Wh What Youll ll Learn arn Today ay Wh Which rate should we use - - PDF document

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Aa Aaron Stevens EC1 EC171 71 20 20 Septem September ber 201 2011

Rates of Return, Inflation, and Inflation Protection

Wh What You’ll ll Learn arn Today ay

Wh Which rate should we use for PV/FV pr probl

• blem

ems? Wh Why are there di different rates? Th The e mos

• st

t des estr truc ucti tive ve for

• rce

e in n th the e uni univer verse De Defense against the destructive force

Reca Recall: Fut Futur ure e Value ue

Suppos Suppose e that that yo you save $6000 each year. Ho How much will you have in n 30 30 years? Wh What if you earn 12% on your money? Ab About $1.5 mi million. Wh What if you can only earn 5%? Ab About $400,000.

Wh Which is is the Current In Interest R Rate?

A. A. 0.5 .52% B. B. 4.2 .29% C. C. 4.1 .18% D. . 14.5 .55% Sou Source ce: http ttp://w //www.bankr krate te.com/ com/

Wh What factors determine interest rates?

6-mo month Cer ertifi ficate e of f Dep eposit 48-mo month new ew car loan 30-yea ear fi fixed ed-rate e mo mortgage cred edit card (aver erage) e)

Di Different Interest Rates?

Inte Interest st rate tes s are se set t by th the market, t, e. e.g.

• g. suppl

upply y an and d dem deman and. d. Wh What factors infl fluence rates?

 default risk is the chance that the borrow will not repay  reinvestment risk is the chance that rates will change and investors will not be able to reinvest at the same rate  inflation risk is the risk that the FV will not be able to purchase the same quantity of goods as the PV.

Reca Recall: Co Compounding Effect

“The mos most p t pow

• werful f

for

• rce

ce in in th the univ iverse is is comp compou

• und in

inte terest”

• wron
• ngly a

attr ttrib ibute ted to A to Albert E t Ein inste tein in

And And Now, Now, The he Mos Most De Destructive Force Some Some Pr Prices Ri Rise…

Some Some Pr Prices Fa Fall… Wh What Do Does a Do Dollar Bu Buy?

Co Consumer Price Index

Th The CPI CPI is “a a measure of the average change over time in the prices paid by ur urban ban cons

• nsum

umer ers for

• r a

a mar arket ket bas basket ket of

• f cons
• nsum

umer er good goods and and ser ervices es."

Wh What is Purchasing Powe wer?

Ex Examp mple: e: M&Ms cost $1 $1/package, e, and you have e $1 $100 cash. You dep eposit $1 $100 in a CD @ 5% fo for one e yea ear. M&Ms will cost $1 $1.0 .05 nex ext yea ear. How ma many M&Ms can you buy: this yea ear? nex ext yea ear? Your $1 $100 can by 100 M&Ms this yea ear, or 105/1.0 .05 = 100 M&Ms nex ext yea ear.

Wh What is Purchasing Powe wer?

Ex Examp mple: e: M&Ms cost $1 $1/package, e, and you have e $1 $100 cash. You dep eposit $1 $100 in a CD @ 5% fo for fi five e yea ears. Aft fter er 5 yea ears, you will have e $1 $127.6 .63. M&Ms will cost $1 $1.2 .20. How ma many M&Ms can you buy in 5 yea ears? 127.6 .63/1.2 .20 = 106 M&Ms Yo Your r “rea eal” g gain is 6% over er 5 yea ears -- about 1.2 .24% per er yea ear

Pur Purcha hasing ng Pow Power

If the i If the infl flati ation

• n r

rate i ate is hi s higher gher than than the the ra rate o

• f re

f return rn o

• n y

your i r invest stment, y , you wi will lose purchasing powe wer.

The The Rea Real Ra Rate e of

• f Ret

Retur urn

Th The e real eal rate ate of

• f retur

eturn n des escribes bes your your chan change i e in p purchasi chasing p power over time.

The The relat relationship ionship bet between ween nominal nominal rat rate, e, real real rat rate, e, an and d in inflat flatio ion is is give give by by the he Fisher Fisher equat equatio ion:

Wh Where: i i = nomin inal rate r r = = re real ra rate π = = infl flation

Sh Show

• w:

http ttp://w //www.zvib ibod

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ie.com/ com/ ma marke ketin tindica icator torsvie iew

Bo Bonds

Pr Principal al: : the amount borrowed. By convention, $1000. Ma Maturity: : the term of the loan, stated as a maturity date. Inte Interest st ra rate: th the rate at which interest is paid; usually paid in in s semi- i-annual in installments. Exam Exampl ple: e: A A 10-year US treasury bond at 2.625%. Yo You pay $1 $1000 for the he bond today. Yo You receive semi-annual interest payments (“co coupons”) ) of $1 $1000 000 * 2. 2.625% 625% / / 2 2 = $1 $13. 3.125 25 ev ever ery y six x months hs (20 20 coupons) At At the he end of 10 0 years, you ge get your $1000 back. A A bond is a bo borrowing co contract ract bet between een an an is issuer an and a investor.

“Ri Risk Free” B Bonds

Go Government bonds are generally co considered dered to be be “ri risk-free.” Wh Why?

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com/marke kets ts/r /rate tes-bon

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ment- t-bon

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In Inflatio ion-In Indexed B Bonds

http ttp://e //en.wikip ikipedia ia.org/w /wiki/I iki/Inflation tion-in indexe xed_b _bon

• nd

Tr Trea easur sury Inf nflation-

• n-

Pr Prot

• tected

d Se Secur urities

• Bonds issued

ed by US Trea easury - “risk fr free ee”

• Des

esigned ed to guarantee ee your purchasing power er

• Inter

eres est paymen ment + infl flation adjustmen ment You can purchase TIPS via TreasuryDirect.com, in a brokerage account, or with a mutual fund. Also: iBonds

How How TI TIPS PS Wor

• rk

TI TIPS PS pay pay yo you u inter eres est at at th the stated real rate, as well an adj adjus ustmen ent to pri princi cipal pal bas based ed on chan changed ged in the he CPI PI. Exam Exampl ple: e: You bought a $10,000 10-year TIPS bond on 1/16/2007. The interest rate was set to 2.375%. On its issue date it had an index ratio of 1.0. On July 15, the index ratio was at 1.02773, so the principal

• f the bond was worth $10,277.30.

Also, semi-annual interest was paid: Interest = $10,000 * 1.02773 * 2.375% /2 = $122.04 Suppose the index ratio on 1/15/2017 is 1.25 (maturity). You’ll get back $12,500 of principal, in addition to the last semi-annual interest payment.

Huma Human n Ca Capital is a Gr Great He Hedge dge Aga Agains nst Inf nflation

• n

Wh What You Learned Today

Cho Choose the he di discount rate very caref careful ully! y! Be Be wary ary of as assum umpt ptions. Infl Inflati tion

• n will

ll erod

• de you
• ur purchasi

sing ng pow power. er. TI TIPS PS an and d iB iBonds ar are only the risk- fr free anti ntidote

• te to

to infl nflati tion.

• n.

Hu Human an Cap Capital al is a a great at he hedg dge agai against infl flat ation.

Announc Announceme ment nts and nd To

• Do

Do

Readings:

• FE,

E, ch ch 4 Homework 2 due today

In Inflatio ion o

• r D

Deflatio ion?

Rea Real Int nter erest est Ra Rates es