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discussion post to the three videos
(1.5 hours) These video lessons allow students to connect the dots between theory and practice by reading short passages, watching videos, and practicing what they’ve learned. The topics include inflation and interest rates (40 min), pure expectations theory (35 min), and real risk-free rate (15 min).
Video 1
Nominal and real interest rates. First off, nominal interest rates. Nominal interest rates are the interest rates that you see in the market. Alright? That’s like how much you’re paid on a bank CD or what the coupon rate on a bond is or something like that. While those are useful, you’ve got to be careful because what you really want to concentrate on are not nominal interest rates, but real interest rates. Real interest rates are the nominal interest rates, but then minus the inflation rate. So the real interest rate gets you to the true kind of rate of return once you adjust for inflation. Alright. So you see why this is important, think about how distortionary inflation could be. Alright. You could have a nominal interest rate on, say, a bank savings account of five percent. You think that you’re doing pretty well. Your money’s growing by five percent. Yeah, but not really. If the inflation rate is at four percent, then what happens is your real interest rate — the real rate of return, again, once it adjusts for inflation — is only one percent. Or think about what happens if that nominal rate is five percent and the inflation rate turns out to be six percent. Then you get a negative real interest rate. What that means is in real terms, when adjusted for inflation, the value of your money is actually falling. Even though you may have a positive nominal interest rate, the real interest rate can actually be negative. So that’s why it’s important to understand the difference between nominal and real interest rates.
Video 2
The pure expectations theory is used to try to explain the yield curve. Here’s the basic idea. The pure expectations theory says that the yield on longer-term bonds is made up of what the market expects the yield to be on shorter-term bonds in the future. All right, to see how this works, think of a very simple example. All right, think about a two-year bond, right? You could buy a two-year bond, hold the thing to maturity. Or what you could do is you could hold a sequence of two one-year bonds. All right? So to make you indifferent between the yield on a two-year bond and the two consecutive one-year bonds, uh-uh — yields have to be the same. So think about holding two consecutive one-year bonds. All right, you’ve got the yield on a one-year bond today, plus then, you have the expectation of what you think the one-year bond is going to pay in the one year from now. So the average of those two things, the average of what the one-year pays today and what you think the one-year is going to pay in one year, the average of those two things has to equal the two-year bond, right, to make you indifferent. So what, then, determines the yield on the two-year bond? Well, it is the yield on the one-year bond plus what you expect the one-year bond to pay in the one year. And that is the idea of the pure expectations theory, that the yield on longer-term bonds is made up in great part by what we expect short-term bonds to pay in the future.
Video 3
You read in The Wall Street Journal that 30-day Treasury bills are currently yielding 5.8%. Your brother-in-law, a broker at Safe and Sound Securities, has given you the following estimates of current interest rate premiums. Inflation premium, 3.25%; liquidity premium, 0.6%; maturity risk premium, 1.85%; default risk premium, 2.15%. On the basis of these data, what is the real risk-free rate of return? The real risk-free rate of return would be the interest rate that would exist on default-free U.S. Treasury securities if no inflation were expected. That is, the real risk-free rate is equal to the nominal risk-free rate minus any expected inflation. We are given the 30-day Treasury bill is yielding 5.8%. We will use the 30-day Treasury bill to approximate the short-term risk-free rate. So the nominal risk-free rate is 5.8%. The inflation premium is given at 3.25%. Therefore, the real risk-free rate is equal to the nominal risk-free rate minus the inflation premium, which gives us a real risk-free rate of 2.55%.
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