Understanding Interest Rates

Interest Rate: it is the percentage amount that you pay for borrowing, or get for
lending money, for a period of time.
Measuring interest rates:
Present Value: A dollar paid to you one year from now is less valuable than a dollar
paid to you today
Why? A dollar deposited today can earn interest and become $1 x (1+i) one year from
today.
P V = t o d a y 's ( p r e s e n t ) v a lu e
C F = f u t u r e c a s h f lo w ( p a y m e n t )
Simple Present Value
i = th e in te re s t ra te
CF
PV =
Four Types of Credit Market Instruments (1 + i )
n

1. Simple Loan: In which lender provides the borrower with an amount of funds,
which must be repaid to the lender at the maturity date along with an additional
payments for the interest. (Commercial loans to businesses)
2. A fixed-payment loan (fully amortized loan): The lender provides the borrower
with an amount of funds, which must be repaid by making the same payment every
period (such a month), consisting of part of the principal and interest for a set of
year. (Installment loans (such as auto loans) and mortgages).
3. A coupon bond: It 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. (Treasury bonds, corporate bonds)
4. A discount bond (zero-coupon bond): It is bought at a price below its face value
(at a discount) and the face value is repaid at the maturity date.
These four types of instruments require payments at different times:
 Simple loans and discount bonds make payment only at their maturity dates
 Payments loans and coupon bonds have payments periodically until maturity
Yield to Maturity: The interest rate that equates the present value of cash flow
payments received from a debt instrument with its value today.
Application of this principle reveals that bond prices and interest rates are negatively
related: when interest rate rises, the price of the bond must fall, and vice versa.

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The Distinction between Interest Rate and Returns
For any security, the rate of return is defined as the payments to the owner plus the
change in its value, expressed as a fraction of its purchase price.
T h e p a y m e n ts to th e o w n e r p lu s th e c h a n g e in v a lu e
e x p re s s e d a s a fra c tio n o f th e p u rc h a s e p ric e

C Pt  1 - Pt
RET = +
Pt Pt

R E T = re tu rn fro m h o ld in g th e b o n d fro m tim e t to tim e t + 1

P t = p ric e o f b o n d a t tim e t

P t  1 = p ric e o f th e b o n d a t tim e t + 1

C = coupon paym ent

C
= c u rre n t y ie ld = i c
Pt

Pt  1 - Pt
= ra te o f c a p ita l g a in = g
Pt

 The return equals the yield to maturity only if the time to maturity equals the
holding period.
 A rise in interest rates is associated with a fall in bond prices, resulting in capital
losses on bond whose terms to maturity are longer than the holding period
 The more distant a bond’s maturity, the greater the size of the price change
associated with an interest-rate change
 The more distant a bond’s maturity, the lower the rate of return that occurs as a
result of the increase in the interest rate
 Even though a bond has a substantial initial; interest rate, its return can turn out to
be negative if interest rates rise
The Distinction between 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 = n o m in a l in te re s t ra te

i r = re a l in te re s t ra te


e
= e x p e c te d in fla tio n ra te

W h e n th e re a l in te re s t ra te is lo w ,

th e re a re g re a te r in c e n tiv e s to b o rro w a n d fe w e r in c e n tiv e s to le n d .

T h e re a l in te r e s t ra te is a b e tte r in d ic a to r o f th e in c e n tiv e s to

b o rro w a n d le n d .

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