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Interest Rates

Empirical Properties Click to edit Master subtitle style

The Nominal Interest Rate


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Suppose you take out a Rs.1000 loan today. You agree to repay the loan with a Rs.1050 payment in one year.
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Interest = Payment (Face Value) Principal (Price) Interest = Rs.1,050 - Rs.1,000 = Rs.50 Interest Rate = (Interest/Principal) Interest Rate = (Rs.50)/(Rs.1,000) = .05 (5%) Per Year This is the one year spot rate INTEREST RATES ALWAYS HAVE A TIME PERIOD ASSOCIATED WITH THEM!!!

Annualizing
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Suppose that you invest Rs.1 at a quarterly interest rate of 2%. What is your annual return?
Rs. 1 Rs.1.02 Rs.1.04 Rs.1.06 Rs.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
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Suppose you earn a cumulative interest rate of 5% over a 4 year period. What is your annualized return?
Rs. 1 Rs.?? Rs.?? Rs.?? Rs.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 jIndiat divide by 4

The Yield Curve

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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
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Forward rates are interest rates for contracts to be written in the future. (F)
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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


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The current annual yield on a 1 yr Treasury is 2.0% while a 2 yr Treasury pays an annual rate of 2.6%
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Rs.1(1.02) = Rs.1.02 (Rs.1 invested for 1 year) Rs.1(1.026)(1.026) = Rs.1.053 (invested for two years) (Rs.1.02)(1+F(1,1)) = Rs.1.053

Therefore, the implied return from the 1st year to the second is Rs.1.053/Rs.1.02 = 1.032 = F(1,1) = 3.2%
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Calculating Forward Rates


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The current annual yield on a 2 yr Treasury is 2.6% while a 3 yr Treasury pays an annual rate of 2.9%
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Rs.1(1.026)(1.026) = Rs.1.053 (invested for two years) Rs.1(1.029)(1.029)(1.029) = Rs.1.09 (invested for 3 years) (Rs.1.053)(1+F(2,1)) = Rs.1.09

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Therefore, the implied return from the 2nd year to the third is Rs.1.09/Rs.1.053 = 1.035 = F(2,1) = 3.5%

Spot Rates & Bond Prices


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Zero Coupon (Discount) Bonds are convenient becaIndiae they only involve one payment.
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Maturity date (Term) Face Value (Assume Rs.100) A 90 Day T-Bill is currently selling for Rs.99.70 Yield (Yield to Maturity) = (Rs.100 - Rs.99.70)/Rs.99.70 = . 003 (.3%) Annualized YTM = (1.003)^(365/90) = 1.012 (1.2%)

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Spot Rates & Bond Prices


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STRIPS (Separately Traded Registered Interest and Principal) were created by the Treasury department in 1985.
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Maturity date (Term) Face Value (Assume Rs.100) A 10 Yr. STRIP is selling for Rs.63.69 YTM = (Rs.100 - Rs.63.69)/Rs.63.69 = .5701 (57.01%) Annual YTM = (1.5701)^(.1) = 1.0461 (4.61%)

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Forward Rates and Bond Prices


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STRIP prices also imply forward rates


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An AugIndiat 2015 STRIP is currently selling for Rs.63.55 while an AugIndiat 2014 STRIP is selling for Rs.68.07. F(9,1) = Rs.68.07/Rs.63.55 = 1.07 = 7%

Interest Rates & Bond Prices


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Now, consider the same 1 year, Rs.100 discount bond with a price of Rs.94.00

i = (Rs.100 Rs.98.00) *100 i = (Rs.100 Rs.94.00) *100 = =2% 6.4% Rs.98.00 Rs.94.00
Higher bond prices are associated with Lower Returns!!

Interest Rates & Bond Prices


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Whats the difference between a bond price and an interest rate? They are both relative prices
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Interest Rate = Price of a current Rs. in terms of foregone future dollars. Bond Price = Price of a Future Rs. in terms of foregone current dollars

Interest Rates in the India (1984 2004)


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 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 India


Term Mean Std. Dev. Corr (+1) Corr (+2) Corr (+3) Corr (+4) Federal Funds 1Yr TBill 5.88 2.98 .988 .968 .949 .934 5 Yr. TBill 10 Yr. TBill

Interest Rates in the India


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 India


Term Mean Std. Dev. Corr (+1) Corr (+2) Corr (+3) Corr (+4) Federal Funds 5.80 3.39 .986 .961 .937 .915 1Yr 5.88 2.98 .988 .968 .949 .934 5 Yr. 6.49 2.75 .992 .979 .968 .957 10 Yr. 6.69 2.68 .994 .985 .976 .969

Correlations
1YRTB 1YRTB 5YRTB 10YRTB FF 1 0.966104 0.934983 0.973375 5YRTB 1 0.993211 0.914724 10YRTB FF

1 0.879391

Interest Rates
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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

Interest Rates & Inflation

Interest Rates & Inflation


MEAN (Inflation Rate) STDEV (Inflation Rate) Corr(FF) Corr(1YRTB) Corr(5YRTB) Corr(10YRTB) 3.90 3.6746435 0.5899089 0.5552795 0.4879992 0.4666077

Inflation rates are highly correlated with interest rates (less so for longer term rates)

Characteristics of BIndiainess Cycles


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All recessions/expansions look similar, that is, there seems to be consistent statistical relationships between GDP and the behavior of other economic variables. l Correlation (procyclical, countercyclical) l Timing (leading, coincident, lagging) l Relative Volatility

Interest Rates vs. GDP

Nominal Interest Rates tend to be Procyclical and lagging

Interest Rates vs. Money

Interest rates tend to be negatively correlated with changes in money (in the short run)

Nominal vs. Real Interest Rates


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A Rs.1000 investment at a 10% annual interest rate will pay out Rs.1100 in one year. Nominal Return (i) = (Rs.1100 - Rs.1000)/Rs.1000 = .10 (10%) or (1+i) = Rs.1100/Rs.1000 = 1.10

Nominal vs. Real Interest Rates


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A Rs.1000 investment at a 10% annual interest rate will pay out Rs.1100 in one year. To get a real (inflation adjIndiated) returns, we mIndiat divide by the price level (current and future) Real Return (r) = ((Rs.1100/P) (Rs.1000/P))/ (Rs.1000/P) or (1+r) = (Rs.1100/Rs.1000)/(P/P) (1+r) = (1+i) / (1+ inflation rate)

Nominal vs. Real Interest Rates


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A Rs.1000 investment at a 10% annual interest rate will pay out Rs.1100 in one year. To get a real (inflation adjIndiated), we mIndiat 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
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We have the following:


(1+i) = (1+r)(1+inflation) (1+i) = 1 + r + inflation + r*inflation i = r + inflation. + r*inflation ( Indiaually r*inf is small)

Ex) r = 10% - 5% = 5%

Real Interest Rates: 1975-1985

Why would anyone accept a negative real rate of return?

Ex Ante. Vs. Ex Post


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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

1/ 1/

-5 0 5 Expected Actual Real Rate

-10 10 15 20
19 78 7/ 1/ 19 78 1/ 1/ 19 79 7/ 1/ 19 79 1/ 1/ 19 80 7/ 1/ 19 80 1/ 1/ 19 81 7/ 1/ 19 81 1/ 1/ 19 82 7/ 1/ 19 82 1/ 1/ 19 83 7/ 1/ 19 83 1/ 1/ 19 84 7/ 1/ 19 84 1/ 1/ 19 85

Inflation Expectations

Inflation Expectations and Real Returns


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Inflation expectation tend to be quite persistent (i.e. investors dont seem to update to new information). Therefore, real interest rates also have a high degree of persistence.