Alan Cring Productions in association with Emergent Light Studio presents
the Illinois State Collegiate Compendium, academic lectures in business and economics.
This is Business Finance, FIL 190 for spring semester 2024.
Music
Today, interest rates. I'll do one quick thing with Excel to show you a little upgrade that I made to that present value and future value sheet.
Just so you're aware of that, and then we'll move on from there.
But always, as always, we will look at the numbers. And the numbers are not particularly pleasant.
Definitely, this is a bare day. And we've had a couple of them in a row, sort of a run of them over the past week or so.
It's nothing really to panic about, but there's just not a lot of happy news.
As you can see, the Dow and the S&P 500 are down a quarter of a percent in the early trading here this morning.
The NASDAQ is down more, which you would expect, higher risk portfolio and all that good stuff.
But like I said, this is not some massive sell-off. It's just grouchy the markets are right now.
Kind of not seeing all kinds of happy news to make them go up.
But if we go over here and have a look while crude, it had gotten above that 72 to 79 long-standing trading bear area, and now it's back into it.
And so that's kind of good news. It's still a little on the high side of the trading area.
But it's definitely, it chickened out. It got up to that neckline, got up on the other side of it, and didn't like what it saw, and then came back down through.
But it is up a little bit in the trading that's been going on since the oil markets opened again last night.
So it's there. The gold is still sitting there above the 2,000, but it's not really doing anything that we could worry too much about.
Now coming over here, the 10-year bond is down. It's down a tiny bit.
The yields are down two-tenths of a basis point. So that's like saying nothing.
It's just almost a flat day right now in the bonds.
It would be nice if we saw the yields going down with demand for bonds going up and pushing the prices up.
But it's not doing that right now. It's just kind of sitting there. Actually, now it's flat on its back.
So there's that. Kind of curious about what was going on over in the other part of the world.
The Nikkei, now you see all that red, but if you look at the percentage from open to close, it was down only a quarter of a percent.
So even though that looks like a bad day, it's really not anything impressive at all.
The markets are just, and you can see over in London later, London just kind of, it's still trading now, but it's about the end of the day.
It started off down and then it just drifted. It's one of those days when the markets are just in a grouchy mood, as you can see, across the globe.
And here over here we see the same thing. Markets are just kind of down a little bit, being crabby about what's going on in the world,
not really being too impressed by anything that's going on.
So we just kind of sit here and wait for some kind of news one way or the other.
Now we'll have some reports coming out next month, of course, inflation report, and we're expecting that to still be under control.
That's good news. And a few other numbers, manufacturing will be coming out.
But there's nothing that's really going to motivate the markets more than just a sustained improvement in the economy.
So that's about all we can say about it in a day like this.
Remember that you don't always have to have some exciting story to tell when you're an analyst.
Actually, the less excitement you have, the better in our world, unless you're an options or futures trader.
But in our world, quiet is kind of a nice thing.
One thing that I meant to show you, let's look at the VIX. Remember that the VIX shows volatility, the vol of the market.
We go over here, VIX, CBOE volatility index.
Really not much of a...we had a little spike there, and we're right now seeing the one day.
Now, notice that this is a market that is open all the time. This doesn't go by a trading bell. It's a volatility.
It's based upon a lot of factors. Some of them would be equities and bonds, but there are other securities and quasi-securities that go into it.
And so since the beginning of the trading day, there was a spike there. About when the sun was coming up this morning, a little before the sun came up, something got the VIX really excited.
But if you look over here at the one month on the VIX, you see that there's been a kind of a trend upward.
You see that short-term trend upward in the volatility of the market. That's an indicator that more uncertainty.
We don't know where things are going, and that is best reflected in the volatility index.
And as you can see, what the hell was that spike there? Good grief. I don't know what that was, but it certainly got...something got the market excited.
But for the most part, it just kind of floats along there, just looking stupid, wondering what it should do next.
And if you are into that kind of a world where you're looking more at volatility, which way is it going to go, then you would want to...I think I brought this up before.
SQQ is very much a...this is a bear security. And it wins when the vol is showing a lot of negativity in it.
And as you can see, today it's up a little bit because it's a bear day, as you saw from the original numbers, the indexes.
And so this would be one that if you are a bear, this would be a broad, broad bet that you were right.
Now if you're a bull, you might look at something like TQQQ. And you can see, surprise, surprise, it's down today because it is not a bull market today.
These are not straight up bets on stocks. These are bets on directions of securities in general.
And so these are more those kinds of things that if you see the...want to deal with the larger picture and not with the individual stocks and hoping to God they do what you want them to,
then these are the kind of instruments that you would want to work with in your own investing or in the investing if you were making recommendations for people
and you didn't want to step into the snake pit of individual stocks and where they're going to go.
So just keep that in mind for something to put in your hat for a potential investment.
And there are options on these too. And the options can be really nasty or great because these are already magnifiers.
SQQQ, TQQQ are already magnifying market movements. And if you go to the options, those are magnifying them again.
And so these can be either real winners or in my case the primary reasons you're in bankruptcy.
But keep that in mind as you do your investments. And there is a whole world of investment alternatives that you have that are not just stocks and bonds.
And we'll get into a little more of that and especially into how you trade with those.
Now let me do something here. We're going to get off this horse for a while here and go over here to something.
Now I keep improving these templates that you're using and I've done one last improvement on the internal rate of return,
I'm sorry, on the present values and future values tables, spreadsheets, I'm sorry. And over here let's have a look where the heck is it.
Present value and future values.
Now I do that all the time. Instead of downloading it, I click on it and then you don't, it's just a preview. Okay, here we go.
Let me come up here.
Well, I haven't downloaded it to you yet. Let me do it over here. I will fix this Leaves student view. Bear with me.
I must have downloaded it to the 240 courses instead of to yours. Yours is a little bit more robust version of it.
But I must have downloaded your version over here, files, and I'll re-upload it to yours here.
Spreadsheets, present value, and future value. There we go. That's the one. Download.
And now I'll re-upload this one, finish with it.
Okay, good. I'm going to have to reduce the scale of this a little bit so you can see it all.
Now, here you will see that the main thing that I did was I have written one more routine that will find the balance on a loan.
See here in the middle, you can calculate loan payments. Well, this one right here, this will also allow you to calculate the balance on a loan.
What's due still on the loan after a certain number of years.
So, for example, if I were to say the...
We borrow on a six-year loan with monthly payments and an APR of, let's say, 5.89%, and we're going to borrow a total of...we're going to buy a car for $35,000.
And let's...whoops. Okay, there's your payments, $578 a month.
Now, let's see how much we still owe after three years on that car.
It will be $19,000 about.
Well, how much after four years? And after five years?
And then finally, we should see a zero at six years. Yep, we do.
So that's just a little augmentation. Now, let me show...let me point out to you this formula right here.
Let me turn down these lights so you can see this a little better.
There we go.
That Excel formula is surprisingly odd.
Excel does not have an embedded balance on a loan formula.
It doesn't have it, which is kind of weird that it wouldn't have it.
So you have to think about how a loan works.
And in fact, what I...if you'll notice here, I am actually calculating a future value.
Now, the future value, the rate, is obvious. The APR divided by the number of periods per year.
So in this case, 5.89 divided by 12.
Now, the next one would be the number of periods,
which in this case would be the number of years remaining times the periods per year.
So if I were to put in here that 4 again...
Now, the next thing that you're going to see in this formula are the payments.
Well, that was what was calculated up here.
You have to do this part first before this will work.
But you calculated the payments here.
So then I'm going to call those payments right here as part of this future value formula.
And then D7 will be what the original amount was.
So basically what I'm doing is from the start,
I'm seeing what the future value of 4 times 12, or 48 payments, would be
if you started out with that D5 amount of money, I'm sorry, with the original present value, the D7.
So in other words, you just wouldn't expect it to be this way
because the loan payments themselves, as you see, is a present value of an annuity to calculate the payments.
But once you know the payments, then what this formula is actually doing is taking you forward.
If you originally owed $35,000, what would be the future value at 4 years, for example,
of how much you had paid in payments to that point?
It's odd. And that's one of the things that you'll find in Excel.
There's almost always a way to get something done.
But sometimes you have to think in a very unusual way.
Now, would I expect any of you to be able to do this even at the end of this court? Probably not.
I wouldn't. But I'm just showing you that take Excel and think about the finance behind it.
A balance is actually the future value of what you originally borrowed
given that you have put a certain number of payments in already by that future point in time.
That's how you have to think of a balance on a loan.
It's not a present value of any kind. It's a future value.
In 4 years, I owed this much. In 4 years times 12 payments a year, I've made these payments.
So what would be the remaining amount at that point in time?
I just noticed a little bit of something I did there.
I should have put right there, breaking my own rule.
Do you see what I did wrong there?
You get the right answer. But do you see what I did that's sloppy?
Look at the formula. Look where my cursor is.
Remember I said you should never have numbers in a formula?
Well, there I did it and I didn't need to.
What should I have put there?
D8.
What?
D8.
Damn straight. I should have put a D8 in there.
There you go. I got sloppy.
So now, you see, now I have a formula that has no numbers in it whatsoever.
They are called by reference to other places in the spreadsheet.
I don't know. I must have been drunk or something.
I just didn't think about it. But there you go.
Now, there's something else that I want to look at here.
I had done a little repair. Let me look here.
There's 7. D7.
Did I fix that? F7?
I sure did. Now, let me show you.
Suppose that you wanted, you will receive $25,000 in 9 years.
That's all. $27,000 in 9 years.
So your future value is going to be $27,000.
You will put any payments into it.
Let's say the APR is 2.89%.
Now, this is for 9 years. Let's say it's compounded semi-annually.
The present value of it is that.
So in other words, in this application, I'm violating my own orange rule there.
If all you need to do is a lump sum, then what you do is you put that lump sum in the future value slot.
And then you clear out the payments if it's just a lump sum.
So that's all you do to get a lump sum if it's a present value of a lump sum instead of the present value of an annuity.
Now, take it the other way. What about a future value?
Let's say that in 15 years, taking let's say 3.75% interest compounded semi-annually,
I want to know what the present value, what's the future value of let's say $20,000 is.
Oh, I forgot to put a zero there. You have no payments. I was going to say that's way too much.
There you go. So if you want to calculate a lump sum, you zero out the payments.
And then if it's for a future value, you put in the original amount.
And if it's for a present value, you put in the future amount.
And you can get lump sums in this formula that I've done here.
So it can do it both ways.
Now, I would strongly encourage you to master this spreadsheet.
Because if you can master it, you can answer most of the quantitative questions on the midterm exam.
All you have to do is learn how to play with this table.
And you can even get effective rates on money from this table as well.
So this one table will clear out a chapter of formulas and replace tables that you would use
or financial calculators that you could use all in this one table.
So it's worth it for you to master this table.
Play with it. Try it out. See if you can get it to do all the stupid pet tricks I've put in there.
And that's that.
Now I don't want to save that.
Let me do something here real quick.
Let me get that back up there.
And let me fix that balance thing right there.
D8 del D8.
And then let me save this.
And take it back over to Canvas here.
Nope, I don't want to do that.
Actually, I wanted you to put it in your section.
Because I'm not doing this one quite like quite this much. Files, spreadsheets,
upload, and then there it is.
And then let me fix this. Delete the original.
And then change the name of this one to just straight up.
There you go. Now it's in your files.
And this is the freshest, cleanest one of all of them.
All for you.
Now the topic of today's lecture is interest rates.
And as I've already gone through interest rates to a certain extent with you,
interest rates are rental rates on money or capital.
And the one thing about interest rates is that they are,
there are many of those interest rates.
They are not, there's not the interest rate.
There are interest rates on car loans, credit cards,
interest rates that companies pay on their bond issues,
interest rates that are paid on short-term borrowings,
interest rates that banks pay you,
interest rates that banks charge a corporation versus what they charge you,
interest rates on treasury debt.
There are all kinds of interest rates.
We work on the theoretical foundation.
And it's theoretical because we can't have a truth underneath this.
There is not a foundation interest rate underneath that we can see.
It's one of those theoretical objects that we know has to be there
because all these other interest rates are on top of something
that is at the bottom of the pile.
Very much like in the 1950s, in a completely different field,
we knew that there was something called DNA, deoxyribonucleic acid.
We knew that it was the driving force that shaped what a creature looked like.
But we've never seen it.
We knew it was there because we knew what its effects were.
One of the triumphs of the modern age,
and it was published in textbooks in my time,
was the first time that a scanning electron microscope managed to actually get a photograph of it.
And then finally we saw it.
We knew what it looked like even.
But, boy, when we saw that photograph, well, apparently it works that way.
Okay.
We call that substrate interest rate the risk-free rate.
R sub f.
Now we can't even see that.
We know that that thing actually has two pieces to it.
We can't see R sub f.
So we certainly cannot see those two pieces that it has in it.
Now understand that we can find something that is very,
very close to the risk-free rate.
In other words, just the pure opportunity cost of foregone consumption.
We generally, for this purpose, we would take the risk-free rate is somewhere very close to the rate,
the yield on a short-term United States Treasury bill.
So in other words, we will use risk-free rate in a number of calculations in this class as time goes along.
So in order to use it, we use this proxy, which is the yield on a short-term Treasury bill.
And I'm going to show you over the next few minutes, well, a little bit later, that this is the U.S.
And I'm going to put a link to this for you in your Canvas and also in the scrolling marquee on my website.
But these are the yields from the beginning of the year.
Now, generally, the one that we look at is the one-year Treasury bill rate, the yield on a one-year T bill as the proxy for R sub F.
Now, as you can see, this thing was bouncing around early in the year and it's still up there.
It's below 5 percent, but you notice that it doesn't seem to have a lot of will to go stay down.
So that would mean that this substrate rate is probably having a little bit of volatility,
uncertainty about Federal Reserve policy and all of that.
Well, that's fine. But what about this R sub F? What's in there?
Well, we know two things are in there. There is a real interest rate.
In other words, it does not embed inflation.
It is just purely the supply and demand dynamics of money.
Where supply of money meets the demand for money, that is the real interest rate.
But then also in there would be this expected inflation premium.
Now, the book calls this IP, inflation premium. That's not correct.
And even they make sure that you know that this is not the inflation rate.
If it were, it would be easy. We could just measure it.
It is the expected inflation premium.
What that means is that interest rates are not driven by inflation.
They are driven by the expectation of inflation.
That's absolutely critical that you understand that in finance.
We know that markets don't give a rat's ass about history.
They want to know what is going to happen next.
So here we will take a brief example.
I have decided that I am going to hire you for my company.
I figure, you look like you are very well educated and a hard worker.
So full time, I am going to pay you $100 a week. I am a giver.
$100 a week.
So you start working for me and after a year I call you in for your performance review.
You are doing damn good. I am impressed by you.
By golly, I want to keep you.
Inflation last year was 2%. I am going to give you a 2% increase in your wage.
$102 you will be making out. Now get back to work.
So you come in the next year for your annual and I say, well, you are still doing great for us.
I see that inflation last year was 4%. So I am going to give you a 4% increase in your wage.
Now get your ass back to work.
Third year you come in and I do the same thing.
Well, still doing great. Inflation last year was 6%. So I am going to give you a 6% raise.
And at this point you say, okay.
But the next year you come in and I say, well, it looks like inflation is 8% this year.
So I am going to give you an 8% increase. And you say, stop right there fat boy.
No more of this bullshit.
What is wrong with what I am doing?
You are just keeping it consistent with the rate of inflation.
What already happened?
You see, you have lost money because it already had 6%.
It already had the 4%. You are already paying those through the year.
And then I give you 4% raise at the end of the year.
You say, I want wealth 2, 4, 6, no 8. I want 10% because that is what I expect inflation to be eroding my purchasing power over the next year.
Do you understand how it works?
Expectation. It does not matter what already happened. It is what we expect to happen.
I am a loan officer and I decide that I am going to give you, madam, a car loan at 5%.
But inflation is going to be 7% over the life of that loan.
I am not going to do it 5%. I am going to do it 7% because I expect the purchasing power of that money I lent you when I get it back to have been eroded at 7% per year.
That is why markets only price money and capital on expected inflation premium, not on the actual inflation premium.
And that is what the pain in the ass is for the Federal Reserve.
What happens is that, well, let me give you an example.
I will take you a little through the history of it.
I usually do this a little later in the course, but I might as well do it now.
This happened long before, this happened before probably even your parents were born.
But now we understand it better now.
Back in the 1950s we had a very solid growth. It was not impressive, but it was a solid growth.
And we had, we had, by the end of the Eisenhower administration we had balanced the budget.
Eisenhower was kind of the old time moderate conservative.
He had no use for tax cuts. He had done one in 1954 when he first started, but he did not like the tax cuts that the Republicans were screaming about.
He was not really big on social programs like the liberals were screaming about.
But he did a few things, but he kept the economy on a steady course.
Well, he retired at the end of his second term. Well, there were term limits.
The presidential election pitted his vice president, Richard Milhouse Nixon, a hard right conservative,
against this brash World War II officer hero, East Coast liberal, first Irish Catholic who would try to get the presidency,
the name of John F. Kennedy. And it turned out to be sort of a fiasco for poor Nixon because the first live TV debate was grim.
Because John Kennedy was very much aware of the media. He hung out with all these entertainers like Sinatra.
There were even rumors of this affair he was having with this model named Norma Jean, actress.
Her stage name was Marilyn something. I can't remember.
And he was brash. He loved those lights. Now, this was back in the days of black and white where the lights were like stadium lights.
That was all they had to use. And poor old Nixon, he was hunched over with a five o'clock shadow.
He looked like a ghoul. There was Kennedy just loving the lights. And so he came to be president.
And he started pushing different things, social programs. He worked. He was trying to get something called a Civil Rights Act passed.
And he was also sending some advisors to this backwater patch of crap in the middle of nowhere called Vietnam.
Now, understand that Kennedy hated communists like no one. He saw the communist threat as being a domino.
One country falls and then it will just cause a cascade across Asia. Okay, spent a lot of money.
He had a good tax base and all that. But the problem was that Jack was ambitious.
But they called his reign Camelot. His wife was just awesome. She knew all.
She even took the nation on a live tour of the White House that she had redone with Parisian stuff.
She was quite the consummate first lady. And all Camelot ended in Dallas in November of 1963.
And Jack Kennedy's vice president took over. His name was Lyndon Johnson.
Lyndon Johnson was an old blue dog Democrat. He probably still had a white sheet hanging in his closet and all that kind of stuff.
But he was vicious. He was a son of a bitch. He always had been. Hell, he was from Texas.
There's even a famous story about him which has some relevance to what I'm about to say.
But back when he was a senator, he had a couple of opponents that tried to come up against him to take his Senate seat.
And the story goes that he told his campaign manager, I think, I can't remember who his opponent was.
But Lyndon Johnson told his campaign manager, I want you to start a rumor that my opponent is a pig fucker.
So, Lyndon, he ain't no pig fucker. I'm his wife, the little old junkie. So I said, shut up. I told you to tell people that.
Because I don't want him living through this campaign without having to deny that he's a pig fucker.
That was how vicious he was. So when he came into office, of course, I was in this. This was when I was a child.
When Kennedy was killed, all those dancing in the street by all the conservatives in the right-wing nutcases.
Thank God that liberal Catholic is dead. We can get back to Johnson. He's a blue dog Democrat from the South.
He'll get things right. Well, they were wrong.
Kennedy had wanted to get the Civil Rights Act passed.
So, well, his Johnson's cohorts in Congress thought that's over. Johnson said, no, we're going to get it passed.
Well, why? You don't believe in it. Because Jack wanted it, and you're going to do it.
And all these blue dog Democrats, he took them into his White House, closed the doors.
And each one of them, he explained to them exactly why they were going to pass it, because he reminded them of what he could do to them.
Well, that was, and then Jack wanted all these social programs. And Jack wanted Vietnam solved.
So we started pouring money into the projects. We poured money into welfare, food stamps, the whole nine yards.
And we began to bomb the hell out of that piece of nowhere in Southeast Asia.
All this cost money. And sooner or later, it got to the point where we had to start printing money to get all that done.
Printing money.
Well, you see, when you print money, the supply of money goes up, so the price of money goes down.
So the real interest rate, short term, went down.
The expected inflation premium didn't do anything. So the risk-free rate went down.
And every time we needed more money, we'd print it and we'd keep interest rates low, so the business activity would keep going up and up.
It was just a grand old time.
Vietnam turned into an ugly affair. It got really bad.
But Johnson didn't run for office in 68, so Nixon finally got his chance to be the president.
Make no mistake about it, Nixon was a right-wing conservative, hard conservative, harder than most conservatives of that era.
He was more along the lines of a guy named Barry Goldwater.
But even Nixon had his progressiveness, and he was willing to see money being printed to keep the economy going.
And he was willing to print money for other things, too.
Well, the real problem came in what Nixon resigned in 74, I think it was.
But before he resigned, back when he was still president, there was this brouhaha on the other side of the world in the Middle East.
We had established a state called Israel, a place, a haven for the Jews who had come out of the Holocaust and was also being filled by Ashkenazi Jews out of Europe.
And the Arabs hated this. And they had tried to destroy Israel a couple of times, and it didn't work.
So in 73, they decided they were going to put all of their armies together and they were going to drive the state of Israel into the sea.
Well, unfortunately, they got their asses kicked in about three days.
And the Arabs suddenly said to them, now, let's see, how is this working?
How can this tiny little state kick our ass? Oh, it's the United States pouring money into them.
So what the Arabs did in the oil producing and exporting countries, they said, you've got a choice.
And you have made that choice. So here's what we're going to do to the oil.
We're going to turn it off. We're going to put an oil embargo on you.
And so oil prices shot up. Gasoline prices went through the roof. There were lines literally miles long.
I remember them very well, going clear out onto interstate highways and all of this kind of stuff.
And so in order for people to be able to deal with this price shock, the Fed printed money, lots and lots of money.
So that you were bitch, bitch, bitch, bitch, bitch about the oil prices. Here's extra money. You stop bitching.
Okay. Printing money. Well, that, of course, there was a problem starting to seep in because the expected inflation premium was just starting to go up.
And I'll put it over here. But what the Fed did was printing all that money, dropped it.
So the risk-free rate continued down because the balance of the two was still in favor of the supply of money going up.
So the real interest rate going down. Follow with me. It's getting more relevant as we go along here.
Well, Nixon resigned and his vice president, Gerald Ford, moderate conservative, he was characterized as kind of a goofy guy.
He was very tall and he'd crack his head on airplane door ceilings and things like that.
But he understood that inflation was getting to be a problem.
But it was more of a problem than you would want to imagine because when expected inflation began to embed,
the Fed just printed more money to keep interest rates low. That balance up there on that top equation.
Gerald Ford was not a stupid man, but he thought that he could do some kind of a slogan to get people to stop raising prices,
to get companies to stop raising prices, to get unions to stop demanding wage increases.
So his program was called Whip Inflation Now. When?
Well, of course, a slogan isn't going to solve the problem.
So as expected inflation premium began to embed more, even more,
the Fed was correcting the risk free rate by just printing gobs more money to keep the interest rates low.
But it was getting harder because each round of the printing of money embedded expected inflation further.
So there was less and less effect from each printing of money.
Ford was defeated in 1976 at the election by a peanut farmer from Georgia named Jimmy Carter.
It's important to note that Jimmy Carter was also a nuclear physicist.
He understood what was actually happening.
But he also was a very, he didn't want to do what had to be done at first.
He did his own slogan. He said, I believe that this fight against inflation is the moral equivalent of war.
Now, if you work out moral equivalent of war, that has the acronym MEOW.
Most unfortunate, they have those marketing people in the White House.
And so the inflation rolled. Expected inflation became more embedded.
And the Fed was trying to print money, but interest rates were starting to slide upward,
stagnating the economy with inflation. So you got stagflation.
Carter actually was not stupid. He was a physicist for God's sake.
He understood the economics. He knew what was going on.
So in 1979, he appointed a new chairman of the Federal Reserve, who just passed on recently, of all things.
His name was Paul Volcker. Volcker was six feet some inches tall, 250 pounds of I don't give a shit.
He would literally, in that time, he smoked big cigars.
And if he didn't like you, he'd blow the smoke right in your face.
And he walked in there and he said, we are going to clamp down on the money supply.
We're going to crush it. We're going to deal with this.
Now, of course, the markets, yeah, yeah, sure, sure. Expected inflation skyrocketing.
But Volcker was actually cutting the money supply.
Markets didn't believe him. The markets did not believe him.
So they just kept embedding progressively higher expected inflation premium into interest rates,
which were already starting to skyrocket because the supply of money really was being cut.
And so we drifted on the verge of a terrible recession going into the 1980 election.
And Carter looked like an idiot. He looked like a fool.
You made it worse. Now we have these terribly high interest rates.
No one can buy a home.
Corporations are issuing bonds with coupons of 20 percent, for God's sake.
And inflation is rolling. Stagflation is everywhere.
So his opponent won. That opponent's name was Ronald Reagan, former governor of California
and a former movie actor and famous voice for cigarette advertisements.
Reagan won. But Volcker was in effect. And he was not going to let up.
It took probably about two years before Volcker, they answered,
Volcker was simply asking them the question, who's your daddy?
And finally the markets, and finally the expected inflation premium began to seep out in 81 and 82.
The economy began to pick up with a radical tax act that was passed, the Tax Reform Act of 1981.
And after a few years, finally the expected inflation premium began to give way.
And so over a period of the next few years, Volcker began to let up on the money supply a little bit
so that the real interest rate would come down as expected inflation premium was coming down.
That's what happens when you play around with the risk-free rate. It is a bitch.
And getting rid of that expected inflation premium, that's hard.
So let's reel forward to the second decade of the 21st century.
Specifically, we had a major crisis in 2008, which took until 2011, 2012, to fix with some big money.
But the Federal Reserve was holding monetary policy fairly tight.
Inflation was staying under control. Real interest rate was staying under control.
So interest rates in general were relatively stable.
And then problems started.
We enacted the former President Barack Obama was replaced by President Trump in the 2016 election.
In 2017, a major tax act, the deepest, strongest tax act in history was passed,
cutting the corporate tax rate down to 21% from the top marginal that was 39%.
And we went on from there.
So that was going to cause budget deficits, therefore larger and larger budget deficits.
Therefore, we would have to print some more money to try to monetize the shock of those deficits.
The Treasury was selling T-bills and Treasury notes and Treasury bonds.
So, of course, we were borrowing money.
And when you borrow money like that, it's going to cause interest rates to go up.
So the Fed countered that by printing money, and the Fed went to the Treasury auctions and bought the bills itself.
That was the start of the trouble.
And then we got into a mild recession in 2019, 2020.
Now, the Federal Reserve had been threatened by President Trump that he was going to fire the Board of Governors,
which most people say he can't do that, but it scared them enough.
They just started printing money just to keep that recession from getting too interfering too much with the 2020 election.
Then we had COVID, and the Fed printed money hand over fricking fist, making these PPP loans,
sending out COVID checks to everyone and his mother.
And that, of course, ballooned the deficits.
And in order to keep interest rates under control, the Fed printed money.
And hence, guess what happened?
We had that inflation that you saw in the last couple of years.
Well, fortunately, now the Fed this time said, we know where this is going, and it's not a good story.
So they started cracking down on interest rates, cracking down on the money supply, contracted interest rates,
popped through the roof, and of course, we had already gotten an expected inflation premium starting to embed.
And they got in front of it a lot faster this time than they did in the 1960s, 1970s cycle.
And so we got, we're able to get out of it a little faster now too.
So there you are. That's where we are at this point in time.
So this is why this is all relevant to you is so that you understand what the dynamics are of interest rates.
Before I even talk about other parts of interest rates, this risk-free rate is at the core of what we have to use in finance
for our understanding of where interest rates are going to go.
Because as interest rates go up, the present value of future expected cash flows goes down.
Make sure you know that because I'm going to ask that on a quiz and on exams.
When interest rates go up, you try it yourself with those spreadsheets.
Jack up the interest rate. What happens to the present value of future expected cash flows?
So that's an absolutely critical understanding that when we've, yeah.
As interest rates go up, the present value of future expected cash flows goes down.
When interest rates go up, the present value of future expected cash flows goes down.
It's a critical inverse relationship.
I'm allergic to macroeconomics.
So let's do this. Let me show you this.
And I'm taking you in deep. Deep enough that you, in one lecture, will know more than 99.5% of the ho handles out there in this country.
You know that it's not mysterious. It's technical.
And it is the intersection of the physics of money with political will and political challenges.
So here we go. Suppose that you have projects.
And you have the return on investment to these projects, ROI.
Projects A, B, and C.
Now the ROI of A is, let's say, 8%.
The ROI of B is 12%.
The ROI of C is 15%.
You follow?
Now suppose that the prevailing interest rate environment is at this risk level for money for these projects.
Let's say it's 6%.
Well, A is 8%, so yes.
B is 12%, oh yeah.
And 15% for C, yes.
We're going to take on all those projects.
We're going to accept all of them because they return more than the cost of the capital to cause them.
Now is what happens if the interest rates go to 10%.
Well, we still take C, yeah, 15, 12, yeah, we cost the capital, but A is gone.
Suppose interest rates now go to 14%.
Well, C is still there, but now B is gone, and obviously A is gone for good.
Do you see that driving interest rates upward, the cost of capital increases, and it makes fewer and fewer projects doable, profitable?
That's the important point here.
And there's even another nasty effect of this.
First of all, those projects aren't taken on, so obviously employment created by those projects won't happen.
The economy slows down and all that good stuff.
So you're slowing down the economy because the investments aren't as thick and rich.
But there's another nasty effect. If you look at those ROIs, remember that risk and return are directly related.
Do you see how as interest rates are rising, this company is being backed into a corner of risky projects?
Those are the only ones that work. Those are the only ones that are profitable.
So you're pushing companies to get rid of all the nice, steady, low-risk projects and go after only the projects that are risky.
Hence, more bankruptcies because risk sometimes means you get your butt kicked.
And that's what happened here. That's what happens every time.
That's why high interest rates are killers to an economy.
We want to keep interest rates in some stability so that we have that ability to forecast.
Look, if I see interest rates right now at 10%, but I am scared to death that they are going to rise,
I'm not even going to look at Project B because the expectation is that I will not ultimately clear my ROI hurdle with the cost of capital.
You follow with me? It's the expectation. So that's why we can't have instability in the political monetary world.
We need companies to have a certainty so that they can reach forward and know that a 12% project will be profitable.
So that they know that an 8% project will be profitable if interest rates are 6%.
That's where expectations drive us in finance. We can't look at history.
It tells us nothing about what is going to happen in front of us.
Okay, so anyway, you understand where I'm going with all of this.
And this takes you into the realm again, shaping you so that you understand that these aren't magical and mysterious and conspiracy and darkness.
It's all the mathematics and the dynamics and expectations.
And that is one of the things about becoming a world leader or a leader of industry, as you will.
It is that we have to be the adults at the table.
And we have to give the people their bread and circuses and keep them shut the hell up
while we manage the affairs of the economy, the state, and the corporate world.
That sounds harsh, but that's how it is. Now, what else is in here?
There is this... well, if all that matters is this substrate, then all interest rates would be R sub F.
But they are not, because on top of R sub F is this pack of risk premiums.
Premiums in modern language, since we don't use Latin. Risk premiums.
The risk premium. This is what causes interest rates to be different from one another.
It's because each one has a balance of these in it.
Now, I'm going to put these up here.
The first one is the default premium.
You have to add a little bit to every loan in case the borrower defaults.
Now, let's say that you have a mortgage loan, a home loan that carries a mortgage attachment to it.
That would have a low default premium, because even if you default, the bank has an asset recourse.
So the default premium would be pretty low on a home loan, simply because it's backed by an asset.
However, a credit card... you know why those rates are so stupid high?
There's nothing backing them. There's nothing at all.
So they have to just rely on you paying your credit card bill every month. Period.
So that's going to be a high default premium.
That's why a credit card interest rate is higher than a home mortgage loan interest rate.
The next one is the maturity premium.
This one is a volatility thing.
I'm a banker, and you succumb to me for a home loan.
Okay, we're going to charge you 6%.
What happens if in, let's say, five years, it's a 30-year loan, five years, interest rates fall to, on mortgages, fall to 3%?
What would you do with your home loan?
No, you'd refinance it at 3%.
Refi.
And I'm saying, well, you son of a bitch, I was expecting to get 6% for 30 years, and now I'm going to get only 3%.
So I'm going to charge you a little scratch for that possibility that you could screw me.
Sounds good?
Well, what about the other way?
Let's say that instead you got a 6% loan, and mortgage interest rates go up to 12%.
Well, you see, the average homeowner sells the home in about seven years and then gets a new loan.
But if interest rates go clear up to 12%, and you've got a 6% loan, you're not going to flip your house.
Even though now you have eight kids, your brother-in-law lives in the garage with his girlfriend,
and you've got some guy you don't even know who seems to be hanging around in the basement too much.
You've got three dogs, you used to have one dog, now you have three dogs that have four legs among the three of them.
But you've got a 6% loan, and if you sell that house and get another house, you're going to have to get 12%.
No, I'd love to have you do that.
If I get your money back, I'm going to lend it out 12%, but you say, oh, I know you don't, fat boy.
I'm going to stay here.
I'm just going to build another garage, a place where the dogs can stay and not have to run around hobbling.
Basically, the bravest dogs are not running around.
Well, they were.
Found some sticks that they could hold on to.
But you understand what I'm saying here is that no matter which way interest rates move, I'm screwed.
So if interest rates show volatility, I'm going to charge a larger maturity premium.
And another nasty fact, the farther out in time you go, the more likely an adverse event to me is going to happen.
Two years, three years, interest rates aren't going to move that much.
But in 30 years, yeah.
So the longer, that's why we call it a maturity premium, is because the longer the loan is, the more likely an adverse movement of interest rates is going to occur.
It is actually a principle of physics, and you see it all the time.
I had a car.
The tailpipe spewed out black smoke.
When it came out of the tailpipe, it was just like that.
But as it went down the road, everywhere, it backfired, too.
My daughter didn't want me to drop her off at school because she'd get out of the car and I'd make a backfire and she was humiliated.
Bam! Yay, all the other kids would say.
Anyway, you understand that it's just a gas diffusion principle.
As time goes on, the gas will diffuse, and that's what's happening with risk premium, the maturity premium.
It is just simply the fact that as time goes on, there are more events that have some probability of happening.
So in other words, a treasury bill, there's no default premium in government debt, but there is a maturity premium that gets bigger and bigger.
So the maturity premium in a 30-year treasury bond would be much, much larger than the maturity premium in a five-year bond.
And it would also have to do with how volatile we are perceiving future interest rates.
If we don't think they're going to spread too much over time, the maturity premium would calm down.
It would get bigger as time goes on, but it would do so at a slower rate.
But if we are in a high-volatility interest rate environment looking forward, then that maturity premium is going to start out wide and is going to get like that.
So that's the maturity premium. And then there's one last one called the illiquidity premium.
I used to call it the liquidity premium. We used to call it the liquidity premium.
It's just the fact that, and I think I already said this, loans like home loans.
You go to your bank, you get a mortgage, a loan with a mortgage for a house.
That bank doesn't keep that for more than a few hours usually.
It takes the loans, bundles them up, and sells them to a secondary mortgage market like Ginnie Mae, Fannie Mae, Freddie Mac, something like that.
So a CMO? Yeah. Yeah. Well, as a matter of fact, that's what backs those, is those giant packages of loans.
So in other words, home loans have high liquidity. They're easy to dump within hours.
But car loans, there's no such thing as that. They're stuck with them.
If a bank wanted to get rid of its car loans, they'd have to sell them at pennies on the dollar.
The same would be true for credit card debt, a lot of debt.
You see, banks really aren't in the business of loans.
It sounds, wait, wait, what do you mean by that? They are not.
They're in the business of originating the loans, and then they get rid of them, and all they do is then service the loans.
You say, oh, I sent my payment for my mortgage loan to my bank.
Well, yeah, but all they do is keep a little bit of it for their processing fees,
and then they send it on to the secondary mortgage market owner of the bond.
So that's one of those things that's kind of a little bit odd, is to think about the bank not as a lender in the old fashioned sense.
So the liquidity premium is there if a bank can't get rid of a loan easily.
And it's worse, the harder it would be for them to dump the loan.
I've given you enough. This is some good stuff to chew on. That's all I have for you today. I thank you.