Discount rate and interest relationship to stocks

Relationship between bond prices and interest rates (video) | Khan Academy

discount rate and interest relationship to stocks

If you want to become less dependent on stock-based investments, consider the following strategies. What is the relation between market rate and discount rate ? Views 10 Yr Bond issued todaycosts $ and pays $/yr interest. While most investors know that rate cuts usually help stock prices and rate. And since discount rates and present values are inversely related. Discount rate is the interest rate charged to commercial banks and other tiers of loans, and each of them uses a separate but related rate.

Relationship between bond prices and interest rates

Future cash flow and discount rate A deeper look at his rationale is thus important today. A stock is worth the present value of some stream of cash flows that it will produce in the future.

We can calculate this value by projecting out future free cash flows and discounting them back to present. The key variables, therefore, are the future free cash flow and the discount rate used in the calculation. If interest rates rise, so too should our discount rate since we would have more opportunities to do more with our money elsewhere.

And since discount rates and present values are inversely related, value will decline, all else equal, as the result of a rise in interest rates. From tothe stock market went exactly nowhere. In aggregate, no money was made by investors during this period. But yet GDP nearly quadrupled. How is this possible, you may ask. Well, also during this period, interest rates rose dramatically. The rate on long-term government bonds went from a mere 4. This had a devastating effect on stock prices.

discount rate and interest relationship to stocks

Then, as we are well aware, from stocks rose more than tenfold. This can easily be explained by the remarkable drop in interest rates — all the way from that GDP growth, by the way, was actually lower in this second period than it was in the first. This is why Buffett argued in that stocks could not do as well in the subsequent 17 years as it had in the previous.

Interest rates have gone up. Now, let's say you need cash and you come to me and you say, "Hey, Sal, are you willing to buy "this certificate off of me?

discount rate and interest relationship to stocks

I'll actually do the math with a simpler bond than one that pays coupons right after this, but I just want to give the intuitive sense. Or you could just essentially say that the bond would be trading at a discount to par. Bond would trade at a discount, at a discount to par.

Now, let's say the opposite happens. Let's say that interest rates go down.

How Interest Rates Impact Cash Flow Analysis

Let's say that we're in a situation where interest rates, interest rates go down. So how much could you sell this bond for? I'm not being precise with the math. I really just want to give you the gist of it.

discount rate and interest relationship to stocks

So now, I would pay more than par. Or, you would say that this bond is trading at a premium, a premium to par. So at least in the gut sense, when interest rates went up, people expect more from the bond.

  • The Relationship Between Bonds and Interest Rates

This bond isn't giving more, so the price will go down. Likewise, if interest rates go down, this bond is getting more than what people's expectations are, so people are willing to pay more for that bond.

The Relationship Between Bonds and Interest Rates- Wells Fargo Funds

Now let's actually do it with an actual, let's actually do the math to figure out the actual price that someone, a rational person would be willing to pay for a bond given what happens to interest rates. And to do this, I'm going to do what's called a zero-coupon bond.

I'm going to show you zero-coupon bond. Actually, the math is much simpler on this because you don't have to do it for all of the different coupons. You just have to look at the final payment.

There is no coupon. So if I were to draw a payout diagram, it would just look like this. This is one year. This is two years. Now let's say on day one, interest rates for a company like company A, this is company A's bonds, so this is starting off, so day one, day one. The way to think about it is let's P in this I'm going to do a little bit of math now, but hopefully it won't be too bad. Let's say P is the price that someone is willing to pay for a bond.

Let me just be very clear here. If you do the math here, you get P times 1. So what is this number right here? Let's get a calculator out.

Let's get the calculator out. If we have 1, divided by 1. Now, what happens if the interest rate goes up, let's say, the very next day? And I'm not going to be very specific.