Interest Rates

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Interest Rates

• By Matt Webb

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What are Interest Rates?

• Compensation for use of other peoples capital
• Essentially, the cost of money
• All rates relate back to bank rates

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Bank Rates

• Who sets Them?
• In Canada the Bank of Canada
• In the US the FOMC of the Federal Reserve

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Historical US rates
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Determinants of Interest Rates

• Inflation
• Foreign developments and exchange rate
• Demand and supply of capital
• Default risk
• Central bank operations
• Credibility of central bank
• Taken from CSC textbook

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Users of Credit

• Home buyers mortgages
• Car Owners purchase financing leases
• Consumers credit cards
• Businesses working capital loans
• Corporations bonds debentures
• Governments to finance debt

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How They Affect Bonds?

• Inverse relationship
• When interest rates go up, bond prices go down
• When interest rates go down, bond prices go up
• Relates to opportunity costs, on the present
  value of money

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Present Value

• Simple present value
• PV FV divided by (1 r) n
• Where PV present value
• FV future value
• R discounting rate
• N number of compounding periods

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How they Affect Stocks?

• Higher interest rates have two primary effects on
  equities
• They make bonds less appealing to offer
• While also making bonds more appealing to buy

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The P/E interest rate relationship

• P/E ratios should be roughly the inverse of
  interest rates
• Eg, if interest rates are 5 then P/E should be
  20
• (100 div 5 ) 20
• This ratio was not followed whatsoever during
  tech boom