Chapter 4

UNDERSTANDING INTEREST RATES

Interest rate

The cost of holding money

Measuring Interest rates

Ct+1

(1+i) Ct = Ct+i
Ct + i(Ct) = Ct+i

Ct =

C(t+1 )
(1+i)

Ct
Cannot directly compare payments scheduled in different points in timeline
Four types of Credit Market Instruments

Simple Loan
To be paid at the maturity date with corresponding interest
Coupon Bond
Interest paid every period with the principal paid at the maturity date
YTM = CR; Face value = Purchase Price
Coupon rate and YTM is negatively related
YTM> CR; Face Value > Purchase Price
Fixed Payment
To be paid every period with some part of the principal and interest
Consol or Perpetuity a bond with no maturity date that does not repay principal but
pats fixed coupon payments forever

*Yield to maturity the interest rate that equates the present value of cash flows payments
with its value today
Current Bond prices and interest rates are negatively related
Interest Rates and Returns

RET =

C Pt 1Pt
+
Pt
Pt

Holding period = Maturity; RET = YTM

Rise in interest rates is associated with a fall in bond prices, resulting in capital loss if
MAT>HOLDING
More distant maturity = the greater size of the percentage price change assoc with
interest rate change

More distant maturity = the lower the rate of return occurs assoc with interest rate
change

Interest-rate risk

Prices and returns for long-term bonds are more volatile than short term bonds
No interest-risk for bonds MAT=HOLDING

Distinction Between Real and Nominal Interest Rates

8% int rate =

( 1+0.08 ) ( 100 )= 108

1+
108
With inflation (9%):

( )

( 1+0.08 ) (100)
<100 -> investing in this rate is
(1+0.09)

unprofitable
Fisher Equation
F

(1+i r )( 1+ ) F = YTM

Future

Present RET

i=i r + e

Real interest rate is low, there is greater incentives to borrow and fewer
incentives to lend
Real interest rate is a better indicator of the incentives to borrow and lend and
of tightness of credit market conditions