Lecture 4 Flashcards
What are nominal interest rates?
the ordinary interest rates on money
How are nominal interest rates normally quoted?
on an annualised compounding basis
the interest is paid and then you pay interest on interest
What does the yield curve show?
interest rates that apply today and 1 yr, 2 yrs and 3 yrs into the future
ie. they are yields or interest rates across different contract maturity lengths for a similar debt contract
If inflation is expected to rise, nominal interest rates are expected to what?
increase too
What is the equation for compound interest and what do each of the components mean?
A = P(1+[r/n])^(rt)
where P = principle (ie. starting amount)
r = interest rate
n = number of times it is compounded per year
A $1000 10% for 2 years means you are given $1000 now. At the end of 1 year, how much do you owe? How much do you owe after 2 years?
- 1 year: $1000 x (1 + (0.10/1)) = 1000 x 1.10 = $1100
- 2 years: $1100 x (1 + (0.10/1))
= 1100 x 1.10 = 1210
A = $1000*(1 + 0.10)^2 = $1210
A $1000 10% loan for 90 days (1/4 year) means you are given $1000 now and at the end of the 90 day, how much do you repay?
A = $1000*(1 + 0.10)^0.25 = $1025
A $1000 invested at 10% for 2 years compounded monthly means you have to pay back how much at the end of the 2 years?
A = 1000(1+(0.1/12))^(12)(2) = $1220.39
Built into the yield curve are expectations about
inflation
What are the three different variations of the yield curve?
Positive yield curve
Inverted yield curve
Flat yield curve
What does a positive yield curve indicate?
- investors expect strong future economic growth and higher future inflation (that is increasing inflation expectations and this, higher interest rates)
What does an inverted yield curve indicate?
investors expect sluggish economic growth and lower inflation (that is falling expectations and thus lower interest rates)
What does a flat yield curve indicate
this generally indicates that investors are unsure about future economic growth and inflation
Someone investing for 2years could invest for 1 year now and reinvest for another year in a year’s time. If they equate returns then what is the equation?
(1 + i(t)2)^2 = (1 + i(t)1)^1 + (1 + i(t+1)1)^1
What does (1 + i(t)2)^2 mean?
you invest today (t) for 2 years
What does (1 + i(t)1)^1 mean?
you invest today (t) for 1 year (1)
What does (1 + i(t+1)1)^1 mean?
you invest in one year for 1 year
Investing today for m+n years is equal to what?
investing today for n years + investing in n years for m years
Where can a good explanation of the future interest rates equation be found?
on slide 6 of 2a-1 Yield Curve
Suppose 2 year rates are 6% and one year rates are 5%. What is the expected 1 year rate in 1 year’s time?
2i(t)^2 = i(t)^1 + i(t+1)^1
2 x 6 = 1 x 5 + i(t+1)^1
i(t+1)^1 = 7%
Suppose 3 year interest rates are 6%, and 1 year interest rates are 5%. What is the expected 2 year rate in one years time?
3i(t)^2 = 1i(t)^1 + 2i(t+1)^2
3 x 6 = 1 x 5 + 2i(t+1)^2
2i(t+1)^2 = 13
i(t+1)^2 = 6.5%
Suppose 3 year interest rates are 6%, and 1 year interest rates are 5%. What is the expected 2 year rate in one years time?
3i(t)^2 = 1i(t)^1 + 2i(t+1)^2
3 x 6 = 1 x 5 + 2i(t+1)^2
2i(t+1)^2 = 13
i(t+1)^2 = 6.5%
Suppose real rates wee constant at 2%, and we expect 4% inflation this year, 2% in t+1 and 0% in year t+2. What would we expect the yield curve to look like and why?
We would expect it to be downward sloping because inflation is falling (and so interest rates are going to fall too)
Where is the rest of lecture 4 and why?
on google docs because brainscape is a fucking piece of shit
