Interest Rates

Interest rates are the price of borrowing money — and they're one of the most important factors affecting securities prices. Understanding how rates work and how they impact investments is crucial for the SIE exam.

What Are Interest Rates?

An interest rate is the cost of borrowing money, expressed as a percentage of the principal. It's also the return earned by lenders for providing funds.

Key Interest Rates

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The Federal Funds Rate

The federal funds rate is the benchmark for short-term interest rates in the U.S. economy. The Fed sets a target range, and banks trade reserves to stay within it.

How It Influences Other Rates

1. Fed sets federal funds target
2. Prime rate typically = Fed funds + 3%
3. Other rates adjust accordingly
4. Eventually affects mortgages, car loans, credit cards, and business loans

Example Rate Chain

If Fed funds target is 5.25-5.50%:

• Prime rate ≈ 8.50%
• Credit cards ≈ Prime + 10-15%
• Mortgages influenced by longer-term Treasury rates

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Interest Rates and Bond Prices

This is one of the most important relationships in finance:

Bond prices and interest rates move in opposite directions.

Why the Inverse Relationship?

When interest rates rise:

1. New bonds are issued with higher coupon rates
2. Existing bonds (with lower coupons) become less attractive
3. Existing bond prices must fall to offer competitive yields

When interest rates fall:

1. New bonds are issued with lower coupon rates
2. Existing bonds (with higher coupons) become more attractive
3. Existing bond prices rise

Example

You own a bond paying 4% interest. If new bonds start paying 5%:

• Who would pay full price for your 4% bond?
• Your bond's price must drop until its yield matches 5%

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Duration: Measuring Rate Sensitivity

Duration measures how sensitive a bond's price is to interest rate changes.

Rule of Thumb

For every 1% change in interest rates, a bond's price changes approximately equal to its duration:

• 5-year duration bond → ~5% price change per 1% rate change
• 10-year duration bond → ~10% price change per 1% rate change

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The Yield Curve

The yield curve plots interest rates across different maturities, typically using Treasury securities.

Types of Yield Curves

Why It Matters

• Normal curve: Investors demand higher rates for longer commitments (time value of money)
• Inverted curve: Investors expect future rates to fall (often preceding recessions)
• Historically: Inverted yield curves have preceded most U.S. recessions

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Real vs. Nominal Interest Rates

Example

If your bond pays 5% (nominal) and inflation is 3%:

• Real return = 5% - 3% = 2%
• Your purchasing power only grows 2%

Why Real Rates Matter

• Investors care about purchasing power, not just dollars
• Negative real rates (inflation > nominal rate) erode wealth
• Real rates influence investment decisions

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Interest Rates and Stock Prices

Interest rates affect stocks through multiple channels:

Sector Sensitivity

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Inflation and Interest Rates

Inflation and interest rates are closely linked:

The Relationship

• High inflation → Fed raises rates to cool economy
• Low inflation → Fed can lower rates to stimulate growth
• Deflation → Rates may go to zero or negative

Inflation Expectations

Bond yields incorporate expected inflation:

• If investors expect 3% inflation, they demand at least 3% yield
• Real yield = Nominal yield - Expected inflation

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Interest Rate Risk

Interest rate risk is the risk that changes in rates will affect investment values.

Who Faces Interest Rate Risk?

Managing Interest Rate Risk

• Shorter duration bonds — Less price volatility
• Floating rate securities — Rates adjust with market
• Laddering — Spread maturities across time
• Diversification — Mix of rate-sensitive and less-sensitive investments

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Key Takeaways

• Interest rates are the price of borrowing money
• Bond prices move inversely to interest rates
• Duration measures a bond's sensitivity to rate changes
• The yield curve shows rates across different maturities
• An inverted yield curve often signals recession ahead
• Real interest rates account for inflation
• Interest rates affect both stocks and bonds, often in opposite ways