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. When the returns to holding stocks and bonds are highly volatile, investors who 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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