Chapter 4 Understanding Interest Rates

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Present Value
A dollar paid to you one year from now is less valuable than a dollar paid to you today.

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Discounting the Future

Let i = 0.10 In one year $100 x (1+0.10)= $110 In two years $110 x (1+0.10)=$121 or $100 x (1+0.10)2

In three years $121 x (1+0.10)= $133

or $100 x (1+0.10)3

In general $100 dollars in n years:

$100 x (1+i)n
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Simple Present Value

PV = todays present value
CF = future cash flow or payments i = interest rate

CF PV n (1 i)
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Four Types of Credit Market Instruments I

1. Simple Loan: The lender provides the borrower with the principal that is repaid at the maturity date with interest 2. Fixed Payment Loan: The lender provides the principal which is repaid by making the same payment (principal + interest) every period for a set period of time.

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Four Types of Credit Market Instruments II

3. Coupon Bond: A coupon bond pays the owner of the bond a fixed interest payment (coupon payment) every year until the maturity date, when a specified final amount (face value or par value) is repaid 4. Discount Bond: A discount bond (also called a zerocoupon bond) is bought at a price below its face value (at a discount), and the face value is repaid at the maturity date. - special case: consol bond (perpetuity)

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Yield to Maturity
The yield to maturity is the interest rate that equates the present value of cash flow payments received from a debt instrument with its value today.

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Simple LoanYield to Maturity

PV = amount borrowed = $100 CF = cash flow in one year = $110 n= number of years = 1
$110 $100 (1 i)1 (1 i)1 x $100 $110 $110 (1 i) $100

For simple loans, the simple interest rate equals the yield to maturity
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Fixed Payment Loan Yield to Maturity

The same cash flow payment every period throughout the life of the loan LV= loan value FP = fixed yearly payment n= number of years until maturity

FP FP FP LV ... 2 n 1 i (1 i) (1 i)

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Coupon BondYield to Maturity I

Using the same strategy used for the fixed-payment loan P=price of coupon bond C = yearly coupon payment F= face value of the bond n= years to maturity

C C C C F P ... 2 3 n 1 i (1 i) (1 i) (1 i) (1 i)n

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Coupon BondYield to Maturity II

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Coupon BondYield to Maturity III

Three facts about coupon bonds: 1. When the coupon bond is priced at its face value, the yield to maturity equals the coupon rate. 2. The price of a coupon bond and the yield to maturity are negatively related. 3. The yield to maturity is greater than the coupon rate when the bond price is below its face value.

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Consol or Perpetuity
A bond with no maturity date that does not repay principal but pays fixed coupon payments forever.
C Pc ic Pc price of the consol C yearly interest payment ic yield to maturity of the consol C Can rewrite the above equation as : ic Pc

For coupon bonds, current yield is an approximation of yield to maturity

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Discount BondYield to Maturity

For any one year discount bond: F P i P F = face value of the discount bond P =current price of the discount bond. The yield to maturity equals the increase in price over the year divided by the initial price. As with a coupon bond, the yield to maturity is negatively related to the current bond price
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Yield on a Discount Basis

Yield on a discount basis:

F P 365 idb x P days to maturity

idb = yield on a discount basis

F= face value
P= purchase price
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Rate of Return
C Pt 1 Pt RET Pt Pt RET return from holding the bond from time t to t 1 Pt price of bond at time t Pt 1 price of the bond at time t 1 C coupon payment C current yield ic Pt Pt 1 Pt rate of capital gain g Pt
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Rate of Return and Interest Rates I

The return equals the yield to maturity only if the holding period equals the time to maturity. A 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 period. The more distant a bonds maturity, the greater the size of the percentage price change associated with an interest-rate change.

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Rate of Return and Interest Rates II

The more distant a bonds maturity, the lower the rate of return that occurs as a result of an increase in the interest rate.

Even if a bond has a substantial initial interest rate, its return can be negative if interest rates rise.

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Rate of Return and Interest Rates III

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Interest-Rate Risk
Prices and returns for long-term bonds are more volatile than those for shorter-term bonds. There is no interest-rate risk for any bond whose time to maturity matches the holding period.

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Real and Nominal Interest Rates

Nominal interest rate makes no allowance for inflation. Real interest rate is adjusted for changes in price level so it more accurately reflects the cost of borrowing. Ex ante real interest rate is adjusted for expected changes in the price level. Ex post real interest rate is adjusted for actual changes in the price level.

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Fisher Equation
i ir e

i = nominal interest rate ir = real interest rate e = expected inflation rate

When the real interest rate is low, there are greater incentives to borrow.
Low interest rates reduces the incentives to lend. The real interest rate is a better indicator of the incentives to borrow or lend.
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Indexed Bonds
December 10, 1991, when the government of Canada began to issue indexed bonds. Indexed bonds are bonds whose interest and principal payments are adjusted for changes in the price level

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