FMI

Interest Rates
Dr. Avinash Ghalke, CFA
Interest Rates
 Interest rate changes directly affect the values of
financial securities
 Interest rates actually observed in financial markets
are Nominal Interest Rates
 Factors Affecting Nominal Interest Rates
 Inflation
 Real risk-free rate
 Default risk
 Liquidity risk
 Special provisions — provisions like taxability,
convertibility, and callability
 Term to maturity

Dr Avinash Ghalke, CFA © 2022 2

Real Risk-Free Rate (Real RFR)
 The risk-free rate that would exist on a default free
security if no inflation were expected
 Nominal rate , expected inflation and real RFR are
related as

Dr Avinash Ghalke, CFA © 2022 3

Term structure of Interest rates – Yield Curve
 A comparison of market yields or interest rates on
securities, ceteris paribus except maturity

Source: http://www.worldgovernmentbonds.com/country/india/

Dr Avinash Ghalke, CFA © 2022 4

 Forecasting Interest Rates
 Ability to predict interest rates is critical to the
profitability of investors
 Yield curve represents the market’s current
expectations of future short-term interest rates

1R0 1R1

1 2
0 2R0

 A forward rate is an expected or “implied” rate on a

short-term security that is to be originated at some
point in the future

Dr Avinash Ghalke, CFA © 2022 5

Forward rate numerical
 A firm issued PQR two bonds. One bond with one-
year maturity offered a 8.25% return, while the
bonds with two years maturity offered a 8.75%
return. What is the implied one-year forward rate?

9.25%

Dr Avinash Ghalke, CFA © 2022 6

Time Value of Money
 Most fundamental in finance
 First Principle
 “A dollar today is worth more than a dollar tomorrow.”
 Second Principle
 “A safe dollar is worth more than a risky one”
 Interest rate is the compensation for delaying the
consumption

Dr Avinash Ghalke, CFA © 2022 7

Time Value of Money (TVM)
 Present Value
 Value of the investment cashflows as of today
 Future Value
 Value of the investment cashflows at the end of the
investment horizon
 Two forms of TVM
 Lump sum payment
 A single cash flow occurs at the beginning and end of the
investment horizon with no other cash flows exchanged.
 Annuity
 A series of equal cash flows received at fixed intervals over the
investment horizon.

Dr Avinash Ghalke, CFA © 2022 8

Lump Sum Valuation

Compounding

Discounting

 You want to buy a car that is currently priced at 10

Lacs. However, you will have to wait for 2 more
years before you graduate. You expect the prices will
rise at 5.65% over the next 2 years. What will be
price of the car after 2 years ?
 11,16,192

Dr Avinash Ghalke, CFA © 2022 9

 You are looking to buy a car 2 years later. You would
like to set aside the required amount in 2 year FD,
where bank is offering 8%. What is the principal
amount of FD ?
 9,56,955

Dr Avinash Ghalke, CFA © 2022 10

Interest Rate - Compounding Frequency
 If r is the yearly rate and m is the frequency of
compounding,

Effective rate =

m = 12 for monthly
4 for quarterly
2 for Half yearly

Dr Avinash Ghalke, CFA © 2022

 You are looking to buy a car 2 years later. You would
like to set aside the required amount in 2 year FD,
where bank is offering 8%. What is the principal
amount of FD ? The bank agrees for a quarterly
compounding.
 9,52,659
 What if the bank goes for continuous compounding
i.e number of time periods is infinite

 9,51,156

Dr Avinash Ghalke, CFA © 2022 12

Present Value of Annuity

C = Amount of each payment, end of period

 What amount must one invest today at 8%

compounded annually so that you can withdraw
3,000 at the end of each year for the next 4 years?
 9936

Dr Avinash Ghalke, CFA © 2022

Future Value of Annuity

Dr Avinash Ghalke, CFA © 2022 14

Present Value of Perpetuity
 Annuity payments for perpetuity
 PV of perpetual CF
PV = C / r
where
C is the perpetual equal CF, r is the discounting rate

A Perpetual bond is issued that pays interest of 60

every year. The current interest rate in the market is
5.3%. What is the present value of the cashflows for
the perpetual bond holder.
1132.075

Dr Avinash Ghalke, CFA © 2022

Annuity Due
Annuity due - Level stream of cash flows starting
immediately

How does it differ from an ordinary annuity?

PVAnnuity due  PVAnnuity  (1  r )

How does the future value differ from an ordinary annuity?

FVAnnuity due  FVAnnuity  (1  r )

Dr Avinash Ghalke, CFA © 2022
Valuing Growing Annuities
 Assuming the annuity grows at a rate of g, till
perpetuity

PV = C1 / (r –g)
Where C1 is the cashflow next year

Assume you received a dividend of Rs 5 this year. The

company announced that they would be increasing
dividend at the rate of 3% till perpetuity. Assuming a
discounting of 11%, what is the present value of the
dividends ?
64.375

Dr Avinash Ghalke, CFA © 2022