Interest Rate Sensitivity

  

Categories: Bonds, Incorporation

Sensitivity. Take off your shoes. Hold hands. Everyone say, "Ommmmm." There we go.

So...think about a company teetering on the edge of bankruptcy with EBITDA or cash flow of $100 million and $1.2 billion of debt at average interest of 8%. So that's $96 million of debt service. Whoa. That's close. If cash flow goes down just 5%, the company won't make its payments. If its debt payments are adjustable or moveable, and rates go up even a tiny bit, the company is dead.

You can imagine how volatile the stock of this company would be, were it publicly traded. A cash flow multiple change of one turn would have enormous effect. So the company's stock then carries enormous interest rate sensitivity, and the phenomenon has the same vibe with companies in highly leveraged industries...like banks, many media companies, and other industries that typically sell their wares in a manner driven by loans: cars, homes, washing machines, etc. If rates go up a lot, those industries get...hurt.

Related or Semi-related Video

Econ: What are Real Interest Rates and I...0 Views

00:00

And finance Allah shmoop what are really interest rates and

00:06

inflation Correction Riel interest rate of percent figure that tracks

00:12

her actual interest in any given conversation like you bump

00:15

into your old roommate and he starts talking about his

00:17

foot polyp riel Interest rate Fifteen percent He starts talking

00:21

about the time he was kidnapped by Basque nationalists while

00:24

on a yacht with Kate Upton Riel Interest rates yet

00:27

ninety five percent Well the more famous version of a

00:29

really interest rates have to do with finance It tracks

00:33

the rate of interest after subtracting the impact of inflation

00:37

Right So it's real It's not just nominal Your friend

00:40

wants to buy a pure bred show pig for next

00:42

year's County Fair It costs a grand but she doesn't

00:45

have the cash on hand so she borrows the money

00:47

from you You agreed alone the thousand dollars for one

00:51

year at fifteen percent annual interest That's the interest rate

00:55

written into the contract The nominal rate The loan has

00:58

to be paid back at the end of the year

00:59

Well meanwhile the inflation rate this year totals five percent

01:03

Prices on everything They're going up up up by an

01:05

average of five percent during those twelve months when the

01:08

money was borrowed So you alone the grand on January

01:10

one and buy the next December thirty one while you

01:13

get eleven fifty back That's fifteen percent nominal interest However

01:18

inflation has eaten into some of that profit for you

01:21

At least rent on your money every January you like

01:24

to buy a set of dinosaur shaped novelty T infuser

01:27

Sze to give away his New Year's gifts last January

01:30

you could buy a hundred tea infusions for thousand dollars

01:33

this New year's those same hundred T infuser is cost

01:36

a thousand fifty right The five percent inflation is at

01:39

work when you loaned the money out Well eleven hundred

01:42

fifty dollars could buy you one hundred fifteen t infuser

01:47

by the time you get the money back While eleven

01:49

fifty will only buy you about one hundred ten tion

01:51

fuse er's and you'll have to throw in about five

01:54

dollars of extra money to get the one hundred tenth

01:56

one of the math They're well Your money buys last

01:59

because of inflation The real interest rate takes into account

02:01

what you can buy with the money Write it subtracts

02:04

inflation from your rate of return So here is the

02:06

back of the envelope Way to calculate the rial interest

02:08

rate Take the nominal rate and subtract the rate of

02:11

inflation Yep that's it Bingo What's left over is the

02:14

real rate Very fancy The answer you get when you

02:16

do this calculation is approximate but it's an easy way

02:19

to get close See alone out the thousand dollars of

02:21

fifteen percent interest but inflation that years five percent So

02:24

fifteen minus five is ten in the rial interest rate

02:27

here Yes it's ten percent Well that checks out if

02:30

you don't count money as money but counted as what

02:32

you can buy with the money like T infuse er's

02:35

Last January one you loaned out enough money to buy

02:38

one hundred T infuser a thousand dollars back one An

02:40

infuser cost ten bucks each Now it's December thirty one

02:44

In the same year you got back enough money to

02:46

buy approximately one hundred ten T infuser Right You got

02:49

eleven fifty back but infuser is cost ten fifty each

02:52

Now Right five percent inflation One hundred fuses worth of

02:55

money last year turned into enough to buy one hundred

02:57

ten in futures this year one hundred to one hundred

02:59

ten That's ah ten percent net riel return That's the

03:03

rial interest rate When you're the lender inflation eats into

03:06

your profit What should be a fifteen percent return then

03:10

becomes a realty ten percent return because five percent of

03:13

our money got slurped up by higher prices On the

03:16

other hand well it can be helpful in the same

03:18

deal your friend is paying you back in currency That's

03:21

five percent easier to get arm or liquid When you're

03:23

a borrower inflation helps you pay off alone easier It's

03:27

why a lot of countries who are highly in debt

03:29

love having inflation because it makes their debt so much

03:32

easier to pay back That's why lenders have to keep

03:34

the inflation rate in mind when they're quoting raids for

03:37

what they'll lend money at So let's look at it

03:40

on a national scale Greece is in trouble yet again

03:43

The country needs like eighteen billion dollars in loans from

03:46

the World Bank just so it can afford the marbled

03:48

cleaning bill for the Parthenon The World Bank has to

03:51

decide what interest rate to charge Well inflation's been running

03:54

high lately Last year was eight percent Experts predict it

03:57

will be about that same level for the foreseeable Yes

04:00

we're totally making up these numbers with the real world

04:03

way lower than that Meanwhile the World Bank wants to

04:05

secure a really interest rate of five percent Well what

04:08

does it do Well it wants a five percent real

04:10

rate when inflation's aid so it has to set the

04:12

nominal rate that's going to charge Greece to about thirteen

04:15

percent That's by plus eight equals thirteen even in Greece

04:18

So what about inflation Correction Well inflation correction is the

04:21

process of taking inflation out of an equation You adjust

04:25

a figure to take inflation into account It's the process

04:28

you're using to determine the rial rate Will the nominal

04:31

rates thirteen percent inflations eight percent after correcting or adjusting

04:35

for inflation while you end up with a real rate

04:37

Then of yes five percent Grease takes its loan with

04:40

thirteen percent interest Now it can keep the Parthenon sparkling

04:44

clean and tracked all those tourists who keep it out

04:46

of bankruptcy And hopefully it'll bring in enough dough to

04:49

fix the Olympic Stadium next year Good luck with that 00:04:52.71 --> [endTime] grease

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