Investment Analysis

Bodie, Kane and Marcus, Investments, Tenth Edition (2014), Chapter Summaries, Ravi Shukla

Chapter 5 Risk, Return and the Historical Record 5.1 Determinants of The Level of Interest Rates

• Interest rates are determined by demand and supply of money, and are affected by several macroeconomic factors as well as government policy • Inflation is one such macroeconomic factor. Please read the statement above carefully. Inflation is a factor affecting interest rates; it is not the factor that determines the interest rates. • Inflation reduces purchasing power of money Due to inflation rate (i), real interest rate (r) is less than the nominal interest rate (R). Specifically: 1+r = 1+R 1+i =⇒ r= R−i 1+i

Suppose the price of a commodity a year ago was $1. So, with $100 you could buy 100 units of this commodity. Instead of buying the 100 units of the commodity, you loaned your $100 to a borrower at the interest rate of 20% per year. The borrower pays back the loan with $120 today. During the year, the price of the commodity went up to $1.10, an inflation of 10%. At the inflated prices, you can buy $120/$1.10 ≈ 109.09 units of the commodity. So, in terms of money, you earned 20% interest ($100 −→ $120) but in terms of the real commodity, you earned 9.09% interest (100 units −→ 109.09 units). Mathematically: 1 + 9.09% = 1 + 20% 1 + 10%

• The relationship can be approximated as: r ≈R−i if the inflation rate (i) is small. • Real interest rate is the foundation of the interest rates and rates of returns we observe Real interest rate reflects our demand for immediacy. Alternatively, the real interest rate is the price we charge for deferring consumption. • Real interest rate, r, is unobservable. We observe and enter financial contracts using the nominal interest rate, R. If a bank makes you a loan at 8% per year interest rate, then 8% per year is the nominal interest rate. • Suppose I want to earn a real interest rate r on a loan I make. If the inflation rate is expected to be E(i),...