Business Finance 1

Lecture 5:
Valuation of Financial Assets; the cost of
money (Interest Rates)
Muslim Reza Mooman

1
  Learning Objectives 
• To learn how to measure and calculate
interest rates and the prices of financial
assets.
• To understand the relationship between the
interest rate on a financial instrument and its
market value.
• To look at the many different ways that banks
and other lending institutions calculate the
interest rates they charge borrowers for loans.
  Learning Objectives 
• To determine how interest rates or yields on
deposits in banks, credit unions, and other
depository institutions are figured.
 Units of Measurement
For Interest Rates and Security Prices
• The interest rate is the price that is charged to a
borrower for the loan of money.
• Interest Fee required by the lender for
rate on = the borrower to obtain credit  100
loanable Amount of credit made
funds available to the borrower
• Interest rates are usually expressed as annualized
percentages. However, both 360-day and 365-day
years are commonly used. The compounding
terms may also differ.
 Units of Measurement
For Interest Rates and Security Prices
• A basis point equals 1/100 of a percentage
point.
• Example
10.5% = 10% + 50 basis points, or 1050 basis points
 Units of Measurement
For Interest Rates and Security Prices
• The prices of common and preferred stock are
measured today in many markets in terms of
dollars and decimal fractions of a dollar (or
some other currency unit).
• Example
$40.25 per share (versus $40 1/4 in the recent past)
 Units of Measurement
For Interest Rates and Security Prices
• Bond prices are usually expressed in points
and fractions of a point, with each point
representing $1 on a $100 basis or $10 for a
$1000 bond.
• Example
A bond priced at 97 is selling for $97 on a $100
basis, or $970 for each $1000 in face value.
 Units of Measurement
For Interest Rates and Security Prices
• Security dealers usually quote two prices for
an asset.
• The higher ask price is the dealer’s selling
price, while the lower bid price is the dealer’s
buying price.
• The difference between the bid and ask prices
– known as the spread – provides the dealer’s
return for creating a market for the security.
 Measures of the Rate of Return (Yield)
On a Financial Asset
• The coupon rate of a security is the contracted
interest rate that the security issuer agrees to
pay at the time the security is issued.
• Example
A bond with a par value of $1000 and a coupon rate
of 9% pays an annual coupon of $90.
 Measures of the Rate of Return (Yield)
On a Financial Asset
• The current yield of a security is the ratio of
the annual income (dividends or interest)
generated by the security to its market value.
• Example
The current yield of a share of common stock selling
for $30 in the market and paying an annual dividend
of $3 to the shareholder is $3/$30 = 0.10, or 10%.
 Measures of the Rate of Return (Yield)
On a Financial Asset
• The yield to maturity of a financial asset is the
rate of interest that the market is prepared to
pay today for the financial asset.
• It is the rate that equates the purchase price
(P) with the present value of all the expected
annual net cash flows (CF) from the asset.
CF1 CF2 CF3
P   
1 ytm  1 ytm  1 ytm 
1 2 3
 Measures of the Rate of Return (Yield)
On a Financial Asset

• A bond trades at a discount from par if its price

is less than its par value, i.e. if its current yield
to maturity is higher than its coupon rate.
• A bond trades at a premium over par if its price
is more than its par value, i.e. if its current
yield to maturity is lower than its coupon rate.
• A bond trades at par if its price equals its par
value, i.e. if the current market interest rate on
comparable securities equals its coupon rate.
 Measures of the Rate of Return (Yield)
On a Financial Asset
• The holding-period yield is the rate of return
from an investment over its actual or planned
holding period.
• It is the discount rate equalizing the purchase
price (P0) of a financial asset with all the
discounted net cash flows (CF) received from
the asset from the time the asset is purchased
until the time it is sold (in period n).
CF1 CF2 CFn
P0    
1 hpy  1 hpy 
1 2
1 hpy n
 Yield-Asset Price Relationships
• The price of a security and its yield or rate of
return are inversely related – a rise in yield
implies a decline in price, while a fall in yield
implies a rise in the security’s price.
• This inverse relationship can be seen by noting
that investing funds in financial assets can be
viewed from two different perspectives –
 the borrowing and lending of money, and
 the buying and selling of securities.
 Yield-Asset Price Relationships
Equilibrium Security Prices and Interest Rates (Yields)

Interest-Rate Determination Security Price Determination

Interest Price
Demand
Rate (borrowing) Demand
(lending)

Supply Supply
(lending) (borrowing)
rE  PE 

Loanable Securities
QE Funds VE
 Yield-Asset Price Relationships
 demand for loanable funds   supply of securities

Interest-Rate Determination Security Price Determination

Interest D’ Price
Rate
D S D S
S’

 


Loanable Securities
Funds
 Yield-Asset Price Relationships
 supply of loanable funds   demand for securities

Interest-Rate Determination Security Price Determination

Interest Price D’
Rate
D S D S
S’

 


Loanable Securities
Funds
 Interest Rates
Charged or Paid by Institutional Lenders
• The simple interest method assesses interest
charges on a loan only for the period of time
that the borrower has actual use of the
borrowed funds.
• Interest = principal  rate  term
• The more frequently a borrower makes
repayments on a loan, the lesser the total
interest will be.
 Interest Rates
Charged or Paid by Institutional Lenders
• In the add-on rate approach, interest is calculated
on the full principal of the loan, and the sum of
interest and principal payments is divided by the
number of payments to determine the dollar
amount of each payment.
• In a single payment loan, the simple interest and
add-on methods give the same interest rate.
However, as the number of installment payments
increases, the borrower pays a higher effective
rate under the add-on method.
 Interest Rates
Charged or Paid by Institutional Lenders
• The discount method determines the total
interest charged to the customer on the basis
of the amount to be repaid. However, the
borrower receives as proceeds of the loan
only the difference between the total amount
owed and the interest bill.
• Hence, the effective interest rate is
Interest paid  100
Net loan proceeds
 Interest Rates
Charged or Paid by Institutional Lenders
• Each monthly payment of a home mortgage
loan first covers in full the monthly interest on
the outstanding principal. The remainder is
then applied to the principal of the loan, such
that the amount owed is reduced
progressively.
• The monthly
 L
r
12

 1 r
12

payment
t 12
where
L = total amount owed

1 r
12

t 12
1 r = annual loan interest rate
t = number of years of the loan
 Interest Rates
Charged or Paid by Institutional Lenders
• The U.S. Consumer Credit Protection Act of
1968 (Truth in Lending) requires lending
institutions to calculate and tell the borrower
the annual percentage rate (APR) he or she is
actually paying.
• The constant ratio formula usually gives a
close approximation to the true APR.
2mc m = number of payments in a year
APR   100 c = annual interest cost
N  1 P N = total number of payments
P = principal of the loan
 Interest Rates
Charged or Paid by Institutional Lenders
• The compounding of interest means that the
lender or depositor earns interest income on
both the principal amount and any
accumulated interest.
• The formula for calculating the future value of
a financial asset earning compound interest is:

 
FV = future value of the asset
tm
FV  P 1  r P = principal value of the asset
m r = annual interest rate
m = annual compounding frequency
t = term of the asset in years
 Interest Rates
Charged or Paid by Institutional Lenders
• The U.S. Truth in Savings Act of 1991 requires
depository institutions to use the daily
average balance in a customer’s deposit over
each interest-crediting period to determine
the customer’s annual percentage yield (APY)
for that deposit account.
 365
 where
 i
APY  1    1  100

d
i = interest earned
 b   b = daily average balance
  d = term in days
Money and Capital Markets in Cyberspace

• The measurement or calculation of interest

rates is a popular subject on many websites.
See, for example,
– http://www.interestratecalculator.com/
– http://www.compareinterestrates.com/
– http://www.digitalcity.com/
 Chapter Review
• Units of Measurement for Interest Rates and
Security Prices
– Definition of Interest Rates
– Basis Points
– Security Prices
 Chapter Review
• Measures of the Rate of Return, or Yield, on a
Loan, Security, or other Financial Asset
– Coupon Rate
– Current Yield
– Yield to Maturity
– Holding-Period Yield
• Yield-Asset Price Relationships
 Chapter Review
• Interest Rates Charged or Paid by Institutional
Lenders
– Simple Interest Rate
– Add-On Rate of Interest
– Discount Method
– Home Mortgage Interest Rate
– Annual Percentage Rate (APR)
– Compound Interest
– Annual Percentage Yield (APY)