interest rates

freeze4real

hello guys

I have been having problems understanding the concept of interest rates.

how do interest rates affect money in general ?

later12

Could you be a little more specific in terms of what is troubling you?

At a very basic level, the interest rate set by a Central Bank is what essentially controls the money supply.

In theory, increased interest rates lead to a lower demand for money, lower supply of money and ultimately deflation or disinflation.
You can also work it the other way around, with an lower interest rate and an increased supply of money.

That's just line 1, paragraph 1, though. Maybe you could specify your query.

freeze4real

thanks for that I just wanted to know how it affected demand for money and supply of money.

whats the effect of interest rates on bonds. I know they move in opposite in direction.

andrew

The interest rate is the 'opportunity cost' of holding cash. If you've say 100 euro, then you've a choice. Either you can hold that 100 euro as cash, or you can keep it in the bank. When it's in the bank, it earns interest for you, but when it's cash it doesn't earn interest. So if you've decided to hold cash, you're forgoing the interest you could've earned on it.

When you think about it like this, the consequences of a change in the interest rate for the quantity of money demanded make sense. When they go up, people will hold less money, and when they go down, people will hold more money. Similarly, when the interest rate is high banks will keep their money on reserve with the central bank and so the quantity of money supplied will be lower, and when it's low banks will lend out more money in order to try to make a higher profit on their holdings.

The reality, of course, is more complicated; a change in the interest rate has many different effects; I can explain more if you like though. What level of economics do you have already (if any).


Regarding bonds:

If you buy a bond and hold it to maturity, you get the face value of that bond plus interest. The interest is earned on the face value of the bond; if you buy a €100 bond at a 5% interest rate, you get back €105 when it matures.

But lets say you want to sell that bond. And the most someone will offer you for it is €60. If you sell it, the recipient will end up with €105, a profit of €45, or 75%. So the interest rate on this bond is now 75%. So when the price goes down, the interest rate goes up, to reflect the fact that the profit on holding the bond has now risen. The opposite is true also.*

*I'm not 100% sure on all of this, but I'm pretty sure this is how it works.

krd

andrew wrote: »

If you buy a bond and hold it to maturity, you get the face value of that bond plus interest. The interest is earned on the face value of the bond; if you buy a €100 bond at a 5% interest rate, you get back €105 when it matures.

But lets say you want to sell that bond. And the most someone will offer you for it is €60. If you sell it, the recipient will end up with €105, a profit of €45, or 75%. So the interest rate on this bond is now 75%. So when the price goes down, the interest rate goes up, to reflect the fact that the profit on holding the bond has now risen. The opposite is true also.*

*I'm not 100% sure on all of this, but I'm pretty sure this is how it works.

No. When bonds are issued first, usually/always through a bank (after the 2008 crash the bankers made huge bonuses selling the government bonds issued to bail them out - haw haw - jam on both sides of their bread), the government offers an interest rate (coupon) on the bond. This could be 5%. So a one year bond (€100) on maturity, will pay out €105. At the first issue, whoever wants to buy the bond buys them. The interest rate will be decide before the issue - the idea should be to set it at the minimum the market can bear.

Then the bonds can either be held or they can enter the secondary market.

Bonds on the secondary market are always traded at a discount.

If the country looks credit worthy - if it doesn't look like it's going to default - then the discount is really small. A bond with a maturity value of €105, might trade for €104.5 or even €104.995. It depends on a lot of things - how close to maturity etc.

If once the bonds are in the secondary market - and the country looks like it could default. People holding the bonds may want to cut their losses and run.

They may then offer these bonds at a huge discount. A bond with a €105, for €50.

If you buy the bond at €50, and it matures and pays out, your return is over 50%........There is a risk you'll get nothing.

This situation is really bad for the country borrowing - the country whose bond it is. As they have to issue more bonds. Countries generally roll over their debt, just paying the interest and covering the principle with new bond issues.

If the market is trading bonds at €50 for bond €100 with a %5 coupon - that €50 difference is the price the market is putting on the risk.

So, for the next round of bonds the country must offer at least 55% coupon for their €100 bond....... they have to offer to payout €155. And that's the kind of trouble Greece and elsewhere are in - it's the kind of trouble Ireland has been in and why we have the IMF.

There's also a market in bond insurance - derivatives that are insurance against a bond defaulting. All the stuff you hear about Ireland or Greece's borrowing rate jumping up and down is based on calculating the rate, accounting for how much insurance is being demanded to insure a bond. I'm not sure of the precise calculation, but it's something like: If they're looking for 2% of the face value of a bond to insure it, and the bond is 105% - effectively the issue of the next bond must be at least 107.1%. IF - efficient markets theory is to be believed - that 2.1% is the price of the risk.

andrew

krd wrote: »

No. When bonds are issued first, usually/always through a bank (after the 2008 crash the bankers made huge bonuses selling the government bonds issued to bail them out - haw haw - jam on both sides of their bread), the government offers an interest rate (coupon) on the bond. This could be 5%. So a one year bond (€100) on maturity, will pay out €105. At the first issue, whoever wants to buy the bond buys them. The interest rate will be decide before the issue - the idea should be to set it at the minimum the market can bear.

Then the bonds can either be held or they can enter the secondary market.

Bonds on the secondary market are always traded at a discount.

If the country looks credit worthy - if it doesn't look like it's going to default - then the discount is really small. A bond with a maturity value of €105, might trade for €104.5 or even €104.995. It depends on a lot of things - how close to maturity etc.

If once the bonds are in the secondary market - and the country looks like it could default. People holding the bonds may want to cut their losses and run.

They may then offer these bonds at a huge discount. A bond with a €105, for €50.

If you buy the bond at €50, and it matures and pays out, your return is over 50%........There is a risk you'll get nothing.

This situation is really bad for the country borrowing - the country whose bond it is. As they have to issue more bonds. Countries generally roll over their debt, just paying the interest and covering the principle with new bond issues.

If the market is trading bonds at €50 for bond €100 with a %5 coupon - that €50 difference is the price the market is putting on the risk.

So, for the next round of bonds the country must offer at least 55% coupon for their €100 bond....... they have to offer to payout €155. And that's the kind of trouble Greece and elsewhere are in - it's the kind of trouble Ireland has been in and why we have the IMF.

There's also a market in bond insurance - derivatives that are insurance against a bond defaulting. All the stuff you hear about Ireland or Greece's borrowing rate jumping up and down is based on calculating the rate, accounting for how much insurance is being demanded to insure a bond. I'm not sure of the precise calculation, but it's something like: If they're looking for 2% of the face value of a bond to insure it, and the bond is 105% - effectively the issue of the next bond must be at least 107.1%. IF - efficient markets theory is to be believed - that 2.1% is the price of the risk.

Ah, so when it's said that the interest rate on bonds has gone up, it's only on new bonds, not currently issued ones. I probably should have known that

freeze4real

thanks for the help guys.

SBWife

krd wrote: »

Then the bonds can either be held or they can enter the secondary market.

Bonds on the secondary market are always traded at a discount.

That is incorrect. Bonds can trade at face value, at a discount or at a premium.

The price depends on how both the level of interest rates in general and the credit risk of the issuer have changed since the bond has been issued.

All else being equal a decline in the risk-free rate after a bond has been issued will result in it trading at a premium and an increase in the risk-free rate will result in a discount from face value.

In a static environment a bond should move towards its principal plus coupon value as the coupon date approaches.

When they talk about the interest rate increasing on bonds what they normally mean is the current yield. This is the amount the bond will pay out divided by the current price. In theory if the issuer where to return to the market and issue more debt this is the interest rate that they would have to issue the debt at, it may not actually be the case in reality in particular for countries like Ireland. Irish debt is quite illiquid so if there is a large seller the yield can increase dramatically in a short period of time.