Potential recession ahead

Why It Matters

- Normal curve: Investors demand higher rates for longer commitments (time value of money)

- Inverted curve: Investors expect future rates to fall (often preceding recessions)

- Historically: Inverted yield curves have preceded most U.S. recessions

Real vs. Nominal Interest Rates

Nominal rate: The stated rate; What you see quoted

Real rate: Rate adjusted for inflation; Formula - Nominal rate minus Inflation

Example

If your bond pays 5% (nominal) and inflation is 3%:

- Real return = 5% - 3% = 2%

- Your purchasing power only grows 2%

Why Real Rates Matter

- Investors care about purchasing power, not just dollars

- Negative real rates (inflation higher than nominal rate) erode wealth

- Real rates influence investment decisions

Interest Rates and Stock Prices

Interest rates affect stocks through multiple channels:

Borrowing costs: Companies pay more to borrow, lower profits

Consumer spending: Higher mortgage/loan payments, less spending

Valuation: Future earnings worth less (higher discount rate)

Competition: Bonds become more attractive vs. stocks

Sector Sensitivity

Utilities: High; Compete with bonds for yield investors

Real Estate: High; Higher mortgage costs hurt demand

Banks: Moderate benefit; Earn more on loans (but borrowers may default)

Technology: High; Future earnings heavily discounted

Inflation and Interest Rates

Inflation and interest rates are closely linked:

The Relationship

- High inflation: Fed raises rates to cool economy

- Low inflation: Fed can lower rates to stimulate growth

- Deflation: Rates may go to zero or negative

Inflation Expectations

Bond yields incorporate expected inflation:

- If investors expect 3% inflation, they demand at least 3% yield

- Real yield = Nominal yield minus Expected inflation

Interest Rate Risk

Interest rate risk is the risk that changes in rates will affect investment values.

Who Faces Interest Rate Risk?

Bondholders: Rising rates hurt existing bond values

Stock investors: Rate changes affect valuations

Banks: Mismatch between deposit rates and loan rates

Borrowers: Variable rate loans become more expensive

Managing Interest Rate Risk

- Shorter duration bonds - Less price volatility

- Floating rate securities - Rates adjust with market

- Laddering - Spread maturities across time

- Diversification - Mix of rate-sensitive and less-sensitive investments

Key Takeaways

- Interest rates are the price of borrowing money

- Bond prices move inversely to interest rates

- Duration measures a bond's sensitivity to rate changes

- The yield curve shows rates across different maturities

- An inverted yield curve often signals recession ahead

- Real interest rates account for inflation

- Interest rates affect both stocks and bonds, often in opposite ways