First, I want to thank everyone who took the financial literacy quiz since I posted it! And even better, everyone that took the quiz got 4 or 5 of the questions correct and the only question people got wrong was question three! Over 80% of the people got the bonus question correct too! Today, I’ll go over question three and the bonus question to try and clear up any confusion about them.
Question 3:
If interest rates rise, what will typically happen to bond prices? Rise, fall, stay the same or there is no relationship?
The correct answer is that bond prices will fall if interest rates rise. A bond is a form of debt issued by a government or company. A bond will be issued with a ‘face value’ and a ‘coupon’ or interest rate. Once bonds are issued, they may be bought and sold, and the selling price of the bond is influenced by the overall interest rates of the financial markets. The coupon remains constant over the lifetime of the bond. For example, if you bought a $1,000 bond with a 5-year duration and 5% interest rate at issuance, you would receive $50 every year in interest, and when the bond matured in 5 years, you would also receive you $1,000 back. The $50 payment each year is fixed, but depending on change in overall financial market interest rates, the value of the bond may change during the 5-years before the bond is redeemed. If interest rates rose to 6%, the bond value at that time would only be $833.33, but if you held until redemption (5 years), you would still get $1,000, unless the government or company was unable to repay the debt and was forced into bankruptcy. If this was confusing, that is okay. It is definitely the most difficult question on the quiz, which is also why I’ll go over another example of price and interest using a company’s stock.
For the second example, I will use a company that pays a dividend and everyone has heard of and has visited at some point in their lives: CVS. As of the financial markets close at 4pm Eastern on Thursday February 24, 2022, a single share of CVS was worth $100.77. Right now, CVS pays an annual dividend of $2.20, which results in a dividend yield of 2.18%. The dividend payment is constant for now, so CVS will pay $2.20 to each shareholder for every share they own no matter what the price of a single share is. Someone owning 100 shares would receive $220 in dividend payments from CVS annually. Now, getting to how the interest rate or dividend yield changes, CVS will pay the $2.20 per share whether every share is $75, $100, or $125. Depending on the share price of CVS, the dividend yield will be different. At $75 per share, the dividend yield would be 2.93%, and at $125 per share, the dividend yield would be 1.76%.
Bonus Question:
Suppose you owe $1,000 on a loan and the interest rate you are charged is 20% per year compounded annually. If you didn’t pay anything off, at this interest rate, how many years would it take for the amount you owe to double? Less than 2 years, 2 to 4 years, 5 to 9 years, or 10 or more years?
The correct answer was 2 to 4 years. There are two ways to come up with the answer, and I’ll cover both here. One way is to compound the interest annually (once per year) at 20%.
After year one: $1,000 x 1.20 = $1,200
After year two: $1,200 x 1.20 = $1,440
After year three: $1,440 x 1.20 = $1728
After year four: $1,728 x 1.20 = $2,073.60
The other way to determine the time it would take to double is to use the “Rule of 72”, which states that the years to doubling money (in this case a debt) is equal to 72 divided by the interest rate.
For this situation the equation would be:
# years to double = 72/20 = 3.6 years
So it would take 3.6 years to double the debt at a 20% interest rate.
I hope these explanations were helpful. Thanks again to everyone that took the quiz! And you all did great on it as well! Feel free to let me know if there are any topics that you want to hear about through the Contact Us page.
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