Discount Rate


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Discount Rate

  1. 1. Discount Rate Determinants 1 Determinants of the Discount Rate Financial Investments Professor Finnie BUSA 335 Greg Wittreich Max McKay
  2. 2. Discount Rate Determinants 2 Determining forces that affect interest rates is a complex route that takes a developed understanding of several different factors. Investors must not get caught up in following crowds and listening to others proclaiming knowledge of forces that affect these rates. Investor must start to research and investigate empirical data in order to apprehend market behavior. Only then can one be truly successful and understand how the market really works. When looking at empirical data, we found a number of factors that, in some way, influence each other. Interest rates, inflation, unemployment, savings rates, the CPI index, S&P indexes and many other factors are all connected, as each component has its own definite affect on the market. To help make sense of this system, we have put it into a cycle to show the influence of interest rates, and the various determinants that affect interest rates. We start the cycle at a time when interest rates are low. When this occurs, people are willing to buy many goods and services that they may or may not need. With lower interest rates, burrowing increases and savings decrease. Consumers often see this time
  3. 3. Discount Rate Determinants 3 as a booming economy because unemployment is low and businesses are burrowing money to expand. A large amount of spending equates to an increase in demand of goods to buy. If the increase in demand exceeds the increase in supply of the goods, then the price of those goods will ultimately rise. This sequence of events temporarily increases inflation and the price of goods and services. This small cycle is illustrated in the first chart. In the long run, inflation drives interest rates up causing the prices to fall back down again. After inflation increases, people become apprehensive of whether or not they should buy as many goods and services. Banks then raise nominal interest rates to offset rising inflation and induce consumers to save money. In the short term, people save more and burrow less as the nominal rate increases. Consequently, as inflation continues to increase, the real rate falls and investors are actually losing money that they think is earning interest from higher nominal rates. Despite empirical data that proves this, people continue to put their money into banks under these circumstances. The following graphs illustrate the relationship between increased inflation and Nominal rate v. Inflation nominal rates, and the effects it 16.00 has on consumer savings. 14.00 12.00 Nominal Rate 10-year T-bond (%) 10.00 8.00 Linear (10-year T- 6.00 bond (%)) 4.00 2.00 0.00 R2 = 0.3856 0 5 10 15 20 Inflation
  4. 4. Discount Rate Determinants 4 As investors notice the rise in nominal bond rates, they begin to pull money out of the stock market and invest in bonds. If the bond rate increase to a point where the return percentage is close to the return percentage of the stock market, investors’ pull their money out of the stock market due to the higher risk associated with stocks. If investors can get the same, or near the same return in bonds, which incur less risk, they will opt to invest in bonds rather than stocks. The ten-year bond rate percentage, and its correlation to the price adjusted S&P is illustrated in the graph below. The S&P (Standard and Poor) is a financial services company that rates stocks in an index, according to risk Personal Savings rate v. 10 yr. bond profiles. The lower the 14.00 12.00 Personal savings rate 10.00 bond rate, the more people 8.00 Personal Savings Rate 6.00 (%) invest in the stock market. 4.00 2.00 0.00 The negative side to 0.00 5.00 10.00 15.00 20.00 -2.00 10 yr. bond the increase in nominal savings rates is that it is supplemented by a rise in rates at which loans are given out. 10yr Bond v. Price Adjusted S&P 1800.00 1600.00 Price Adjusted S&P 1400.00 1200.00 1000.00 10-year T-bond (%) 800.00 600.00 400.00 200.00 0.00 0.00 5.00 10.00 15.00 20.00 10 yr bond
  5. 5. Discount Rate Determinants 5 If the bank is going to increase the rate they give you for loaning them money, then the bank is also going to increase the rate for people wanting to take out a loan. When the interest rates increase, the economy begins to slow down. This is also known as deflation. Businesses are now squeezed to make large purchases, like new buildings, because of high interest charges. Similarly, consumers are unable to purchase homes as easily because the increase in interest rates. In this case, people begin to save more and burrow less. Essentially, businesses start to lose money because they cannot grow and expand operations, instigating a cutback in employees. This ultimately generates an increase in unemployment. The below chart depicts the inverse relationship between unemployment and inflation. In this chart, named the Phillips Curve, the line shows that as inflation increases, unemployment also increases. Inflation leads to the increase in interest rates, which creates more savings, which in turn slows business and creates an increase in unemployment. Following the increase in unemployment, consumer spending falls
  6. 6. Discount Rate Determinants 6 as people are trying to hold onto their money. As people save, the demand for goods goes down. Prices then start dropping because of the decrease in demand. When the demand falls, the rate of inflation slows back down. And the whole cycle starts over. The research collected and shown here proves that there are many intertwining factors that affect interest rates, and the unyielding influence interest rates have in the economy. The cycle shows how important different factors are in the market. Mistakes can easily be repeated if not studied and learned from. Although inflation may be considered harmful, it is important to not that without a small steady rate of inflation, the economy would become completely stagnant. Understanding the correlation between inflation and interest rates is essential in understanding market behavior. If investors are able to identify patterns and trends taken from historical data and invest before others catch on, success will follow. In conforming with others, return on investments may directly be affected by the perception of the very people you followed.
  7. 7. Discount Rate Determinants 7