Lecture 15: Interest Rates (Pt. 3) Formation and Importance of Interest Rates

Lecture Overview

  • Course: ECON 371: Business Finance 1

  • Lecture: 15 - Interest Rates (Part 3)

  • Main Focus: Formation and Importance of Interest Rates

Learning Catalytics Activities

  • Statement Voting:

    • Students are encouraged to participate in a survey at the beginning and end of class regarding reflective assignments.

Reflective Assignment Statements

  • Statement A: “Interest rates are like fire: a good servant but a bad master.”

  • Statement B: “Interest rates are evidence that central planning can work in some cases.”

  • Statement C: “Interest rates are like a tightrope: without balance, abyss follows.”

Current Mortgage Rates in Canada (Mar 02, 2023)

  • 1-Year Term: 5.74%

    • Best for short commitments when fixed rates are uncertain.

  • 2-Year Term: 5.59%

    • Suitable if expecting lower fixed rates in two years.

  • 3-Year Term: 4.99%

    • A middle-ground option minimizing risk.

  • 4-Year Term: 4.84%

    • Good when rates are much lower than the 5-year fixed.

  • 5-Year Term: 4.59%

    • Most popular term with generally the lowest rates.

Determinants of Interest Rates

  • Inflation and Real vs. Nominal Rates:

    • Nominal Interest Rates: Rates quoted indicating money growth when invested.

    • Real Interest Rates: Growth of purchasing power after adjusting for inflation.

Calculating Growth in Purchasing Power

  • Formula:1 + Growth in Purchasing Power = 1 + real rate = 1 + nominal rate1 + inflation rate

Real Interest Rate Calculation

  • Real Rate Calculation:

    • Formula: Real Rate = Nominal Rate − Inflation Rate

    • Approximation: 1 + Inflation rate ≈ Nominal Rate − Inflation Rate

Importance of Real Interest Rates

  • Real rates gauge purchasing power.

  • Inflation may diminish real interest rates.

Personal Experiences with Inflation

  • Severe inflation can cause economic and personal struggles.

    • Example: Witnessing women faint due to economic strain.

Investment and Interest Rate Policy

  • Investment Costs vs. Benefits:

    • An increase in interest rates may reduce the net value of an investment if costs precede benefits.

Project Evaluation Example

  • Invest $1 million for cash flows of $260,000/year over four years.

  • Compare project evaluation at different real interest rates (1.5% vs. 2%).

Yield Curve and Interest Rates

  • Term Structure: Relationship between investment term and interest rate.

  • Yield Curve: Plot of bond yields by maturity.

  • Risk-Free Rate: Rate for borrowing/lending without risk over time.

Interest Rate Determination

  • Bank of Canada influences short-term interest rates through the overnight rate.

  • Forecasted future interest rates can affect long-term rates to attract investors or borrowers accordingly.

Yield Curve Shapes

  • Steep Yield Curve: Long-term rates significantly higher than short-term rates.

  • Inverted Yield Curve: Long-term rates lower than short-term rates, potentially indicating recession.

Indicators of Economic Trends

  • Analysis of yield curves from Bank of Canada Bonds and US Treasury Bills aids in predicting potential recessions.

Take-Home Messages

  • Inflation and Interest Rates: Strong connection between the two.

  • Monetary Policy Impact:

    • Nominal rates affected by risk-free rates set by central banks.

    • Real rates influenced by inflation.

    • Mild inflation can stimulate growth; high inflation can lead to negative rates.

  • Bond Yield Curves: Useful indicators for impending recessions.

  • Reminder: Complete the end-of-class survey.