Real Interest Rates & Stocks and other assets

inflation-indexed securities

offer opportunities to borrow & lend in real rather than nominal terms

investors purchase shares to..

own a piece of the corporations and make some claim on its profits

because of the additional erosion of returns due to taxes,

people save & invest less when inflation is high than when inflation is low

realized real interest rate or the ex-post real interest rate

the nominal interest rate adjusted for actual inflation; also called the ex-post real interest rate

expected real interest rate

the nominal interest rate adjusted for expected inflation; also called the ex-ante real interest rate

Real interest rate

the nominal interest rate adjusted for expected or actual inflation (over the period until the debt security matures)

capital gains yield

the percentage increase in the price of the stock

anticipated inflation affects

the prices of goods, as well as the number of dollars a security pays, but not any inflation adjusted amount. that is, dollar payments adjust to the same change in the inflation rate

can distortions of taxes be eliminated?

Impose taxes on real interest income - calculations can be difficult Reduce inflation to zero - though progress has been made, seems unlikely

well known stock indexes

- Dow Jones Industrial Average - Standard and poor's 500 - Russell 2000 - Wilshire 5000

how inflation-indexed securities work

- a fixed real payment until maturity is guaranteed on purchase - nominal value of the principal increases with inflation - value of the principal is adjusted & interest is paid every six months

Prices are somewhat predictable..

- a significant relationship exists between a stock's return from one week to the next - movements in share price are relatively greater than changes in earnings - high returns in one period are associated with low returns in others

forecasts of the future inflation rates by economists are useful & with them one can calculate

- expected real interest rates - realized real interest rates

advantages of dividends

- generation of cash flow for the investor (selling shares may be both inconvenient & costly) - reassurance for investors of company's cash flow position

Disadvantages of dividends

- investors must pay taxes on dividends earned - less incentive for companies to pay out dividends (though tax burden was lowered in 2003)

two factors that may cause changes in expected real interest rates

1) changes in the expected inflation rate 2) changes in phase of business cycles

profits help shareholders in two ways

1) the firm may pay out part of its profits in the form of dividends 2) the firm may retain profits to use for investment in capital improvements, intended to lead to even more profits in the long run

investors deplore inflation for 2 reasons

1) the value of their returns is reduced by inflation 2) the predictability of inflation increases the risk to the real return on their investments

The fisher hypothesis

A rise in the expected inflation rates lead to a rise in the nominal interest rates, while expected real interest rates remain the same

stock index

a number that represents the average price of a (specific) collection of stocks, such as the Dow

adjustable rate mortgages

allow interest rates on a loan to adjust as market interest rates change

real present value

allows the concept of "real interest rates" to be applied to past returns, expected returns, & yields to maturity.

like inflation, taxes

also reduce the returns of investors

index funds

are a special type of mutual fund which try to mimic a particular stock index

mutual funds

are companies that pool the funds of many investors and buy large numbers of different securities, are a way for investors to diversify

shareholders (or stockholders)

are investors who own shares of stock in a corporation

implicit capital gains

are subject to more favorable tax treatment as a result, incentivizing investors to hold shares longer, known as the lock in effect

the risk to real return

can be expressed as the standard deviation faced by the investor

realized real interest rate =

nominal interest rate - actual inflation rate

the lock in effect causes

distortions in the prices of stocks by reducing trading that might otherwise occur more frequently

two components to an investors total return on stock ownership

dividend yield and capital gains yield

when accounting for inflation,

effective real tax rates are much higher than stated tax rates

A stock exchange ( or stock market)

facilitates the interaction of stockholders selling their shares. They may exist physically or virtually

past inflation discount factor

for every dollar's worth of goods bought at an earlier date, how much money would it take now to buy the same amount of goods after N years of inflation rate

future inflation discount factor

for every dollar's worth of goods bought today, how much money will it take in N years to buy the same amount of goods when the average future inflation rate is (pie)e

lower than expected inflation

hurts the borrower and helps the lender, who is paid back in dollars worth more than they had predicted when making the loan.

Higher than expected inflation

hurts the lender and helps the borrower, who pays back their loan with dollars worth less than those they originally spent.

expected real interest rate =

nominal interest rate - expected inflation rate

anomalies

incidents of predictable patterns to stock prices that investors could exploit, even accounting for risk aversion

efficient market hypothesis

is the idea that stock prices fully reflect all available info at any given point -assumes stock markets are both deep (many buyers & sellers) and liquid (easy to buy or sell) -as soon as new info becomes available about a company, the supply &/or demand for its stock are immediately affected

the importance of profits

the main incentive for buying stock is the belief in the company's profitability

reducing inflation

leads to large social benefits

the riskiness of inflation

matters just as much as the rate of inflation to investors

demand and supply for debt securities depends

more on after-tax expected real interest rates than before-tax expected real interest rates

after-tax realized real interest rates have often been

negative, discouraging saving & investing and slowing economic growth

investors must also pay taxes on....

realized capital gains

when actual inflation is greater than expected

realized real rates decrease

when actual inflation is less than expected

realized real rates increase

higher tax rates

reduce economic efficiency

higher standard deviations

signify higher risk of inflation, & hence higher risk to real returns

indexes report only...

stock price, ignoring both returns and dividends

indexes tend to be more..

tandem, but often show markedly different total returns

dividend yield

the amount of divdend's paid divided by the share price

Nominal interest rate

the amount of interest paid expressed as a percentage of the principal

when actual & expected inflation differ

the expected real rate differs from the realized real rate

random walk

the idea that movements of stock prices from day to day, year to year, or decade to decade are not predictable

corporations issue shares of stock...

to raise funds to invest in the business

data on nominal interest rates & actual inflation rates are easily obtainable,

while measuring expected inflation rates is more difficult