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Understanding Interest Rates

The document discusses key concepts related to interest rates including present value, yield to maturity for different types of loans and bonds, the relationship between bond prices and yields, and the distinction between real and nominal interest rates. It provides examples and facts for many of these topics.

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Yulianti Raharjo
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46 views12 pages

Understanding Interest Rates

The document discusses key concepts related to interest rates including present value, yield to maturity for different types of loans and bonds, the relationship between bond prices and yields, and the distinction between real and nominal interest rates. It provides examples and facts for many of these topics.

Uploaded by

Yulianti Raharjo
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPT, PDF, TXT or read online on Scribd
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Chapter 4

Understanding
InterestRates
Present Value
FourTypesofCreditInstruments
1. Simpleloan
2. Fixedpaymentloan
3. Couponbond
4. Discount(zerocoupon)bond
ConceptofPresentValue
Simpleloanof$1at10%interest
Year 1 2 3 n
$1.10 $1.21 $1.33 $1x(1+i)n
$1
PVoffuture$1=
(1+i)n
2004 Pearson Addison- 4-2
Yield to Maturity: Loans
Yieldtomaturity=interestratethatequatestodaysvaluewith
presentvalueofallfuturepayments
1. SimpleLoan(i=10%)
$100=$110/(1+i)
$110$100 $10
i= = =0.10=10%
$100 $100

2. Fixed Payment Loan (i = 12%)


$126 $126 $126 $126
$1000 = + + + ... +
(1+i) (1+i) 2
(1+i) 3
(1+i)25
FP FP FP FP
LV = + + + ... +
(1+i) (1+i) 2
(1+i) 3
(1+i)n
2004 Pearson Addison- 4-3
Yield to Maturity: Bonds
3. Coupon Bond (Coupon rate = 10% = C/F)
$100 $100 $100 $100 $1000
P= + + + ... + +
(1+i) (1+i)2 (1+i)3 (1+i)10 (1+i)10
C C C C F
P= + + + ... + +
(1+i) (1+i)2 (1+i)3 (1+i)n (1+i)n

Consol: Fixed coupon payments of $C forever


C C
P= i =
i P
4. Discount Bond (P = $900, F = $1000), one year
$1000
$900 =
(1+i)
$1000 $900
i= = 0.111 = 11.1%
$900
FP
i=
P
2004 Pearson Addison- 4-4
Consol (or Perpetuity)
Aperpetualbondwithnomaturitydateandnorepaymentof
principalthatmakesfixedcouponpaymentsof$Cforever.

FirstsoldduringtheNapoleonicWars(17991815)bythe
BritishTreasury.

P=C/i
Theformulaofinfinitesum

2004 Pearson Addison- 4-5


Relationship Between Price
and Yield to Maturity

ThreeInterestingFactsinTable1
1. Whenbondisatpar,yieldequalscouponrate
2. Priceandyieldarenegativelyrelated
3. Yieldgreaterthancouponratewhenbondpriceisbelowparvalue
2004 Pearson Addison- 4-6
Current bond prices and interest rates are
negatively related

Whentheinterestraterises,
thepriceofbondfalls

Whentheinterestratefalls,
thepriceofbondrises.

2004 Pearson Addison- 4-7


Distinction Between Interest Rates
and Returns

RateofReturn
C+Pt+1Pt
RET= =ic+g
Pt

C
where: ic = = current yield
Pt

Pt+1 Pt
g= = capital gain
Pt
2004 Pearson Addison- 4-8
Key Facts about Relationship
Between Interest Rates and Returns

2004 Pearson Addison- 4-9


Maturity and the Volatility
of Bond Returns
KeyFindingsfromTable2
1. Onlybondwhosereturn=yieldisonewithmaturity=holdingperiod
2. Forbondswithmaturity>holdingperiod,iPimplyingcapitalloss
3. Longerismaturity,greateris%pricechangeassociatedwithinterest
ratechange
4. Longerismaturity,morereturnchangeswithchangeininterestrate
5. Bondwithhighinitialinterestratecanstillhavenegativereturnifi
ConclusionfromTable2Analysis
1. Pricesandreturnsmorevolatileforlongtermbondsbecausehave
higherinterestraterisk
2. Nointerestrateriskforanybondwhosematurityequalsholdingperiod

2004 Pearson Addison- 4-10


Distinction Between Real
and Nominal Interest Rates
RealInterestRate
Interestratethatisadjustedforexpectedchangesinthepricelevel
ir=ie i
(1+i)=(1+ )(1+ e)
r

1. Realinterestratemoreaccuratelyreflectstruecostofborrowing
2. Whenrealrateislow,greaterincentivestoborrowandlesstolend
ifi=5%and e=3%then:
ir=5%3%=2%

ifi=8%and e=10%then
ir=8%10%=2%

2004 Pearson Addison- 4-11


U.S. Real and Nominal Interest Rates

2004 Pearson Addison- 4-12

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