3

I was reading an article that says "Interest rates play an essential role in financial markets. Foremost, they represent the rate at which investors discount risk-free as well as risky future cash flows." and I don't get what "discount risk-free as well as risky future cash flow" means.

Also, is it true that controlling interest rates is one of the few instruments a central bank has to avoid economy burnout (i.e. companies contracting ever growing debt stimulated by low interest rates) ?

2

As @Chris Degnen says - it is kind of the opposite of an iterest rate. Lets see if I can give you some more intuition on this.

Risk-free rate and risk premium

Imagine you are making an investmenet, lending money or whatever. You are doing it so that you get back more money than you lent - otherwise why would you.

The interest rate you want to charge has two components - the time-value of money and the risk. Imagine you had absolute certainty that you would be paid back the same value - you would still want some rate of interest - what would be called the "risk-free" rate.

If the is some risk about the value you well get back - from currency fluctuations, default risk, uncertainty over profits, uncertainty over inflation, etc you will also want a 'risk premium' on top of the 'risk-free rate' to compensate you for the risk you are bearing. The greater the risk the greater the premium.

The actual levels of risk premium and risk-free rate are set by the interaction of investors and investees in the financial markets.

Discounting

If you were asked for 25% interest to borrow £10 for a year you would have to repay £12.50 in the future. i.e. £10 x (1 + 25%)

The flip side is that the value to me NOW of £10 next year is £10/(1+25%) = £8.0 because I could conceptually invest £8 at 25% and have £10 next year. The PRESENT VALUE of £10 one year from now is only £8 - it is valued at a discount. The rate at which it is reduced is called the "discount rate". The further into the future we go, the greater the extent to which value is discounted.

Effect on capital investment

A higher discount rate is like a higher interest rate. Returns on new investment have to be higher and sooner to make sense. Low discount rates mean longer lower return projects become worthwhile, so companies will take on more debt to fund these projects.

The bank lending rates, driven by central bank lending rates are key drivers of company investment as they can borrow money to fund more projects if they think the return exceed the cost of borrowed capital.

So increasing central bank lending rates means that companies will reduce long term low return projects, and reduce the level of debt they take on.

  • So if I understand correctly debt is discounted using the sane rates and it gives a measure of how borrowed money is being eaten away by the applied requested rates – noplace Oct 15 at 21:29
  • Maybe. Not 100% sure what you mean. Discounted cash flows are about how money you get in the future is less valuable too you than money you have now, essentially because you can't make any return on the money you don't have yet but can make a return on the money you have. – Duke Bouvier Oct 16 at 1:44
3

Discounting is simply the opposite of applying interest. Whereas applying interest finds the future value (FV) of an amount, discounting finds the net present value (NPV) of a future amount.

FV  = $100 (1 + 10%) = $110
NPV = $110/(1 + 10%) = $100

Raising interest rates suppresses economic activity, but according to the Economic Policy Institute ...

The wrong tool for the right job

The Fed shouldn’t raise interest rates to manage asset bubbles

Policymakers should stop invoking asset bubbles as an argument for raising interest rates. There are better tools for deflating asset bubbles before they grow big enough to damage the economy:

  • Communications. The Fed can issue statements warning of an asset bubble ...

  • Deleveraging. The Fed and other regulators ... could require that potential buyers front more of their own money ...

  • Supervision. The Fed could require that financial institutions be prudently managed. ...

0

The risk free simply means that an entity is always paying you back no matter what (safest investment an investor can make)- so think government bond when you hear risk free. The federal gov- in the u.s.of-.a has AAA bond rating (meaning that they are good for paying your investment back with interest), and therefore the rate paid on the bonds is 4.25%; this is the equivalent of the risk free rate (could be another asset too, treasury 30 yr bond. Search the Fred site, and you'll see a few examples of how to get the R.F rate.

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service, privacy policy and cookie policy

Not the answer you're looking for? Browse other questions tagged or ask your own question.