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

Rates of Return, Inflation, and Inflation Protection Aaron Stevens Aa EC1 EC171 71 20 20 Septem September ber 201 2011 1 Wh What You’ll ll Learn arn Today ay  Wh Which rate should we use for PV/FV pr probl oblem ems?  Wh Why are there di different rates?  Th The e mos ost t des estr truc ucti tive ve for orce 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% 6-mo month Cer ertifi ficate e of f Dep eposit B. B. 4.2 .29% 48-mo month new ew car loan C. C. 4.1 .18% 30-yea ear fi fixed ed-rate e mo mortgage cred edit card (aver erage) e) D. . 14.5 .55% Source Sou ce: http ttp://w //www.bankr krate te.com/ com/ What factors determine interest rates? Wh

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. Recall: Reca Co Compounding Effect “The mos most p t pow owerful f for orce ce in in th the univ iverse is is comp compou ound in inte terest” - wron ongly 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 onsum umer ers for or a a mar arket ket bas basket ket of of cons onsum 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 Purcha Pur hasing ng Pow Power If the i If the infl flati ation on r rate i ate is hi s higher gher than than the the ra rate o of re f return rn o on y your i r invest stment, y , you wi will lose purchasing powe wer.

The The Rea Real Ra Rate e of of Ret Retur urn Th The e real eal rate ate of of retur eturn n des escribes bes your your chan change i e in p purchasi chasing p power over time. The relat The 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 = nomin i inal rate Sh Show ow: r r = = re real ra rate http ttp://w //www.zvib ibod odie ie.com/ com/ marke ma ketin tindica icator torsvie iew π = = infl flation Bo Bonds A bond is a bo A borrowing contract co ract bet between een an an is issuer an and a investor. Principal Pr al: : the amount borrowed. By convention, $1000. Maturity: Ma : the term of the loan, stated as a maturity date. Interest Inte st ra rate: th the rate at which interest is paid; usually paid in in s semi- i-annual in installments. Exampl Exam ple: e: A A 10-year US treasury bond at 2.625%. You pay $1 Yo $1000 for the he bond today. You receive semi-annual interest payments (“co Yo 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 the At he end of 10 0 years, you ge get your $1000 back.

“Ri Risk Free” B Bonds Go Government bonds are generally co considered dered to be be “ri risk-free.” Wh Why? http ttp://w //www.bloomb oomberg.com/ma com/marke kets ts/r /rate tes-bon onds/g /gov overnme ment- t-bon onds/u /us/ 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 ond

Tr Trea easur sury Inf nflation- on- Pr Prot otected 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 ork 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 of 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 on 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 on will ll erod ode you our purchasi sing ng pow power. er.  TI TIPS PS an and d iB iBonds ar are only the risk- fr free anti ntidote ote to to infl nflati tion. on.  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 o Do Do Readings: • FE, E, ch ch 4 Homework 2 due today In Inflatio ion o or D Deflatio ion?

Rea Real Int nter erest est Ra Rates es