If you mention the words “interest rates” to most people, there is one thing that immediately comes to mind – sleep. If a short article on interest rates can cure insomnia, why would we offer a full course on the subject?Interest rates are the building blocks for all financial decisions. The house you buy, trips you take, education you receive, and hours you work all depend on interest rates. They are also the foundation for determining all asset prices, including options. If you wish to become a better investor or desire to expand your knowledge of options and strategies, you must understand interest rates, how they are determined, how they are controlled.
So what exactly are these things we call interest rates?
Interest rates can be thought of as the price of money. If you wish to borrow money to buy a new car, for example, you must pay back the loan plus an additional amount. That additional amount is the “price” you are paying for the loan, which is solely determined by the interest rate charged. If that interest rate (price) is too high, many potential buyers will decide against the loan, which in turn influences the number of buyers for the car.
Any time you borrow money, your decision is influenced by the interest rate, which in turn dictates whether new products or services will come to market. Even if you never borrow money, the interest rate still plays an important role since it represents a cost to you. It’s the amount of money you’ll lose by not leaving it in the bank.
At the same time, interest rates influence the supply of money deposited at banks. The higher the rate, the more willing people are to deposit money. As the deposits increase, the supply of money available for loan increases, which in turn puts downward pressure on the interest rate.
While interest rates are determined by the supply and demand for money, they differ from other prices in the United States. The reason is that the Federal Reserve (also called the Fed) can change the supply of money, thus influencing the rates. Understanding the Fed and how they influence rates is critical for understanding why and when consumers and corporations make the decisions they do.
If you understand the function of interest rates and how they are determined and controlled, you will be able to anticipate the longer term directions of the market, the likely actions of the Federal Reserve, and therefore make more informed decisions about the choice and timing of your investments.
Further, there are many option strategies that attempt to profit from changes in interest rates. Once again, to understand when and why these opportunities appear, you must understand interest rates.
We will cover all the information you need to know – from A to Z – necessary to understand the mysterious phenomenon of interest rates. We’ll present it in a way that is easy to understand but, most of all, useful. We don’t want you using it to catch up on sleep. We want you to become better investors.
Before we get started, there are three fundamental economic concepts you must understand which will appear throughout the course and greatly enhance your understanding of advanced concepts covered later:
The Power of Incentives
Opportunity Costs
Supply and Demand
We’ll take an in-depth look at each of these in turn. They are essential to your understanding of interest rates.