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Understanding Interest Rates: © 2005 Pearson Education Canada Inc

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Yasser Almishal

Money, Banking

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© All Rights Reserved
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Understanding Interest Rates: © 2005 Pearson Education Canada Inc

Uploaded by

Yasser Almishal
27 views14 pages
Money, Banking

Original Title

ch04

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© © All Rights Reserved

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PPT, PDF, TXT or read online from Scribd

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Money, Banking

Copyright:

© All Rights Reserved
Download as PPT, PDF, TXT or read online from Scribd
Download as ppt, pdf, or txt
27 views14 pages

Understanding Interest Rates: © 2005 Pearson Education Canada Inc

Uploaded by

Yasser Almishal
Money, Banking

Copyright:

© All Rights Reserved
Download as PPT, PDF, TXT or read online from Scribd
Download as ppt, pdf, or txt
You are on page 1/ 14

Chapter 4

Understanding
Interest Rates

© 2005 Pearson Education Canada Inc.


Present Value
Four Types of Credit Instruments
1. Simple loan
2. Fixed-payment loan
3. Coupon bond
4. Discount (zero coupon) bond
Concept of Present Value
Simple loan of $1 at 10% interest
Year 1 2 3 n
$1.10 $1.21 $1.33 $1x(1 + i)n
$1
PV of future $1 =
(1 + i)n
© 2005 Pearson Education Canada Inc. 4-2
Yield to Maturity: Loans
Yield to maturity = interest rate that equates today’s value with
present value of all future payments
1. Simple Loan (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
© 2005 Pearson Education Canada Inc. 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
F–P
i=
P
© 2005 Pearson Education Canada Inc. 4-4
Relationship Between Price
and Yield to Maturity

Three Interesting Facts in Table 1


1. When bond is at par, yield equals coupon rate
2. Price and yield are negatively related
3. Yield greater than coupon rate when bond price is below par value

© 2005 Pearson Education Canada Inc. 4-5


Current Yield
C
ic =
P

Two Characteristics
1. Is better approximation to yield to maturity, nearer price is to par and longer is maturity
of bond
2. Change in current yield always signals change in same direction as yield to maturity
Yield on a Discount Basis
(F – P) 365
idb = x
P (number of days to maturity)

A 91-day bill, P = $988, F = $1000


$1000 – $988 365
idb = x = 0.0487 = 4.8%
$988 91
Two Characteristics
1. Understates yield to maturity
2. Change in discount yield always signals change in same direction as yield to maturity

© 2005 Pearson Education Canada Inc. 4-6


Bond Page of the Newspaper:
Canada Bonds

© 2005 Pearson Education Canada Inc. 4-7


Bond Page of the Newspaper:
Provincial and Municipal Bonds

© 2005 Pearson Education Canada Inc. 4-8


Bond Page of the Newspaper:
Corporate Bonds

© 2005 Pearson Education Canada Inc. 4-9


Distinction Between Interest Rates
and Returns

Rate of Return
C + Pt+1 – Pt
RET = = ic + g
Pt
C
where: ic = = current yield
Pt

Pt+1 – Pt
g= = capital gain
Pt
© 2005 Pearson Education Canada Inc. 4-10
Key Facts about Relationship
Between Interest Rates and Returns

© 2005 Pearson Education Canada Inc. 4-11


Maturity and the Volatility
of Bond Returns
Key Findings from Table 2
1. Only bond whose return = yield is one with maturity = holding period
2. For bonds with maturity > holding period, i  P implying capital loss
3. Longer is maturity, greater is % price change associated with interest
rate change
4. Longer is maturity, more return changes with change in interest rate
5. Bond with high initial interest rate can still have negative return if i 
Conclusion from Table 2 Analysis
1. Prices and returns more volatile for long-term bonds because have
higher interest-rate risk
2. No interest-rate risk for any bond whose maturity equals holding period

© 2005 Pearson Education Canada Inc. 4-12


Distinction Between Real
and Nominal Interest Rates
Real Interest Rate
Interest rate that is adjusted for expected changes in the price level
ir = i – e

1. Real interest rate more accurately reflects true cost of borrowing


2. When real rate is low, greater incentives to borrow and less to lend
if i = 5% and e = 3% then:
ir = 5% – 3% = 2%

if i = 8% and e = 10% then


ir = 8% – 10% = –2%

© 2005 Pearson Education Canada Inc. 4-13


U.S. Real and Nominal Interest Rates

© 2005 Pearson Education Canada Inc. 4-14

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