[Joseph_E._Stiglitz,_Carl_E._Walsh]_Economics(Bookos.org) (1)

Internet Connection
CALCULATING INTEREST RATES
The Federal Reserve Banks of New York and Chicago have
Web sites that explain how interest rates are calculated. Their
addresses are www.ny.frb.org/education/calc.html#calc and
www.chicagofed.org/consumer_information/abcs_of_figuring_
interest.cfm.
BONDS
Bonds are a way for corporations and government to borrow. The borrower—whether
a company, a state, a school district, or the U.S. government—promises to pay the
lender (the purchaser of the bond, or investor) a fixed amount in a specified number
of years. In addition, the borrower agrees to pay the lender each year a fixed return
on the amount borrowed. Thus, if the interest rate on a ten-year bond is 10 percent,
a $10,000 bond will pay the lender $1,000 every year, and $10,000 at the end of ten
years. The date on which a loan or bond is to be paid in full is called its maturity.
Bonds that mature within a few years are called short-term bonds; those that mature
in more than ten years are called long-term bonds. A long-term government bond
may have a maturity of twenty or even thirty years.
Bonds may seem relatively safe, because the investor knows what amounts will
be paid. But consider a corporate bond that promises to pay $10,000 in ten years
and pays $1,000 every year until then. Imagine that an investor buys the bond, collects
interest for a couple of years, and then realizes that he needs cash and wants
to sell the bond. There is no guarantee that he will get $10,000 for it. He may get
more and he may get less. If the market interest rate has fallen to 5 percent since
the original bond was issued, a new $10,000 bond now would pay only $500 a year.
Clearly, the original bond, which pays $1,000 a year, is worth considerably more.
Thus, a decline in the interest rate leads to a rise in the value of bonds; and by
the same logic, a rise in the interest rate leads to a decline in the value of bonds.
This uncertainty about market value is what makes long-term bonds risky. 1
Even if the investor holds the bond to maturity, that is, until the date at which it
pays the promised $10,000, there is still a risk, since he cannot know for sure what
$10,000 will purchase ten years from now. If the general level of prices increases at
1 The market price of the bond will equal the percent discounted value of what it pays. For instance, a 3-year
bond that pays $10 per year each of 2 years and $110 at the end of the 3rd year has a value of
10
1 + r + 10
+ 110
,
(1 + r) 2 (1 + r) 3
where r is the market rate of interest. We can see that as r goes up, the value of the bond goes down, and vice
versa.
INVESTMENT ALTERNATIVES ∂ 867