Chapter 4
Chapter 4Understanding Interest Rates 2013 Pearson Education,
Inc. All rights reserved. 4-# 1Why are interest
rates?http://www.youtube.com/watch?v=Pod73wrvdSQ&list=PLgLzhdC3EzlJb3Ws4zfjUtmmWtCFzlWD-
2013 Pearson Education, Inc. All rights reserved. 4-# What are
Cash Flows?Different streams of cash payments to the holders of
debt instruments (e.g. Bonds, Annuities, etc.) 2013 Pearson
Education, Inc. All rights reserved. 4-# Measuring Interest
RatesWhat is the Present Value?Would you rather have money today or
tomorrow?A dollar paid to you one year from now is less valuable
than a dollar paid to you todayWhy?A dollar deposited today can
earn interest and become $1 x (1+i) one year from today. 2013
Pearson Education, Inc. All rights reserved. 4-# 4Discounting the
Future
2013 Pearson Education, Inc. All rights reserved. 4-# 5Simple
(Loan) Present Value
2013 Pearson Education, Inc. All rights reserved. 4-# 6Quick
Check!Whats the PV of a Loan that has to be paid ($250) in two
years, if the interest rate is 15%?
PV = $250 / (1 + 0.15) = $250 /1.3225 == $ 189.04 2013 Pearson
Education, Inc. All rights reserved. 4-# Time
Line$100$100Year01PV1002$100$100n100/(1+i)100/(1+i)2100/(1+i)nCannot
directly compare payments scheduled in different points in the time
line 2013 Pearson Education, Inc. All rights reserved. 4-# Four
Types of Credit Market InstrumentsSimple LoanE.g. Commercial loans
to businessesFixed Payment LoanMortgagesCoupon BondA Bond that pays
a coupon (interest) every year or every 6 monthsDiscount BondAlso
called, Zero-coupon bondDoes not pay a coupon (interest)Always
issued at a Discount ( < $1,000) 2013 Pearson Education, Inc.
All rights reserved. 4-# 9Yield to MaturityThe interest rate that
equates the present value of cash flow payments received from a
debt instrument with its value today 2013 Pearson Education, Inc.
All rights reserved. 4-# 10Differences/SimilaritiesSimple loans and
discount bonds make payment ONLY at their maturity dates.
Fixed-payment loans and coupon bonds have payments periodically
until maturity 2013 Pearson Education, Inc. All rights reserved.
4-# Simple Loan
2013 Pearson Education, Inc. All rights reserved. 4-# 12Fixed
Payment Loan
2013 Pearson Education, Inc. All rights reserved. 4-# 13Coupon
Bond
2013 Pearson Education, Inc. All rights reserved. 4-# 14Table 1
Yields to Maturity on a 10%-Coupon-Rate Bond Maturing in Ten Years
(Face Value = $1,000)When the coupon bond is priced at its face
value, the yield to maturity equals the coupon rateYour book
(confusing): The price of a coupon bond and the yield to maturity
are negatively related. My own opinion: Price of a coupon bond and
YTM have an inverse relationshipThe yield to maturity is greater
than the coupon rate when the bond price is below its face
value
2013 Pearson Education, Inc. All rights reserved. 4-# 15Consol
or PerpetuityA bond with no maturity date that does not repay
principal but pays fixed coupon payments forever
For coupon bonds, this equation gives the current yield, an easy
to calculate approximation to the yield to maturity 2013 Pearson
Education, Inc. All rights reserved. 4-# 16Discount Bond
2013 Pearson Education, Inc. All rights reserved. 4-# 17The
Distinction Between Interest Rates and Returns
Rate of Return: 2013 Pearson Education, Inc. All rights
reserved. 4-# 18The Distinction Between Interest Rates and Returns
(contd)The return equals the yield to maturity only if the holding
period equals the time to maturityA rise in interest rates is
associated with a fall in bond prices, resulting in a capital loss
if time to maturity is longer than the holding periodThe more
distant a bonds maturity, the greater the size of the percentage
price change associated with an interest-rate change 2013 Pearson
Education, Inc. All rights reserved. 4-# 19The Distinction Between
Interest Rates and Returns (contd)The more distant a bonds
maturity, the lower the rate of return that occurs as a result of
an increase in the interest rateEven if a bond has a substantial
initial interest rate, its return can be negative if interest rates
rise 2013 Pearson Education, Inc. All rights reserved. 4-# 20Table
2 One-Year Returns on Different-Maturity 10%-Coupon-Rate Bonds When
Interest Rates Rise from 10% to 20%
2013 Pearson Education, Inc. All rights reserved. 4-#
21Interest-Rate RiskPrices and returns for long-term bonds are more
volatile than those for shorter-term bondsThere is no interest-rate
risk for any bond whose time to maturity matches the holding period
2013 Pearson Education, Inc. All rights reserved. 4-# 22The
Distinction Between Real and Nominal Interest RatesNominal interest
rate makes no allowance for inflationReal interest rate is adjusted
for changes in price level so it more accurately reflects the cost
of borrowingEx ante real interest rate is adjusted for expected
changes in the price levelEx post real interest rate is adjusted
for actual changes in the price level 2013 Pearson Education, Inc.
All rights reserved. 4-# 23Fisher Equation
2013 Pearson Education, Inc. All rights reserved. 4-# 24Figure 1
Real and Nominal Interest Rates (Three-Month Treasury Bill),
19532011
Sources: Nominal rates from www.federalreserve.gov/releases/H15
and inflation from ftp://ftp.bis.gov/special.requests/cpi/cpia.txt.
The real rate is constructed using the procedure outlined in
Frederic S. Mishkin, The Real Interest Rate: An Empirical
Investigation, Carnegie-Rochester Conference Series on Public
Policy 15 (1981): 151200. This procedure involves estimating
expected inflation as a function of past interest rates, inflation,
and time trends and then subtracting the expected inflation measure
from the nominal interest rate. 2013 Pearson Education, Inc. All
rights reserved. 4-# 25Problems AssignedPage 91: 1, 2, 3, 4, 5, 6,
7, 11, 12
Enjoy this Homework! We will go over them during next class!
These Questions/Problems are brought to you by: The University
of Curacao
2013 Pearson Education, Inc. All rights reserved. 4-#
