By: Julio Perez, Fall 2017 IAC Graduate Research Assistant
I have talked about “risk” so much in this blog series that I’m starting to develop semantic saturation, but, unsurprisingly, it is hard to talk about the difference between low and high interest rates without talking about risks.
The shortest yet least elucidating definition for interest rate I could find describes it as “the price paid for borrowing money expressed as a percentage rate over a period of time.” This definition is much clearer if you read it, not from the point of view of the investor, but of the entity you are investing in. Interest rates apply to you when you are lending money (by taking out a bond, for example). I guess it also does when you are borrowing, but let’s focus on investing.
Let’s imagine you are taking out a bond from the government. As previously explained, bonds are IOUs, and when the government hands you a bond, they promise to pay you back for the money you have lent them. But the bond isn’t promising just to pay you back what you initially gave the government, otherwise there is no incentive for you to put $20 at risk just to get $20 back later (technically less than $20, since your $20 tomorrow will be worth less than your $20 today).
This is when interest rates come in. To get you to lend them your $20, the government pays the price as a borrower in the form of an interest rate set (or not) at a certain percentage. At the end of the time period, they return to you your initial $20 and that additional promised percentage.
The “price paid” representation is also an effective method of explaining risk. Since it is the government lending you money, you have a fairly safe expectation that they will pay you back what they promised by the time they promised (insert joke of having bigger problems if the government is unable to pay back your $20). Due to that safety, the government will promise you a modest interest rate for your loan, partly because your own risk in the matter is so low and because if you think the rate is too low the government can easily take it to another investor willing to take out the safe bond.
If, on the other hand, you want to take a bond out from “Shady, Sketch & Iffy, LLC” then you will be taking a much bigger risk on your $20, with the possibility you might not see a single penny in the future. Since you are already so opposed to lending your money to the LLC, they have to entice you with a much larger interest rate than the government, especially since not many other investors are considering taking out their bonds and they don’t want to risk turning you away.
Something else for investors to consider is “interest rate risk.” This phenomenon can be described as follows: when interest rates rise, bond prices fall, and when interest rates fall, bond prices rise. This trend is largely based on the actions of the Federal Reserve which raises or lowers interest rates depending on the economic panorama. The Fed also sells bonds to banks, and price the bonds according to the current interest rate. This means that if you buy a bond at a 5 percent rate and rates go up to 7 percent next month, your bond became less appealing to buyers. If, on the other hand, the interest rate drops, the price on your bond rises, becomes more desirable, and suddenly you can sell your bond at a premium and make a profit.
Although bonds and interest rates pay off in different ways than the stocks we have been examining, the concept of risk still pervades: the bigger the risk you taken on, the more you are willing to win or lose when investing.
Translated: “I lent a shady company a lot of money, but they promised to pay me back double in three months! If they pay me back…”