Interest Rate

1. Definition

The Interest Rate is the "Price of Money." * It is the amount charged by a lender to a borrower for the use of assets, expressed as a percentage of the principal. * Concept: It represents the "Cost of Time." If you want to spend money now that you don't have, you must pay for that privilege.

2. The Gravity of Finance

Financial gurus often compare interest rates to gravity. * High Rates: Increase the gravitational pull on asset valuations. The present value of future cash flows decreases, causing stock and real estate prices to fall. * Low Rates: Weaken gravity. Asset prices float upward, often creating bubbles.

3. Real vs. Nominal

• Nominal Rate: The stated interest rate you see at the bank (e.g., 5%).
• Real Rate: The Nominal Rate minus Inflation.
  • $$Real\ Rate \approx Nominal\ Rate - Inflation$$
  • If the Real Rate is negative, cash holders are penalized, and borrowers are rewarded.

4. The Bond See-Saw

There is a mathematically strictly inverse relationship between interest rates and bond prices. * Rates Up $\rightarrow$ Prices Down: Existing bonds with lower coupons become less attractive, so their price must drop to offer a competitive yield. * Rates Down $\rightarrow$ Prices Up: Existing bonds with higher coupons become more valuable.