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

X (1.02)

X (1.02)

$1.04

X (1.02)

$1.06

$1.082

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

$??

X (1+i)

$??

X (1+i)

$??

X (1+i)

$1.05

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 1st 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

Whats 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
4
2
0
1/1/84

1/1/89

1/1/94

1 YR TBILL

1/1/99

1/1/04

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
Funds

Mean

1Yr TBill 5 Yr.

TBill
5.88

Std. Dev.

2.98

Corr (+1)

.988

Corr (+2)

.968

Corr (+3)

.949

Corr (+4)

.934

10 Yr.
TBill

Interest Rates in the US

16
14
12
10
8
6
4
2
0
1/1/84

1/1/89

1 YR

1/1/94

5 YR

10 YR

1/1/99

Fed Funds

1/1/04

Interest Rates in the US

Term

1Yr

5 Yr.

10 Yr.

Mean

Federal
Funds
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

1YRTB
5YRTB

1
0.966104

10YRTB
FF

0.934983
0.973375

0.993211
0.914724

1
0.879391

FF

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
8
6
4
2
0
1/1/84

1/1/89

1/1/94

1/1/99

1/1/04

Interest Rates & Inflation

15
10
5
0
1/1/84

1/1/89

1/1/94

1/1/99

-5
-10
1 YR TBILL

INFLATION

1/1/04

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

4
3

18

2
1

14

0
-1

10
8

-3
-4

-5
-6

Annual Yield

1/
1/
00

1/
1/
95

12
1/
1/
90

-2

16

1/
1/
85

1/
1/
80

Annual Growth

Interest Rates vs. GDP

GDP
1YR TBILL

4
0

Nominal Interest Rates tend to be Procyclical and

lagging

Interest Rates vs. Money

5

14

12

1/1/2004

1/1/2002

1/1/2000

1/1/1998

1/1/1996

1/1/1994

-1

1/1/1992

1/1/1990

1/1/1988

8
1/1/1986

Annual Yield

10

1/1/1984

Annual Growth

M1
1YR TBILL

-2
-3
-4

2
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
5YR
10YR

5
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

1/
1/

-5

-10
1/
1/

7/
1/

1/
1/

7/
1/

1/
1/

7/
1/

1/
1/

7/
1/

1/
1/

7/
1/

1/
1/

7/
1/

1/
1/

7/
1/

19
85

19
84

19
84

19
83

19
83

19
82

19
82

19
81

19
81

19
80

19
80

19
79

19
79

19
78

19
78

Inflation Expectations

20

15

10

5
Expected
Actual
Real Rate

Inflation Expectations and Real

Returns

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.