Money and Banking: Lecture 9 - Interest Rate Risk

you okay what we want to talk about today or start our discussion off with we call them last time interest risk or market risk okay and sometimes there's just a little bit of a twist to this where it might be called interest rate risk but it's the same idea whether you put the rate in there or not okay and let me just kind of show you a simple idea we'll put a bond up here some $1000 face value maybe a 4 percent coupon interest rate and 3 years hence just as an example and we'll have a discount rate maybe 5% and then if we calculate this it has a present value to us of 900 I have it written down here in seventy two dollars and seventy seven cents okay now the idea and this is the price in the marketplace investors will be out there and discounting this future flow of dollars the $40 a year that we receive as the coupon and the $1,000 that we receive at maturity investors are discounting those dollars and so would only be willing to pay nine hundred seventy two dollars and seventy seven cents for this bond and so the idea of interest risk is this suppose you buy this bond and you pay that price for it and you say hey I feel good about this I'm going to get a five percent return on my bond and then after that suppose the marketplace changes and both you and other investors say you know I need a 6% return on my money for whatever reason it could be that there's new risk introduced into the situation it could be that there's inflation that comes along for whatever reason now I need a 6% discount rate well what's going to happen is the value of this bond in the marketplace is going to go down if there's a higher discount rate a lower market value for the bond I want to draw a picture kind of illustrates this two idea and it's a simple picture we'll put the interest rate on one side and prices market values on the other at the moment that bond comes to market like if you're running a company or you're running a city or whatever and your issue in a bond here's what you do you investigate that marketplace and what you want to do is you want to put a coupon interest rate on that bond here we had 4% you want to put a coupon interest rate on that bond that reflects market conditions what's the market look like today and you look out there surveyed the situation and by the way people who issue bonds don't just print them up you know like on their copy machine they hire advisors underwriters and so forth and these advisers tell them what the market is I think we're going to be able to borrow that money for 4% and so you put that bond out there with a coupon that reflects market conditions and the moment that bond is finalized when it goes out the door to be sold to investors I'm gonna put a bar over this that rate is locked in that's it 4% although in different situations could be 3% or 8% or whatever the number would be okay and at that particular time let's even do that in a horizontal line at that particular moment this has got a par value or a face value in this case a thousand bucks and that is its market price I've used three terms of that par value face value and maturity value so anyway all of those the same you know I can do better than a downward sloping horizontal line whatever that means I think I can that's better and the moment that bond goes out the door when you sell it this is locked in the par value the face value it doesn't change it says a thousand dollars on that bond and it says four percent and it's always going to say that and so I put this little bar over each one of these because that's locked into place here's what's not locked into place market interest rates and the market prices of bonds that's not locked in you sell it with a coupon that's said at the market and you charge a market price to people whatever it says on the face of it so when this bond was sold brand-new the first date went out the door yeah thousand bucks but now after that that bond takes on a life of its own and what happens is over time we talked about some reasons last time that over time due to risk or inflation or various circumstances legislation tax laws interest rates discount rates and that's what we're talking about here discount rates change and as those discount rates change the market price of these securities changes and the idea this picture here is to illustrate the idea of interest risk and what we've said is this the market interest rates go up then the market price of those securities go down and this is what we mean by interest risk or market risk on bonds you might say something like this or think something like this hey I bought a bond from the Treasury there's no risk if you have those thoughts what you really mean is this there's no default risk there's no credit risk I'm not worried about the government defaulting on this bond and that's one kind of risk and the risk on that is there's risk on everything you know like a meteor could crash into Earth and kill all living life-forms but other than that you might say there's no risk okay I'll grant you that no default risk no credit risk but there is still market risk and that's what we're talking about now because the moment you buy that bond you said I agree to accept 4% and after that you and the rest of the world may say 4% I'm very good and in this case maybe we say oh I need 5% and if you say I need 5% do this by this bond get a 4% yield I already had a case did not where if this is if the market rate goes up to 5% the price of that bomb will go down to how much nine hundred seventy two dollars and seventy seven cents interest rates in the market place up bond prices down now how do I know that's going to happen think about this you buy the bond you have let's say you buy it at this moment one second later that bond is for sale I mean you own an asset there's a market for that asset you can trade it in that market that's one possibility that you have oh that was a three year bond wasn't I better take this off here because the specific amount isn't important that was for a three year bond and I didn't mean to draw a graph that's specifically a three year bond or for three-year bun you've got this bond you're holding on to it there's a market out there you may need cash at any moment you think not you buy a bond and you're thinking I'm going to hold it for awhile but potentially not something could happen tomorrow you go out get in a car wreck say oh I got to get my car fixed oh I'm in a hospital oh I got laid off work I need the cash I've got an asset there's a market I'm going to sell it so let's just say that you bought this bond it's got a four percent coupon and what that bond says to you is hey we're going to send you 40 dollars a year and right after you bought that bond market conditions change supply and demand and so forth market conditions change and when this discount rates five percent what that means is in the marketplace there are brand-new bonds that are coming out and those brand new bonds say $1,000 and those brand new bonds say 5% because that's the new market interest rate the new discount rate that everybody has and here's a three years hence or whatever and so if you say I want to sell you this bond you've got a bond this one you want to sell it so you say to somebody hey would you buy my bond and they go yeah of course I'll buy a bond I invest in bonds and you say okay I just paid a thousand dollars to those five minutes ago they would go huh well I'm not paying you a thousand dollars more you say why not I just paid a thousand dollars five minutes ago and they say you know because there are brand new bonds coming to the market and they pay 50 bucks a year and this bond that you're trying to sell me for face value it only sends me a check for 40 dollars a year why would I buy your bond from you if I can get a brand new one and it's not the newness issue if I can get one that pays a $50 coupon I'm not interested and you say boy I wish you would and you send the other person says you know this is not about friendship this is not about me punishing you this is about business and the business is your bond that you're trying to sell me pays $40 year the new ones are paying 50 if you want to sell me this bond you got a discount the price you got to lower the price and so here we go market interest rates up and this is the market price of a previously issued bond and that's our story here is it's a previously issued bonds out here in circulation the price of that previously issued bond goes down now let's don't get hung up on this three-year bond let's just think and the numbers I'm going to tell you don't work out exactly right but intuitively I want you to see this now we could do our use our calculator to get an exact number but intuitively think through this process let's just say this is a one-year bond okay and so we've got this 1-year bond you just bought that it matures a year from now here's a 1-year bond the brand-new ones pin so here's a $50 a bond that's paying $40 one year from now that's it and one year it's all but shirred this one is paying $50 and so if you tried to sell me this bond I would say to you you know what these bonds licking all I can set for one thing I'm going to get $40 out of this one I'm going to get $50 out of this one and coupon interest both of them mature the same day both of them I'm going to get a thousand bucks back but this one only 40 this one 50 I'll tell you what I'll do I will buy your bond from you but I got to have that extra $10 I'll tell you what I'll do I'll give you nine hundred and ninety dollars and if I pay you 990 I feel good about that because I'm going to get the $40 coupon and I'm going to get a capital gain of ten dollars and with the $40 coupon the capital gain ten dollars that's 50 bucks return on this bond and a brand new will it be 50 I'll give you a 990 now that's not exactly right but that's pretty close sir it works the opposite way to let's say that a brand new bond came out okay the brand new ones are 3% you'll you own this bond and you say hey I've got a bond but I need some cash so you go out in the market bunch say hey I got a bond for sale you want to buy this and all these investors are out there going buy the bonds is that the government I wish I'd bought one of those yesterday because yesterday we had a 4% coupon in a day they just have a 3% coupon I'm just going to get a thirty dollar interest payment by holding this bond and you go out then you say hey I want to sell this bond anybody want to buy it and everybody in the country not everybody in the country but hundreds of people go I'll take it here's a thousand bucks they want to pay you before you you know get your wits about you and you see how could everybody wants my bond and somebody goes I'll tell you what I'll do I'll give you a thousand in one dollar everybody else will pay you a thousand I'll pay you a thousand and one and somebody else and say I'll give you a thousand - why would they pay extra and answer is because your bonds going to give them 40 bucks income and the brand-new ones coming to market slump 8:30 and so what happened is people would start competing other investors that want to buy your bond and start competing and they would bid that price up to how much a thousand and ten dollars right mmm close you know what's exactly right I just put two zeros in the wrong spot a thousand and ten dollars and so then if somebody bought your bond what they would be thinking is this I'm going to get a $40 coupon but I gotta lose ten bucks on a deal capital loss and that ten dollar loss subtract from the forty dollar coupon I end up a thirty bucks and so what we have not only drew one of these but what we have also is if market interest rates go down then bond prices go up okay now this is story I just told it's not really right we haven't gone into how you calculate yields yet we'll do that in a little while it's not exactly right but it's pretty close but it's intuitively the thinking is exactly what's going on in the marketplace let's erase and do this slightly differently I'll just erase right here oh well I'll just erase that whole thing and what we want to do now is let's talk about a two-year bond okay this bonds come into the market you buy it you get a 4% yield you pay face value for it now you own that bond and you feel good about it okay and then now you need to sell it you need some cash but just before you can sell it interest rates go up from 4% to five in the in the marketplace the discount rates higher and what that means is there's a brand new bond that comes to the market and it says $1,000 and it says we'll say 5% two years hence and so you say hey who wants to pay me a thousand bucks nobody speaks up come on a thousand bucks an investor say why would I pay you a thousand bucks your pawn pays 40 dollars a year in coupons the new ones are paying 50 lives and you say okay I see your point I'll knock ten dollars off because this one only pays 40 a year this one fifty I'll knock ten dollars off I'll charge you nine ninety is that a good deal and investors say and that's not going to work because this is a two year bond and so what's going to happen is I'm going to get $40 per year $40 in the first year of $40 in the second year this one's going to pay $50 in the first year of $50 in the second year that's a hundred all together in coupons this is 80 you want to sell me that bond you know 20 bucks off the price this is making sense to you and so the price goes down to 980 and I'm not going to do it in the opposite direction but if interest rates went down to 3% its price would have gone up by 20 dollars to it 10 20 let me come over to my picture and I want to add something else to before what we had is the idea of market risk this inverse relationship what we added to that is to say that market risk increases with years to maturity and what we just saw is if we had a one-year bond the price fluctuated by 10 dollars it went down from a thousand down to 990 yes here's a thousand the the par value and here's 990 and that was when interest rates went up from four to five percent but if interest rates go from four to five percent and it happens to be a two year bond then the fluctuation was down from a thousand to 980 and so the longer the term to maturity the more that price will go down okay for the most part there are a few exceptions but for the most part the longest bonds in the United States and 30 years few exceptions to that but you're not going to run across those very often usually if you see an exception would be some kind of a a municipal bond issued by some city or county or something like that the u.s. the United States Treasury its longest bonds or 30 years most all corporations 30 years and so if the interest rates go up in the marketplace the bonds that suffer the most from this market risk are the 30-year bonds the longest bonds and their prices will go down by a lot and so you might go out and say oh I'm going to buy a Treasury bond this is great I'm an investor now I'm not running any risk and so you buy a 30 year Treasury bond and you're sitting around you get a 4% yield and it's almost for sure the next day at do you get that interest rates are go up and the price will start going down and you'll say how could this happen this is the safest thing in the world and the answer is it's safe that the government's still going to be in business that is to say there's not much chance of default where they just go you know where we promise to pay you back $1,000 well we're not going to do it that would be default risk it's safe about concerning that kind of risk but the government does not guarantee you that interest rates discount rates can't go up they just can't do that interest rates can go up and when they do bond price is down by the way before we move on let me say this it's not only bond prices later on in this class we're going to talk about banking and what bankers do sometimes bankers buy bonds Treasury bonds and things like that but bankers make loans and so like if you go down to the bank and you say any I want to buy a house and I need some money and they say that's good fill out this loan application and then you know they go through this lengthy process and assuming that they approve you on this loan what they say is how much do you need to borrow I need to borrow a hundred thousand dollars and so they'll say okay a hundred thousand dollars and then they'll say that okay that's a 30-year deal and most mortgages are a long term 15 years would be short 20 be medium-term 30 years would be long so a 30 year loan and then they'll say something like we're going to charge you 5% how much does this look like a bond there's a space value on it there is this what you could call a coupon interest rate that's not what they call it on a mortgage on a home loan but there's an interest rate mentioned on the face of it that has to do with how much interest you pay every year to the banker and then here's a maturity date huh looks like a bond huh and so what I'm saying to you is this if you're running a bank and somebody comes in and you lend them money for a home and you start accumulating these pieces of paper you're accumulating something that looks very much like a bond and then if interest rates start going up this is locked in right there is such a thing as an adjustable rate mortgage but a fixed rate mortgage then which is what most people want that rate is locked in and after that if interest rates go to 6% seven eight and so forth every time those interest rates go up up up up up in the marketplace you the banker you the lender you go oh my gosh if I want to sell this mortgage to an investor and there are investors that buy billions of billions of billions of dollars of the mortgages but oh my gosh interest rates are going up in the marketplace so I want to sell this mortgage to an investor the value is going down down down down down so this is not just a risk interest risk is not something that just affects bonds it does affect bonds corporate bonds Treasury bonds municipal bonds but it also affects loans alone with a locked-in interest rate and that was where we started with this picture where that interest rates locked in one final thing before we go on and it's may be more than one final thing but anyway it's this there is such a thing as an adjustable interest rate and so if interest rates went up to 6% with an adjustable interest rate mortgage it come Bango oh you know when we loaned you that money for your house and you said yeah and you said you remember when we loan that money to you for 5% you said yeah they say well now that's 6% and you go huh that's interesting they say now your house payment just went up and you say really and so an adjustable-rate mortgage would insure the banker against that kind of risk but most mortgages aren't that way and by the way if you get one of those adjustable rate mortgages the banker is insured against that kind of risk you're assuming that risk and so you should be able to get a little bit better interest rate just for taking on that risk but anyway so what I'm saying to you there have been lots of banks and savings and loans and mortgage lenders that go out of business because of this they have loan money for mortgages they got a huge portfolio of these mortgages the interest rates locked in and then market interest rates go up the value of the portfolio goes down and their net worth is going down once that is a negative net worth once they have eaten up the capital of the owners in the bank they closed the doors and they're eating it up pretty fast because that's 30 years you know if there were one year mortgage interest rates up okay we lose a little well guess what those are long-term mortgages now this is the final point I have talked to a number of bankers and here's what they say yeah I make home loans or mortgages mortgage loans all the time and as soon as all the paperwork is signed and the ink dries I take that and I sell it I do not hold on to this for a day it's gone why I don't want that risk I don't want that market risk I just don't want to play that game okay and so anyway a lot of banks make a lot of loans mortgage loans but they do not hold on to those very long sometimes savings or loans and some other mortgage type of lenders they will hold them but bankers just don't like that kind of risk okay now what I told you a moment ago is this and I don't want you to be confused these amounts that I was putting up here like 990 980 those are not exactly correct I did not get my calculator out what if this were a three year loan the way I taught my way through it if interest rates went from four to five percent we'd have to discount that ten dollars each year right and then it would go down to nine hundred and seventy dollars if this were a three year loan well we know that's not true because we already did that one calculation who went down to nine seventy two seventy seven and so the numbers I was putting up here were the kinds of numbers that we can calculate in our head think our way through it and see the concept of market risk or interest risk but that doesn't mean that that number is correct out and you can see right now that it's off almost three dollars on a three-year loan but it's off by more the further out we go that way okay so anyway everybody okay with this deal interest rate risk and it's out there all the time and that affects banks in a big way and bankers do not like to hold long term bonds and they don't like to hold mortgages and I'm speaking in general terms okay let's calculate yield yields interest rates rate of return or depending on the situation you'll hear the terminology slightly different I'm going to use that lowercase letter I to stand for interest rate or a yield I'm going to write something down after that but I want to mention to you well let me write it down first the way we mean this the yield or the rate of return or the interest rate is the return from lending or investing $1 for one year now one dollar for one year what we do is this we standardized information about interest or a return suppose somebody said this to you Wow last year I made $10,000 in interest is that good well it's not so good if they loaned out 10 million dollars if you want at ten million dollars to somebody you get back ten thousand dollars you didn't get much if you lend out fifty thousand dollars and you get ten thousand dollars in interest that's a lot so loans are of different sizes right and so what we have to do if we're going to start comparing interest we need to do something to standardize the amount of interest so that when we talk about interest we're all talking about the same thing and so that's what we do is we say look I'm going to just take however big my loan is if it's a hundred thousand dollar loan so if a five thousand dollar loan or whatever I'm going to take all the interest I get and I'm going to divide it by the size of the loan so I'm just talking about one is worth of that loan if I get $10,000 in interest and it's $100,000 alone how much of interest what I've gotten from just one thousand dollars of that hundred thousand dollar on no I would have gotten ten cents and then the other thing is when we loan money some loans are for a short term you know there are loans for one day there are loans for 30 years and there's loans for any maturity in between when we talk about loans we need to have some standardized way of discussing this and that's really what this is if we didn't I mean if we don't want to worry about the details and just say I got ten thousand dollars or the interest and that's enough okay but it's not enough it's confusing when the world's that way because loans are of different sizes and there are different terms and so what we do is we take all of our interest rate information and we boil it down to one dollars worth alone for a 1-year period and then if we see a number that looks like this point zero four then that says you know what if I loan money out a dollars worth of this loan for one year I'm getting back four pennies and then that's a four percent interest rate and we say four percent but that four percent means four pennies per dollar loan per year if you want a hundred thousand dollars well then you get a hundred thousand oh yeah you get a hundred thousand of those four cents are you with me okay so anyway we always do it that way and next time we'll have a formula bring your calculator and we will work our way through three of these interest rate calculations so on

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Length: 30min 16sec (1816 seconds)

Published: Fri Feb 01 2013