Industry sign banking missouri word simple
last time we were talking about calculating asset values and you remember the fundamental asset values for investors and the fundamental formula that we have in this is a present value calculation and so the present value of some future dollars will use a subscript to indicate how many years we have to wait to get that money but the present value of any future promise of dollars is computed with this formula 1 plus I to the T is in our denominator and that I is our annual interest rate or our annual discount rate and you know there's a tendency to think that that's something official and it's not official at all each investor has their own discount rate and for you you might say something like you know I would let my money go for 3 percent a year and somebody else might say 3 and a half and somebody else might say 2 and so each person has that right it's your money to invest in your discount rate so it's really not anything official it's a personal discount rate for each investor what we tend to do is look at the marketplace and let the marketplace tell us about what that discount rate is that most investors find acceptable and so if we look out there in the marketplace and we say LLL look people are lending their money for 3 years at 2% then we start saying gosh out of the hundreds of billions of dollars being loaned out 2 percent seems to be acceptable to a vast majority of people then we start saying that's about a reasonable discount rate but you still could say no I've got to have 6 percent okay and then this T tells us how long we have to wait you remember this is just a date like 2014 or whatever down here but then this T here would be 2 years well I guess this would be 2014 it would be we have to wait X number of years you know 4 years 5 years 8 years whatever and then this would tell us how many years we have to wait and it's an exponent sir yes yes no then what you say is this I've got some money in the bank I got 50,000 bucks in the bank my discount rates 6% and so then you do the calculations and you say oh I'd be willing to pay a certain them out here and you go well you know nobody would sell me that asset for that price and so then you just leave that $50,000 sitting in a bank can tell something satisfies you and I mean and that is really your choice if you want you can adopt their discount rate you know everybody else's and if you do that then what you'll say is no my money is at work but I'm not being compensated for the risk I'm taking and I mean that's really what it comes down to you know when you buy stocks and bonds and things like that you're putting your money out there in a risky situation and if you're not getting compensated for that risk what are you doing you know I mean why did you do that is it charity do you just say I I just hold General Electric does well and I'm willing to let them use my money so they can do well even though I feel like all things considered I'm doing very well no so you just say no you know there's some risk attached to that investment I've got to have 6% if I invest here I'm only gonna get to no I'm not gonna do it and just keep looking and maybe there's a place out there you want to invest in maybe there isn't if not keep your powder dry ok so anyway that's really that's our options but there may be other places you can invest I mean there are investments that are not just financial investments but they're you can invest in your house you could say oh I'm gonna build you know like back porch on my house or I'm gonna like improve my bathroom on the house and so then I get some service I've got the back porch or I've got a better bathroom and then when I sell the house the value of my house goes up there's a rate of return on that or oh I'm gonna go and take an accounting class in college you know and I'm going to learn a skill and then I'll get promoted at work and there's a rate of return on that investment so these aren't all just financial investments and sometimes the best returns are not for and nature anyway but good question because that is when it comes down to really is your personal discount rate and also what it comes down to without even doing the calculations is you just look out there you say look here's what the financial markets are telling me two percent that's not acceptable for me don't do any calculations that's all you know if they're calculated and they get two percent they say that's worth it then you know that that's not worth it for you because you can only get two you have to have sex so don't be like I'm gonna get the calculator out and work on this and see if somehow or another no the numbers don't add up what I did last time then is I said I guess I added one thing to this this would be for a future payment somebody's going to give me some money on a certain day in the future if we have an investment that promises a series of future payments then we have a present value formula that's more sophisticated or that we have then this is the summation sign from mathematics and of course it's the Greek letter what Sigma right and so what we do is that we look at this this summation of these future payments all the way from that first one to the last and I'll put in up there whenever in is the final payment that we receive and then here are these future payments that we discount each one of them and what this formula is telling us basically is we've got a series of payments first of all we take each one of them individually we'll leave the Sigma sign out take each payment discount it and you get a number and then you do that for all possible future payments from the first to the last and then add all those present values up because this is just a present value isn't it and then we'll just add all those up and when we add them all up that is the present value or just the value of the asset to the investor and what to come back to your question if you calculate all this and you say hey the present value dad asked that to me is $48,000 and then it's price is 50,000 you just say no and another way of saying that is that the rate of return on that investment is not up to your discount rate I mean so those are really telling us the same thing and if you calculate present value say it's $48,000 and the price is only 47,000 I want it and by the way that is the answer I want it's not like huh wonder facts worthwhile because if we calculate present value that is like if I get my hands on this investment whatever it is it's worth $48,000 to me at this moment because that's the present at you now and so if somebody says I'll say you this for 47 that would be like you hand in 47 thousand somebody and they hand you back 48,000 they're both now this is now money and so if you hand over 47,000 now and they hand that back 48,000 now that's like somebody made you a gift right I'll take it so there's no future thinking about this once or you know additional thinking once we calculate present value if it's greater than cost of the investment go ahead so anyway not all but many investments look like this with the series of future payments some investments there's one time pay off down the road boom that's it but a lot of investments and I mentioned last time stocks right you get a series of dividends bonds what you get is a series of I call those coupon payments coupon interest payments let me just kind of refresh your memory by drawing the picture bonds look like this and I just mean in sort of general terms there's this face value of a bond they all have that I also use the term par value or maturity value sometimes people use one term sometimes another then there is a coupon interest rate on all of these every bonds got a coupon okay for example 3% and what that would say is we will send you a check each year equal to 3% of the face value and then they all have a maturity date okay and that could be one year in the future it could be a few months in a future three months six months it could be a year two years it could be 30 years and anything in between because really what this bond is is just an agreement between a borrower and a lender and the borrower and the lender can just get together and work out any terms they want and so usually what happens is the issuer that is the borrower will put these dates on there and say we want to borrow money for 30 years and then they'll say you want to buy these and you can always say no and I move on buy something else but anyway maturity date and like I say I'll tell you what there are one-day Securities and then they don't have that term bond but we're using this as a generic sense but there are one day loans 30-year loans and ever wants to I used to set them a little bit longer than 30 years but anything in between and not only there are new loans coming out today or new bonds coming out today but there are loans and bonds made in the past are issued in the past that are trading out there and so if you say I want something with 27 and a half years to go to maturity then maybe there's nobody issuing a brand-new bond today 27 a half years maturity but there's somebody who two and a half years ago issued a 30-year bond and that bond out they're trading in the markup I say you say that's the one I'm gonna buy it's got 27 and half years ago from today so anyway so what was I doing most this bond then is a really a contract and it says this if you will give me some money today then we'll give you money back in the future the borrower's saying the money I will give you back in the future is this and let's just say hypothetically I'll put some numbers up here let's say this is a thousand dollars and let's say the coupon is I'll use that three percent and let's say the maturity date is three years I'll use a different number because I don't want two threes on my number let's say four years from today four years hence and so this is really just a schedule or a contract and it says hey we're going to send you some money and what we're going to do is one year from today we're going to send you three percent of a thousand dollars there's future money that we're going to get from this bond we're gonna send you 30 bucks two years from today we're gonna send you 30 dollars more that's what these coupons are about three years thirty dollars for years thirty dollars so now those are your coupons we promised you for coupons of thirty dollars apiece three percent of the face value and then also on that day the maturity date we're gonna pay you off we're going to give you a thousand bucks and so really this they say it's a bond it's a contract that promises these future payments and then what we would do is using this approach we would calculate the present value of each one of these and we did that before so I won't go back and do it again now we're gonna get a number here is divided by 1 plus I to the T power you want to do one these calculations let's do that 6% was your discount rate and so let's use 6% this would be divided by one point zero six to the first power divided by one point zero six to the second power one point zero six to the third once you get your calculators on do that if you have a calculator with you oh you're thinking ahead I don't like that instance I want you to always be huh huh how are your discount rate the less you're willing to pay go figure you don't have to calculate around you don't have a pencil out here's the deal you brought your brain and that's something okay the most important thing number one laugh at the jokes I guess come to class laugh at the jokes take notes so anyway so far so good let me get my calculator out 6% are you kind of a demanding guy anybody get any different numbers yes ma'am no ma'am but it's a good question but no no ma'am here's what this is this bond and and let me just clarify the question we got two interest rates here one interest rate is this interest rate that's written on the bond and another interest rate 6% see the difference now what's going on and the answer is this this bond this is not you this is not your personal discount rate this is a contract that says if you'll give me money today I'll send you some payments later so I'll send you money a year from now two years from now three years from now four years from now I'll send you money and so then when they are telling you how much they're going to send you they're using this number here three percent to tell you about what will be coming to you in the future there's thirty dollars and that is the end of that that is no longer relevant after we know that $30 then so what somebody does to you as they say hey see this bond we'll buy it and you say no kind of like a lot of things I will buy most things if the price is right and so then they say how much would you give me for it and that's when you bring your own personal discount right into the story and you say you know I will not let my money go unless I could get 6% for you it might be a different number but the point is you're not governed by this 3% that 3% is just when they are telling you hey we'll give you thirty dollars one year from today $30 two years from a thirty or three to your someday $30 four years some day and then we'll pay you off a thousand bucks and so this bond is really just a contract telling you about a series of future payments okay then what you do at that point is you decide what ready to return do I have to have to let my money go and then I asked somebody and they said six percent for me and so basically what you say is this you know what didn't by the way did anybody else can you confirm this numbers is right is it wrong so we've got an investor says I'll tell you what I'll do I'll give you eight hundred ninety six dollars and force for that promise that you're making me to give me this money in the future eight 9604 and I say okay so what you do is basically there's somebody out there and you loaned them your 896 dollars and four cents would you give 890 605 one more penny just one more penny if you would then what you are also saying is I don't have to have quite 6% a little bit less that's your business but don't be putting 6% into the calculator if you mean I got to have 6% I don't want five point nine nine percent six and if you'll take five point nine nine use five point nine nine here don't but one point zero five nine nine but if you put six percent in that says I don't go up any above that that's it so anyway you make a loan eight 9604 here's the money and now from your loan what you say to them is you pay me these thirty dollar payments and in a thousand dollars later and over time what do we have one two three four we've gettin what eleven hundred and twenty dollars out of this bond at different days in the future then you gave up nine hundred dollars almost right now and on your nine hundred dollars almost eight 9604 you're getting a six percent return now here's another way of saying that and maybe it will make sense to you if you go down to the bank and say hey I won't put money in a savings account what radio paying and they say six percent they say okay here's what I'm gonna do I'm gonna put eight hundred ninety six dollars and four cents in an account and you're paying me six percent right they say that's right and you say that's great wait for one year and you go in there and say I want thirty dollars out of that account they say here you go and you say is it still everything I'll leave it's still earning 6% they say it absolutely yes and say okay then you come back two years from now you take out thirty dollars three or someday take out thirty dollars four years today you come back and say how much is in that account today and they would say King a thousand and thirty bucks and you say give it to me and so if this money is growing it 6% a year and all the interest it generates growing at 6% a year than what I'm saying is you could withdraw this series of payments and finally on the last day of this four year period you'd withdraw the $30 and a thousand you'd take that out and they'd say well huh looks like you've closed your account you say sure huh won't do it again anyway are we okay with this now I gave you an example last time of a stock where the stock would be paying in that case it was not a coupon payment but a dividend and what I said about
hat stock is it just keeps going on dividend dividend dividend ten years 20 years 50 years in theory it goes on forever I know nothing's forever but what I also told you is when we're doing these calculations 30 years is pretty close to forever but anyway there's no payoff day there's no maturity date okay more or less like with me just no maturity date I just keep on going and you know don't mature grow up so anyway and then what we did you remember what we had is we had that infinite series and then we calculated present value of that investment in a simpler way we did have to all these calculations what we did is we just took that annual dividend and divided it by the discount rate of 6% last time it's 5% okay and then with an infinite series it's a little bit easier this works with all kinds of investments let's say the investment is an investment in your education then this future payment that we would put up here is your pay increase that you would get as a result of having an education it's like how much do you get with college pay with college degree minus pay with high school degree and so your future return on that education is the difference in your pay and so if that's $10,000 a year then this would be ten thousand one years from now two years three years four years five years and so forth right now by the way there's more return from going and getting a college degree than just a higher salary but normally working conditions are better normally fringe benefits are better so there are other things normally less risk less unemployment as you go along there are a variety of returns but the point is that whatever the investment is there is some return up here that you're going to get year after year after year in the future and then we discount those returns back to the present what if it's a rental house then what you would do is if it's a rental house and what you'd say is what's my monthly rent and by the way it wouldn't be a once a year pane maybe a once a month payment well how much rent do I get each month and then we would be dividing by a discount rate that you know these would be one month one twelfth of a year each time one twelve to twelve three four five and so forth thirty years would be three hundred and sixty twelve but anyway so you'd have a rent payment payment minus taxes - maintenance if you the landlord are paying utilities - utilities and so forth whatever your costs are doing business are but anyway so you'd have this gross amount - all these other things that you have to pay out and then how much you left with at the end of the month and then we would discount each one of those in the future back to their present value and then you'd come up with some memory say oh look the present value of this house is I don't know 6070 thousand dollars and four hundred there's seventy thousand four hundred dollars you got a number present value of all those future rent payments net of expenses and then you'd say hey how much you asking for that house and somebody would say sixty-four thousand dollars and you go I'll take it no you still bargain just because they say sixty-four thousand and this is more you don't say I'll take it say how about fifty one and then you negotiate but as long as the price is less than that you know the final negotiated price take it right unless there's a better one next door and then buy the better one let this one go better one in your net return if they say we want seventy thousand five hundred dollars and you say let's negotiate they say no that is our bottom dollar take it or leave it you say seventy thousand five hundred leave it every investment we handle it this way by the way you know by the way with the house we would had these monthly rent payments we could do either of two things we could say I'm gonna own this house forever and by the way then we're projecting an amount of rent into the future and then on a forever or what you could say is I'll make a schedule I think I'm gonna own this for about ten years I don't have ten years worth of net rent payments here and then down the last number would be when I sell this house here's what I think I could sell it for right and more or less like the maturity value on the bond but anyway so then we just do the discounting and by the way this is hard to do with the calculator and I don't mean to say the thinking part is hard to do I mean there's a bunch of buttons to be pushed and then you want to change your assumptions that's a little bit and you have to start over it is so much easier to do on a spreadsheet and once you make that spreadsheet up then it's easy to go back and say oh I'm going to change my discount rate oh I'm gonna change my monthly rent oh I'm gonna you know what if taxes are this much and so forth and it's easy to make those adjustments but the thinking part there's no more difficult for one or the other of these and you set it up the same any questions about this what I did tell you last time also though is when we get into these things always remember this personal discount rate that you use should be one that reflects how much riskiness is attached to that investment there are some of investments very safe like if you're buying a bond from the Treasury and it's a five-year bond you kind of have to thank me I bet the treasures in business over the next five years and we'll make these payments to me but there might be some company it might be that there's some rental house that you're thinking about buying and hey I can rent that oh you know the economy is kind of weak here in town and so maybe it'll be hard for me one or two years from now to find a tenant live there or you know there's a lot of crime out here on the street so maybe somebody I'll run a car into this house or blow it up or something I mean these are far-fetched examples but whatever risk is attached to this numerator then we need to use a discount rate that reflects that amount of risk and if I said to you hey what rate of return do you need you say 6% I say really and you say oh just a second tell me about the investment and I tell you you say none not 6% they're 8% on that one 10% 12% 15% okay and so anyway but we always want to use we want to match our numerator and denominator in terms of riskiness okay let's go on and talk about and it's really just a variation on this fluctuation in asset values let's take the stocks to begin with down the hall I don't know if you've noticed it but at the end of the hall the economics departments got a television set up on a shelf there and then we've always got this channel on there the CNBC that's got the stock market and all that stuff going by and you know the prices are changing on those stocks pretty frequently right and I mean in theory they could change every few seconds usually they're a little more stable than that but anyway what causes those changes in asset prices well the answer is if our asset values I'll use that term but if they ask that value and I'm gonna get rid of a Sigma just to put make this look a little simpler but there's got to be that Sigma sign there if this is our calculate or our formula to calculate asset value then when we say hey there is a fluctuation in the value there's a fluctuation in P it's got to be caused by something over here on the right-hand side yes well guess what doesn't fluctuate one that's not going to change and so the stuff that changes is oh it could be that the amount of money we expect to get out of this stock changes over time the amount of money we expect to get from the stock next year the year after that and the year after that and so forth on out our discount rate could fluctuate okay and in theory what could change is we could change the time horizon how far out we think that we're gonna get that money this is pretty unusual but it's not impossible there was a period I don't know and and I want to basically give you a short example about the tea here how that can change and then go on and kind of leave that out of our story after that but there was a period between World War 1 ww1 and World War - ww2 and in this interwar period not immediately because after that World War one was over peoples had no good that war is over that was the war to end all wars he tell the next one there was a period that came along here when people started saying you know there's a lot of tension in Europe a lot these countries kind of the leaders of the countries kind of hate each other it seems like we're gonna have another war and what happened as we you know not we you I wasn't alive them but as we're going along in this period what happened is people are just kind of going home I got that last war was terrible and this one's gonna be worse the bombs are bigger airplanes are a very new idea where or one especially in using them and more on things like that they didn't do very much now that airplanes are bigger now they're dropping bombs they come drop bombs on cities and so what happened as time went by there people in Europe just started thinking is there gonna be a future or we just all going to die and so then what's happening is this tea for people and they didn't say it this way but if we want to go back and put their behavior explain their behavior by looking at the formula what happened was that tea for people started getting shorter and shorter and shorter before that they could say oh here's what's gonna happen in ten years or twenty years or thirty years and all of a sudden they started thinking about there's not gonna be a twenty or thirty years time will still exist but I won't be around or our assets will be destroyed or be taken from us and so what happened was these time periods started getting shorter and shorter and shorter that people would calculate a present value for if you thought about you know let's say you're living in gosh I don't know Paris or someplace like that and you think about oh I'm gonna buy a rental house and rent it out to people really for how many years and it maybe if you were back here and I don't know 1922 you might go oh I'll rip that out for the next hundred years and then over here you might go a couple years and so at that point if this period is just shorter and shorter and shorter then yeah we can that has one effect but don't forget here's the T here as it goes down down down down down a long long time 5 10 15 20 50 hundred years I mean any number as possible and if you start cutting on off and going that's it there is no future then present values are going to be burst so anyway I'm gonna leave that to the side and just come back and say most of these fluctuations and asset values that we would observe today have nothing to do at that time horizon it has to do with these two things how much money do we anticipate getting in the future from an investment and what's our discount rate and so when we look at these stock prices and they are fluctuating what could cause that how about this a change I'll use the Delta sign for change change in expected future earnings of a company let's say some company comes out says hey we just developed a new product now they've been working on this development process for weeks or months or years before but we don't know anything about that and now they come out and say we've got a press release we just developed a new product it's a new let's say a new miracle drug it's a new kind of a computer chip it's a new whatever new kind of car it's superior to everything else can we go wow really and we come back to our formula and we say you know always before I thought this company was going to generate dividends of I don't know let's say three dollars a share per year and now it looks like they're gonna be able to generate dividends of $8 a share per year and so when we get a new expectation about these future earnings and it's an expectation don't forget we don't know we're looking out into the future but when we get a change in these expectations we've got a new F that goes into that formula and so up goes the company's stock value well what about this what if somebody is and I'll stick with this idea of some miracle drug or a car or something like that suppose you're making a car and it's a great car and the company's stock price is going along and whatever I'll go back to $3 here you're paying a dividend of $3 a year and then and maybe you're managing Toyota and you say boy everything's we got this $3.00 dividend and our stock is trading and a good price we feel wonderful about that and then there's some other company Ford or Mazda and they come out and they say hey you know we got a better car than Toyota because they use the whatever technology XYZ and we got a technology it's better than that and so here's some other company that releases information that other company if their technology is better and they can make a plausible story the value of their stock goes up but here's this company we're looking at in this case Toyota and we say oh my gosh the competition just released new information about what's happening to the value of well I'm sorry new information about competition for our product we're not going to be able to make that three dollar dividend we're only going to be paying two dollars and seventy cents dividends if that other company over there is able to make good on its promise and so now Down Goes Toyota stock because that F changed what if you're selling Toyota or what if you're managing Toyota and here's our three dollar dividend each year and Toyota's got this car what the Prius high gas mileage and stuff like that and then what happens is something happens there's a war in the Middle East and the price of gasoline goes from whatever whatever it is that a let's say it goes to $10 a gallon then people call oh my gosh $10 gasoline I'm not gonna buy when these big gas guzzlers I need a Prius and then they go down and they're stand in line at the Toyota dealership and then the people who run Toyota go and you know what we ought to do make more Priuses and in the meantime raise the price of the ones we got now people still buy them Oh profits go up dividends go up five dollars a share and if the dividend goes up price of the stock goes up now it'd be rare for the price of gasoline to go from where it is today to ten dollars overnight but guess what it's going from wherever it is today to wherever it is tomorrow it's changing all the time and there's somebody that's affected if the price of gasoline goes up five percent there's somebody it goes I'm gonna buy Prius and if the price goes down five percent there somebody says you know I was gonna buy a Prius but I think I'm gonna buy that whatever hot rod on a daily basis we're getting new news new information and it's not only about the company that we are looking at that we're trying to value it stuck but it's about the competition and it's about other technologies maybe somebody comes out and says hey I'm gonna start a new company up and we're gonna have light rail we're gonna have trains that just run between all the cities you know like in metropolitan areas and we'll just pick a city out you know like Springfield and home of The Simpsons and then we're gonna have like small trains I just run between Springfield and within Springfield and all the outlying communities and we're just going to go from city to city to city and then people go oh okay I don't need a new car I'll ride that train down goes the dividend so we've got news on what's happening with the company itself its new technology what's happening with competitors what's happening to fuel prices what's happening to totally different technologies it could be that there is some change in government policy the government might come along and say something like you know what we're gonna do we're gonna impose a $1,000 tax on all cars all cars if you do that people are just gonna say some people I think I'm gonna just put off buying a car not gonna buy quite as fast Thota is not gonna sell as many cars down goes there didn't their profits down goes their dividends or they could say here's a subsidy on buying cars buy more cars people buy more cars up go profits so what I'm saying to you is there's any number of things so when we go down the hall here and we look at those stock prices go
ng by and they're changing all the time why are they changing well they're changing because there's new information in the world all the time and it's not just new information coming out but it's also know people buying into that like if you're a mutual fund manager you know you get up you come the work you're sitting there you're drinking your coffee you're eating your doughnut yelling at subordinates whatever it is to keep them busy and so then somebody comes in and says hey did you get did you hear what Toyota did and you say no I don't hear about that well this has been out for 15 minutes this was this came out yesterday well I didn't hear tell me what has you tell them what it is oh by Toyota sell toilet and so what I'm saying to you is we don't all get the word at the same instant we don't all react equally quickly some people take some time to digest that so the prices are changing because of this new fundamental information and also as people are buying into the story discounting the story sometimes we go oh wow that's a big deal and then by the next day we say you know that wasn't such a big deal and then we kind of back out and so these prices are fluctuating number one because of this a second reason that they fluctuate discount rates change okay oh by the way let me go before I do the discount rate one other thing a change in expected future earnings of a company but how about this one a change in macroeconomic conditions I didn't mean to get ahead of myself here now those macroeconomic conditions will affect the price of or the dividends the profits of a company but to think about the macro economy is that affects pretty much everybody in the same direction and so this would be let's say we go into a recession people might say I'm not gonna buy a Toyota I'm not gonna buy a Ford I'm not gonna buy a Mazda I'm not gonna buy you know whatever and so we just go down the list of what I'm not gonna buy and so in this case it wouldn't be old Toyota's up a little bit Mazdas down a little bit or anything like that it'd be more like Toyota's down Mazdas down you get the idea Ford's down so macro if the macro economy goes against us then we see that going down I mentioned a change in laws and regulations we're talking about stuff that can just change all of the time a change in taxes I'll say tax laws and all tax don't laws don't affect companies the same so some companies may be hurt a little bit by a change in tax laws another a lot some company might be helped by it now back to what I was going to say here as the change off make this number five the change and the discount rate now one thing that makes discount rates discount rates are interest rates as I mentioned before we kind of look out there at the world we look at the financial markets what are interest rates and that's kind of telling us what the discount rate is that most people find acceptable you don't have to buy into that but you might go you know everybody else is saying 3% I'll go along with that because that's kind of common I mean Who am I to be you know disagreeing and who you are is it your money so you can but many people just kind of buy into that story mmm discount rate 3% what can change this is how about monetary policy Federal Reserve might come out and say something like this today we are starting a new monetary policy we're changing our policies and those policies will cause interest rates to go up do they ever do that yeah by the way here's what they don't do and we'll come back to this later and of course the Federal Reserve does not do this it does not say the interest rate is 5% they do not set interest rates for the market economy I mentioned this before interest rates are established by supply and demand and the Federal Reserve doesn't say five percent three percent two and a half percent the Federal Reserve does not set interest rates what the Federal Reserve does is it has policies and those policies supply more or less funds in the marketplace and so by the Federal Reserve's policies they can affect the supply of funds and then that will affect interest rates they don't set it the influence interest rates but the Federal Reserve could say we're gonna start drawing funds out of the economy we're gonna make credit tight and credit conditions tighter and as we do that interest rates will go up and if interest rates go up interest rates go up discount rates go up and if the discount rate is higher then the value of asset values will be lower what asset values houses I mentioned rental houses stocks bonds you said this before hey if interest rates are up discount rates are up bond prices down exactly but guess what interest rates are going up it's very common for stock prices to go down too and very common for housing prices to go down and monetary policy it's not the only thing but monetary policy here's the thing a lot of things affect interest rates which will come back to a lot of things affect interest rates but this is a big thing that affects interest rates and it doesn't gradually have its effect the Federal Reserve just comes out says you know what yesterday our policy was this today it's that and it changed just now and there's a public announcement it's on television and it's as though somebody threw a switch and so then very often when monetary policy changes asset values will start reacting quickly rather than a gradual phase in over the period of one or two years or something like that okay last point and we'll close for the day I'll show you in this formula then I'll write a term down if that discount rate goes up then the value of this denominator is larger we're discounting more discounting those future dollars more and so then the present value of assets goes down right well we have a term for bonds here's what we say if the discount rate increases then there's a decrease in the price of bonds other assets too but now we're talking about bonds and this relationship has a term anybody know the term this is called interest risk sometimes called market risk and so what I'm saying to you is this is that you know a lot of people think stock market kind of risky stock prices can go up or down well guess what bonds are risky too and we're talking about that risk right here if you buy a bond and you're sitting around everything is great and it's worth eight hundred and ninety six dollars and four cents and then all of a sudden discount rates go up that bond that was worth eight 9604 now it maybe is worth eight hundred forty dollars interest rates up the value of bonds down this is interest risk and so bonds are risky as well and they are risky because the market can turn against you this is what we'll start with next time so long
