# Interest Rates For Dummies: Solving The Interest-Rate Puzzle

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Posted: Dec 23, 2011 12:01 AM

Economics textbooks have interest rate stuff in them. But so do finance textbooks. So, are interest rates an economics thing, or a finance thing? As we say in last week’s column, they’re both.

And although that may seem blindingly obvious to you now that you just read it, the entire edifice of Modern Portfolio Theory is based on ignoring the relationship between economics and finance. So for MPT practitioners (which are almost the entire industry) interest rates just are. They don’t come from anywhere. They are not the end result of a long chain of prior causation; they’re just a given. They appear at the beginning of the word problems at the back of the chapter; they are simply an assumption.

This dissolution of the relationship between economics and finance is a huge problem, because interest rates are the theoretical and practical foundation of all financial valuation. All financial instruments are a form of a promise of future cash flows.

Bonds promise fixed future cash flows; stocks promise variable future cash flows. Hybrids between the two, like preferred stocks and convertible bonds offer future cash flows which are partly fixed and partly variable. TIPS, that is Treasury Inflation Protected Securities, offer fixed annual interest payments, but with TIPS the final repayment of principal varies with the Consumer Price Index.

But no matter what the payment details are, every type of financial instrument is a promise, a promise of payment in the future, and so every single one of them presents an important question: How do I compare the value of money invested now, with money which I expect to receive in the future? The key to that is the interest rate.

The interest rate allows me to discount the value of some cash payment in the future to the value the principle would hold for me if I had it now. Human nature is immutable on this point.  Money is worth less to me in a year than it is now. If you offer me 100 dollars and one cent a year from now or 100 dollars now, I will almost certainly take the discounted amount, 100 dollars, now. The difference of 1 cent is too minimal a reward for me to defer gratification. And I’m not even counting default and inflation risk at this point. So how do I decide how much more I’ll need in a year to compensate me for my self-denial? That’s where the interest rate comes in.

Only when one starts with the proper interest rate as the base and then goes on to take various risk factors into account, can investments be properly valued. All of those other risk factors are added to the fundamental base of all valuation, the interest rate.

If treasury bills are without default risk (a big If in these times), and corporate bonds do have default risk, then corporate bonds are less valuable than treasuries to the degree that the default risk rises or falls. Inflation protected securities are more, or less, valuable to the degree that inflation is, or is not, a risk. Stocks are more, or less, valuable to the degree that growth rates and interest rates will be higher, or lower, in the future.

Different durations of bonds vary in value to the degree that interest rates will rise or fall in the future. If interest rates will fall in the future, I’m better off if I lock-in the high rates right now using a longer term bond. If, on the other hand, I’m invested exclusively in short term bonds, then the bond will expire shortly and I’ll have to go out into the market and reinvest the proceeds into a market and get the same lousy yields as everyone else. So, the steepness of the yield curve contains a lot of data about where investors think the economy is going. And consequently, properly valuing the various yields is largely a matter of properly calculating interest rates and various economic risk factors.

F.A. Hayek, towards the end of his masterful, but under-appreciated Prices and Production (free copy here), suggests that the various differentials between different kinds of interest rates could be an extremely useful forecasting tool for businesses. He goes on to say that such a project is beyond the scope of that present work, and to my knowledge, he never takes it up again; nor to my knowledge has any other free-market scholar.  That’s a pity, because it is essential to proper valuation.

I’ve spent the better part of the last year working on Hayek’s suggested project with my daughter, but she keeps telling me that she believes someone must have already done this work. Mercy Isabella Bowyer is a remarkable young lady who has read, among many other things, Ludwig Von Mises’Human Action before age 16, and is on her second reading now.

When she finished reading Prices and Production , we were discussing whether to take up Hayek’s challenge of using risk spreads as forecasting tools. “Why hasn’t anyone else done this work?” She asked. “Because economics and finance are different subjects in school,” I said. And I went on to point out that the few times the disciplines of finance and economics have overlapped in an academic context, it’s almost always from a Keynesian point of view. And that the Keynesian view of interest rates holds that they are the result of chaotic animal spirits and do not fulfill a truth-telling function. And the few economists who most thoroughly understand the central role of interest rates in reflecting economic conditions tend to be of the Austrian school, which tends to have a strong aversion to math personally and epistemologically.

And to top it all off, Modern Portfolio Theory, which is drilled into the head of every finance major and, more to the point, every Certified Financial Analyst exam taker, tells them that finance has no discernible causal relationship with economics.

No wonder the world of finance is such a mess! No wonder investors no longer trust these models!

Mr. Bowyer is the author of "The Free Market Capitalists Survival Guide," published by HarperCollins, and a columnist for Forbes.com. This article appeared orginally at Forbes.com