The variability of interest rates affects decision about how to save and invest.
Investors differ in their willingness to hold risky assets such as stocks and bound.
rely on these assets to provide for their consumption face a relatively large
chance of having low consumption at any given time. For example, before
retirement, people receive a steady stream of income that helps to buffer the
changes in wealth associated with changes in the returns on their investment
portfolios.
This steady return from working helps than maintain a relatively steady level of
consumption. After retirement, people no longer have steady stream of income
from working (though it will in part, be replaced by pension income and social
security). So a less volatile investment portfolio is called for the lower volatility of
investment returns allows return to maintain a relatively even level of
consumption overtime, young investors, who are saving for retirement, are better
able to absorb the risk of holding assets with highly volatile price and returns.
They can weight than portfolio more heavily toward risky stocks and bonds
because they are recurring a steady return from working. For holding these risk
or assets, the young investor will be rewarded with a higher average return on
their investment.
Just as individuals care about managing risk in their investment portfolios, so do
firms. To manage risk, firm must pay attention to interest rate volatility and the composition of their portfolios. Many business firms hold portfolios containing
large numbers of assets and, thus are interested in qualifying the risk of losing
large sum of money. As risk in the economy change, the expected gain and
losses from the investment portfolio change. Measuring the risk involves knowing
how volatile prices of return on assets change together overtime. The volatility of
interest rates is likely to be an important component in quantifying risk and
guiding the investment decisions of these institutions. Interest rate volatility also
has implications for how the prices of certain types of assets are determined.
Options are assets that give investors the right, but not the obligation, to buy (call
options) or sell (put options) other assets (such as stocks or bonds) at a
perspecified time in the future. For options purchased on interest bearing
securities, modern finance theory demonstrates that the option price depends on
the volatility of returns on the underlying asset. The volatility of interest rates in
related to the volatility of returns on these assets.
Thus, interest rates and their volatility have important implications for how both
individuals and firms make investment decisions. These investment decision are
part of the process whereby resources are allocated in the economy. To begin,
we will briefly discuss how bond prices, interest rates and maturities bonds are
related and how interest rates can determined from bond prices.
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