Thursday, December 22, 2016

More on the Rate of Interest

Retroactively viewing my description of the rate of interest which derives from individual time preferences, we came across a point where I described the rate of return differently there than the way I described the rate of return with other prices.

Let us harken that moment. On the market, the difference between buying and selling prices equals the rate of return. This is tantamount to the price of Treasury Notes and Bonds in comparison to the yield rendered.

The 10-year Treasury Note sells at a price of $900 with a yield of 4% in present value terms. Par Value of the bond is $1000, hence when the debt instrument matures it will pay out par value. The coupon is 2%, this is the percent mark up at issue.

Each debt instrument has different contractual terms and different moments in time of paying out cash flows. The cash flows will be paid out over the duration of the contract. Those holding instruments look to make money on the spread.

Hence, the spread would be between the face value of the Note and the coupon. If one is holding the Note, the spread they seize would be between the price they bought the Note at, and the price they sell the note at plus the dollar quantity of cash flows they received for the period of time that they held the Note. The yield is a present value abstract contrivance.

Both Notes and Bonds can either be sold at a discount or a premium depending on which mathematical formula is used to calculate the present value of the debt instrument. If this abstract average, the yield, is above the coupon rate (rate of return) the debt instrument will be sold at lower prices. If this abstract average, the yield, is below the coupon rate (rate of return) the debt instrument will be sold at higher prices.

This brings me back to explaining the difference between the Pure Time Preference Theory of Interest and the Natural Rate of Interest. In my last post I described how within a total income of 10, consuming 1 would leave 9 of savings.

Thus, this ratio would be stated as 1/10 where there is a rate of return of 10%. This is tantamount to the pricing of short-term debt instruments. Treasury Bills are sold at a discount for example, where Par Value would be stated as an increment, 100. In consequence, a stated market value of 98, would mean that the yield is 2 or 2%.

All short-term debt instruments, typically less than one year, are sold at a discount. Due to the contract maturing much quicker than Notes and Bonds, this will always be the case. The latter two, longer-term debt instruments, will tend to fluctuate in price, above or below Par, as mentioned above.

In essence, the micro or individual preference of time derived from subjective value scales can theoretically be summed up as previously mentioned. Human actors endue their investment-consumption ratios where the rate of return is subjectively the consumption portion, leaving the consumption withheld as savings.

This is commensurate to the aforementioned example of Treasury Bills, the market price reflecting a reduced price (discount) of Par. Not only is there profit in accordance with a measured price, but there is also mental profit.

The Natural Rate of Interest on the other hand reflects the price spreads of the various factors of the production process. In general, it is the spread between the buying and selling prices of capital goods within the structure of production. Let us not forget, it is theoretical.

Most importantly, the Natural Rate of Interest can basically be described as the average of all price spreads within the the free market. Factors are made up of savings. Therefore, when observing the stock market, the spreads seized in the speculative process, are also price spreads that contribute to the Natural Rate of Interest.

At any one time, the Natural Rate can be conceptualized within various markets, or more broadly in a city or country's economy as a whole. It pervades all markets.

In a truly free market, without the intervention of government, spreads open and close as the speculative process is undertaken, as well as when the nascence of entrepreneurial creations are introduced in the market.

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