Interest rates: a primer

Simon Williams (00:05): In the past 18 months, interest rates have become increasingly topical and relevant to consumers, businesses and banks alike, everyone grapples with what has been the fastest pace of interest rate hikes in modern history. This has been punctuated by headlines of the recent Silicon Valley Bank collapse, and in the Canadian market, we are seeing a move from all CDOR-based products, whether loans, derivatives, or structured finance instruments from CDOR, which is an interbank rate, to a new risk-free rate that almost nobody has heard of called CORRA.

This is all happening at an order of magnitude of $20 trillion in financial instruments moving to the new rate on one day at the end of June, next year. My name is Simon Williams. I'm counsel in the Toronto office working in the lending structured finance and derivatives group. In this video, I'm going to cover some of the fundamentals of an interest rate and what goes into an interest rate to better understand both the US banking crisis and the transition from CDOR.

Generally, people think of interest rates just as a number. A 3.5% line of credit, a 5% fixed-rate home mortgage. But it's helpful to break it down into its composite parts as diagrammed here, as each of these different elements plays different roles. The bottom two featured prominently in the Silicon Valley Bank collapse, the two in orange here, the term premium and credit spread premium are key to understanding the differences between CDOR and CORRA. So we'll take all of these in turn, starting with the risk-free rate.

Simon Williams (02:01): This is the rate—and I am referring here to the US Fed Funds Rate, with the US being the largest economy, US dollar representing over 60% of global reserves being the global reserve currency. And over 80% of global trade is conducted in US dollars. And so this is really the rate that drives rates on all other currencies. And the Fed Funds Rate—this is the rate that the Federal Reserve sets. It's a target rate at which commercial banks in the US borrow and lend to each other in the overnight market on their reserves that are held at the Federal Reserve Bank. You can think of it as the economic cost of money based on supply and demand factors. When you strip away everything else and setting the Fed Funds Rate is one of the government's key levers in affecting monetary policy.

So along with open market operations, buying and selling bonds, by lowering interest rates, the feds can stimulate borrowing through the creation of money given our fractional reserve banking system; so lower rates, more lending, more money issuance into the economy so that consumers and businesses have more available capital to spend on other goods and services. On the flip side, when there's too much liquidity in the market, prices start to run high as we've seen over the past 18 months or so, with inflation in the US getting up to 8%, 9%, at which point that becomes a political issue, a quality of life issue for many citizens. And then the feds are forced to reverse course and start to hike rates. And we have seen a 20x increase in rates and the Fed Funds Rate just over a year ago at 25 basis points.

As we can see here, when we zoom in to the last 20 years, starting with the dot-com crash, the gray bars of the recessions. The Fed response was to cut rates, stimulate the economy. Similarly, the beginning of the COVID period, March 2020, when the lockdowns first started, large swaths of the economy were shut down. The feds cut the rates to effectively zero down to 25 basis points where they stayed until inflation started to run away. And then at the end of the chart, you can see the spike in Fed Funds Rate as the feds try to catch up with inflation.

Simon Williams (04:41): As everyone knows, time is money, or at least it usually is. And this reflects the future earning potential of productive capital. So like any other asset, if you borrow and have the use of capital, you have to pay a rent on that in the form of a higher interest rate. From a lending perspective, if your capital is tied up for a longer period of time, it's a greater opportunity cost. The lender will demand a higher rate of return. And so the time value of money is effectively a way to quantify that value of money and the applicable rate is the risk-free rate. So it's notable here that the higher the risk-free rate, the higher interest rates are, the bigger the discount factor.

So if you are present valuing future cash flows at a higher rate, you're going to get a smaller number. That's why when rates are higher, the Nasdaq and the tech stocks, which have long dated future cash flow streams, that's why that's hit the hardest. Similarly, if you're buying an asset based on a cash flow model and you present value in future cash flows, the higher the rate, the cheaper that asset's going to become for you.

It's not always the case, though. If you look to Europe, for example, it was only last year that Europe came out of an eight-year period of negative interest rates. In that case, savers or lenders are penalized over time. We have a normal yield curve, and this reflects the fact that the longer capital is deployed for, the higher the rate of return that's expected.

That's the normal case. However, in times of economic duress, economic stress like we're in now, you can get a yield curve inversion. So we have high rates in the short term again. Now, short term rates up at 5%, but the market is anticipating a recession. And the fed’s response to the recession, which would be to cut rates to restimulate the economy, get out of the recession, particularly with an election on the horizon in the United States. And so this inversion has had serious implications for banks managing their treasuries book.

Simon Williams (07:08): Finally, we'll talk about the credit risk premium, which represents the familiar concept where the riskier an investment or a loan, the greater rate of return that's expected. This can be quantified as lenders do, on a probabilistic model. So a lender will ask themselves: If I make this loan 100 times to a borrower in a similar circumstance of a similar credit worthiness, I can expect “x” percent of those loans to go into defaults.

Among those, I can expect some recovery, pennies on the dollar recovery, given that risk of loss, the probability of loss, what is the additional premium I need to charge on this interest rate to compensate for that for that risk of loss? And this, as I mentioned earlier, credit premium is one of the keys to understanding the difference between CDOR, the primary Canadian floating benchmark rate, which does have a credit risk premium because it represents an interbank rate versus CORRA where the market is moving towards, which is essentially a risk-free rate.

Interest rates always play a critical role in the economy, even when they’re not dominating business and news cycles. What factors determine interest rates, and how do interest rates impact decisions in finance, other businesses and the economy at large?

In this video, Simon Williams unravels the various parts of an interest rate and how they work together to drive key decisions for deals, loans and investments in any stage of the business cycle. He covers:

  • Components of an interest rate
  • The link between the risk-free rate and GDP growth and inflation
  • The time value of money
  • Credit spreads, risk premiums and their impact on interest rates

To discuss these issues, please contact the author(s).

This publication is a general discussion of certain legal and related developments and should not be relied upon as legal advice. If you require legal advice, we would be pleased to discuss the issues in this publication with you, in the context of your particular circumstances.

For permission to republish this or any other publication, contact Janelle Weed.

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