Chapter 4

Understanding Interest Rates

Money and Banking

Deokwoo Nam
Department of Economics and Finance
Hanyang University

Page: 1
1. INTRODUCTION

1 Introduction

"Interest rates" are among the most closely watched variables in the economy, because they directly
a¤ect our everyday lives and have important consequences for the health of the economy.
– For instance, interest rates a¤ect the economic decisions of business and households, such as whether to
use their funds to invest in new equipment for factories or to save their money in a bank.
In this chapter, we do the following three things:
1. We understand exactly what the phrase interest rates means.
– Since a concept known as the yield to maturity is the most accurate measure of interest rates, we
discuss how the yield to maturity is measured.
2. We see that a bond’s interest rate does not necessarily indicate how good an investment in the bond is
because what it earns (its rate of return) does not necessarily equal its interest rate.
3. We explore the distinction between nominal and real interest rates.

Page: 2
2. MEASURING INTEREST RATES

2 Measuring Interest Rates

2.1 Present Value

"Di¤erent" debt instruments have very "di¤erent" streams of cash payments to the holder (known as cash
‡ows) with "very di¤erent timing."
– Thus, we …rst need to understand how we can compare the value of one kind of debt instrument
with another before we see how interest rates are measured. To do this, we make use of the concept of
present value.
The concept of present value (or present discounted value) is based on the commonsense notion that a
dollar paid to you one year from now is less valuable than a dollar paid to you today.
– This is because you can deposit a dollar today ($1) in a savings account that earns interest (i) and have
more than a dollar in one year ($1 (1 + i)).
Given an interest rate of 10%, today’s value of $100 will become:

$100 (1 + 0:1) = $110 or $100 (1 + 0:1)1 = $110 in 1 year

$110 (1 + 0:1) = $121 or $100 (1 + 0:1)2 = $121 in 2 years

$121 (1 + 0:1) = $131 or $100 (1 + 0:1)3 = $133 in 3 years

.. .. ..
. . .
$100 (1 + 0:1)n in n years

– The process of calculating today’s value of dollars received in the future is called discounting the future.
For example, $133 = $100 (1 + 0:1)3 three years from now is worth $100 today, so that today’s value
of $133 received in three years is calculated by the following discounting process:
$100 = $133/ (1 + 0:1)3
Page: 3
2. MEASURING INTEREST RATES

We can generalize this process by writing today’s (present) value of $100 as P V and the future cash
‡ow (payment) of $133 as CF , the number of years from today of 3 as n, and then replacing 0:1 by
an interest rate i:
P V = CF / (1 + i)n (2.1)

The concept of present value is extremely useful, because it allows us to …gure out today’s value (price)
of a credit (debt) market instrument at a given simple interest rate i by just adding up the individual
present values of all the future payments received.
– This information enables us to compare the values of two or more instruments with "very di¤erent timing"
of their payments.

2.2 Four Types of Credit Market Instruments

Before moving on to how interest rates are measured (i.e., the concept of the yield to maturity), we look at
four basic types of credit (debt) market instruments in terms of the timing of their cash ‡ow payments:
1. A simple loan in which the lender provides the borrower with an amount of funds (called the principal),
which must be repaid to the lender at the maturity date along with an additional payment for the interest.
– If you made your friend, Jane, a simple loan of $100 for one year, you would require her to repay the
principal of $100 in one year’s time along with an additional payment for interest, say, $10.
– Many money market instruments are of this type – for example, commercial loans to business.
2. A …xed-payment loan (also called a fully amortized loan) in which the lender provides the borrower
with an amount of funds, which must be repaid by making the same payment every period (such as a
year), consisting of part of the principal and interest for a set number of years.
– If you borrowed $1; 000, a …xed-payment loan might require you to pay $126 every year for 25 years.
– Installment loans such as auto loans and mortgages are frequently of the …xed-payment type.

Page: 4
2. MEASURING INTEREST RATES

3. A coupon bond pays the owner of the bond a …xed interest payment (coupon payment) every year until
the maturity date, when a speci…ed …nal amount (face value or par value) is repaid.
– Note that the coupon payment of a bond is determined by its coupon rate, the dollar amount of the
yearly coupon payment expressed as a percentage of the face value of the bond (e.g., 10% of a face
value of, say, $1; 000, so the coupon payment of $100).
– A coupon bond with $1; 000 face value might pay you a coupon payment of $100 per year for ten years,
and at the maturity date repay you the face value amount of $1; 000 – note that given the coupon
rate of 10%, the coupon payment is calculated as $100 = $1; 000 0:1.
– Capital market instruments such as U.S. Treasury bonds and notes and corporate bonds are examples
of coupon bonds.
4. A discount bond (also called zero-coupon bond) is bought at a price below its face value (at a discount),
and the face value is repaid at the maturity date.
– Unlike a coupon bond, a discount bond does not make any interest payments; it just pays o¤ the face
value.
– A one-year discount bond with a face value of $1; 000 might be bought for $900. So in a year’s time
the owner would be repaid the face value of $1; 000.
– U.S. Treasury bills, U.S. savings bonds, and long-term zero-coupon bonds are examples of discount
bonds.
These four types of credit (debt) market instruments require payments "at di¤erent times." In other
worlds, these instruments provide you with di¤erent income (in terms of di¤erent interest rates).
– Therefore, we use the concept of present value to provide us with a procedure for measuring
interest rates on these di¤erent types of instruments, which will be discussed shortly.

Page: 5
2. MEASURING INTEREST RATES

2.3 Yield to Maturity

Of the several common ways of calculating interest rates, the most important is the "yield to maturity," the
interest rate that equates the present value of cash ‡ow payments received from a debt instrument
with its value today.
– Because the concept behind the calculation of the yield to maturity makes good economic sense, econo-
mists consider it the most accurate measure of interest rates.
– To better understand the yield to maturity, we now look at how it is calculated for the four types of credit
market instruments.

1. Yield to Maturity on a Simple Loan

When applying the de…nition of the yield to maturity to a simple loan, its yield to maturity (i) on a simple
loan is calculated by solving for i from the following equation:
CF
PV
|{z} = (2.2)
(1 + i)n
Value of a debt instrument today | {z }
Present value of cash ‡ow payments received from that instrument

where P V = amount borrowed today; CF = cash ‡ow (principal plus interest payment); n = number of
years until maturity.
– For example, if Pete borrows $100 from his sister and next year she wants $110 back from him, what
is the yield to maturity on this simple loan?
$110
$100 = ) i = 10%
(1 + i)1

Page: 6
2. MEASURING INTEREST RATES

2. Yield to Maturity on a Fixed-payment Loan

The yield to maturity on a …xed-payment loan is calculated by solving for i from the following equation:
FP FP FP
LV
|{z} = + + + (2.3)
(1 + i)1 (1 + i)2 (1 + i)n
Value of a debt instrument today | {z }
Present value of cash ‡ow payments received from that instrument

where LV = loan value; F P = yearly …xed payment; n = number of years until maturity.
– For example, suppose that the loan is $100; 000 and the yearly payment is $9; 439:29 for the next 20
years. Then, the yield to maturity on this …xed-payment loan is calculated as follows:

$9; 439:29 $9; 439:29 $9; 439:29

$100; 000 = + + + ) i = 7%
(1 + i)1 (1 + i)2 (1 + i)20

Note that this calculation is not easy, but many …nancial calculators have programs that allow you
to …nd i, given the loan’s numbers for LV , F P , and n.

3. Yield to Maturity on a Coupon Bond

The yield to maturity on a coupon bond is calculated from the following equation:
C C C F
P
|{z} = + + + + (2.4)
(1 + i)1 (1 + i)2 (1 + i)n (1 + i)n
Value of a debt instrument today | {z }
Present value of cash ‡ow payments received from that instrument

where P = price of coupon bond; C = yearly coupon payment (i.e., coupon rate times face value); F =
face value of the bond; n = years to maturity date.
– For example, suppose that the price of a coupon bond is $889:2, its face value is $1; 000, its coupon
rate is 10% (so its coupon payment is $100), and years to maturity is 8. Then, its yield to maturity is:
Page: 7
2. MEASURING INTEREST RATES

$100 $100 $100 $1; 000

$889:2 = 1
+ 2
+ + 8
+ ) i = 12:25%
(1 + i) (1 + i) (1 + i) (1 + i)8

Note that …nancial calculators allow you to …nd i, given the numbers for P , C , F , and n.
Table 1 shows the yields to maturity calculated for "several" prices of the coupon bond maturing in 10
years with its face value of $1; 000 and its coupon rate of 10%, indicating three facts:

(a) When the coupon bond is priced at its face value (P = F ), the yield to maturity equals the
coupon rate (i = c, where c is the coupon rate) – veri…ed by manipulating Equation (2:4).
(b) The price of a coupon bond and the yield to maturity are negative related (that is, as i "
(#), P # (")) – veri…ed directly from Equation (2:4).
(c) When the bond price is below its face value (P < F ), the yield to maturity is greater than
the coupon rate (i > c) – veri…ed using Facts (a) and (b).

Page: 8
2. MEASURING INTEREST RATES

One special case of a coupon bond, consol (or perpetuity), is worth discussing because its yield to
maturity is particularly easy to calculate.
– It is a perpetual bond with no maturity date and no repayment of principal that makes …xed coupon
payments of $C forever:
C C C C C
Pc = 1
+ 2
+ 3
+ ) Pc = ) ic = Pc
(2.5)
(1 + ic ) (1 + ic ) (1 + ic ) ic
| {z }
where Pc = price of the consol (perpetuity); C = yearly payment; ic = yield to maturity of the consol
(perpetuity).
For example, let’s consider a bond that has a price of $2; 000 and pays $100 of interest annually
forever. Then, its yield to maturity is:
$100
ic = = 5%
$2; 000

– ic = PCc in Equation (2:5), the yearly coupon payment divided by the bond price, is a useful approx-
imation for the yield to maturity on any "long-term" coupon bond, and have been named current
yield.
When a coupon bond has a long term to maturity (say, twenty years or more), it is very much like
a perpetuity.
This is because the cash ‡ows more than twenty years in the future have such small present dis-
counted values that the value of a long-term coupon bond is very close to the value of a perpetuity
with the same coupon rate.

Page: 9
2. MEASURING INTEREST RATES

4. Yield to Maturity on a Discount Bond

The yield to maturity on a discount bond is calculated from the following equation:
F
P
|{z} = (2.6)
(1 + i)n
Value of a debt instrument today | {z }
Present value of cash ‡ow payments received from that instrument

where P = price of a discount bond (P < F ); F = face value of the bond; n = years to maturity date.
– For example, let’s consider a one-year U.S. Treasury bill, which pays a face value of $1; 000 in one
year’s time and its price is now set at $900. Then, its yield to maturity is:
$1; 000
$900 = ) i = 11:1%
(1 + i)1

– We also see in Equation (2:6) that for a discount bond, the yield to maturity and the current bond
price are negatively related.

In sum, we see that:

1. The yield to maturity, which is the most accurate measure of the interest rate, is the interest
rate that equates the present value of the future payments on a debt instrument to its value
today.
2. Current bond prices and interest rates are negatively related.

Page: 10
3. THE DISTINCTION BETWEEN INTEREST RATES AND RETURNS

3 The Distinction between Interest Rates and Returns

The return (or rate of return) on a bond or any other security accurately measures how well a person have
done by holding it over a particular time period.
– Let’s see what the return would look like for a $1; 000-face-value coupon bond with a coupon rate of 10%
that is bought for $1; 000, held for one year, and then sold for $1; 200:
$100 + ($1; 200 $1; 000)
= 30%:
$1; 000
This rate of return of 30% di¤ers substantially from the interest rate as measured by the yield to
maturity on that bond, 10% (because P = F , i = c).
Thus, this example indicates that the return on a bond will not necessarily equal the yield to
maturity on that bond.
– More generally, the return on a bond held from time t and time t + 1 can be written as:
C + Pt+1 Pt C Pt+1 Pt
R= = + ) R = ic + g (3.1)
Pt Pt
|{z} Pt }
| {z
Current yield (ic ) Rate of capital gain (g )

where R = return from holding the bond from time t and time t + 1; C = coupon payment; Pt = price of
the bond at time t; Pt+1 = price of the bond at time t + 1; ic = current yield (the coupon payment over
the purchase price; see the section about consol); g = rate of capital gain (change in the bond’s price
relative to the initial purchase price). That is, the return on a bond R is the current yield ic plus the
rate of capital gain g .
Even for a bond for which the current yield ic is an accurate measure of the yield to maturity i, the
return R can di¤er substantially from the interest rate i due to the rate of capital gain g .
Returns will di¤er from the interest rate "especially" if the price of the bond experiences sizable
‡uctuations that produce substantial capital gains and losses.
Page: 11
3. THE DISTINCTION BETWEEN INTEREST RATES AND RETURNS
Let’s look at what happens to the returns on bonds of "di¤erent" maturities when interest rates rise.
– Table 2 calculates the one-year return using Equa-
tion (3:1) on "di¤erent" 10%-coupon-rate bonds
in terms of their "years to maturity," when inter-
est rates on all these bonds rise from it = 10%
to it+1 = 20% in the next year.
Note that all of these bonds are purchased
at par (Pt = F ), so (a) their current inter-
est rates measured by the yield to maturity
equal the coupon rate, it = c = 10%, and (b)
their current yields also equal the coupon rate,
ic = c = 10%).
– Several key …ndings in this table are generally true
of all bonds:
The return equals the yield to maturity only
if the holding period equals the time to
maturity— see the last bond in the table.
A rise in interest rates is associated with a fall
in bond prices, resulting in capital losses on
bonds whose terms to maturity are longer than
the holding periods— see Column (5).
The more distant a bond’s maturity, (a) the
greater the size of the percentage price change
associated with an interest-rate change (10%
change in our example) and (b) the lower the
rate of return that occurs as a result of an in-
crease in the interest rate.
Even if a bond has a substantial initial interest
rate (10% in our example), its return can be
negative if interest rates rise.
Page: 12
3. THE DISTINCTION BETWEEN INTEREST RATES AND RETURNS

Maturity and the Volatility of Bond Returns: Interest-Rate Risk

– We saw that the prices of "longer-maturity" bonds respond "more" dramatically to (given)
changes in interest rates.
– This …nding helps explain an important fact about the behavior of bond markets:
Prices and returns for long-term bonds are more volatile than those for shorter-term bonds.
Price changes of +20% and 20% within a year, with corresponding variations in returns, are
common for bonds more than twenty years away from maturity.
In other words, longer-term bonds are more subject to interest-rate risk, the riskiness of an asset’s
return that results from interest-rate changes.
On the other hand, short-term bonds do not have substantial interest-rate risk.
Indeed, there is no interest-rate risk for any bond whose time to maturity matches the holding
period, because the price at the end of the holding period is already …xed at the face value, and then
the change in interest rates can have no e¤ect on the price at the end of the holding period, and
the return will therefore be equal to the yield to maturity known at the time the bond is purchased.

Page: 13
4. THE DISTINCTION BETWEEN REAL AND NOMINAL INTEREST RATES

4 The Distinction between Real and Nominal Interest Rates

What we have so far been calling the interest rate makes no allowance for in‡ation, and it is more precisely
referred to as the nominal interest rate.
We now distinguish the nominal interest rate from the (ex-ante) real interest rate, the interest rate that is
adjusted by subtracting expected changes in the price level (expected in‡ation).
– The "ex-ante" real interest rate is most important to economic decisions, and typically it is what econo-
mists mean when they make reference to the real interest rate.
On the other hand, the "ex-post" real interest rate is the interest rate adjusted for actual changes in
the price level (in‡ation) – it describes how well a lender has done in real terms after the fact.
The real interest rate is de…ned from the Fisher equation, which says the nominal interest rate i equals the
real interest rate r plus the expected in‡ation rate e :
e
i=r+

Rearranging terms, we …nd that:

r=i e (4.1)

– For example, when the nominal interest rate is 8% and the expected in‡ation rate is 10% over the course
of a year, the real interest rate is 2%.
Although you will be receiving 8% more dollars at the end of the year, you will be paying 10% more
for goods.
Thus, you will be able to buy 2% fewer goods at the end of the year, and you will be 2% worse o¤ in
real terms.

Page: 14
4. THE DISTINCTION BETWEEN REAL AND NOMINAL INTEREST RATES

– Figure 1 shows real and nominal interest rates on the three-month Treasury bill from 1953 to 2011,
indicating that nominal and real interest rates often do not move together:

Note that real interest rates are not observable because expected in‡ation are not known, so they are
estimates.
When the U.S. nominal rates were high in the 1970s, the real interest rates were actually extremely
low (often negative).
As in Figure 1, the data indicates that nominal and real interest rate do not move together.
– So the distinction between real and nominal interest rates is important because the real interest rate,
which re‡ects the "true" cost of borrowing in terms of "real" goods and services, is both a better
indicator of the incentives to borrow and lend and a more accurate indicator of the tightness of
credit market conditions than is the nominal interest rate:
1. When the real interest rate is low, there are greater incentives to borrow and fewer incentives to lend.
2. If the real interest rate is low, credit market conditions are not tight because it is not expensive to
borrow in real terms.

Page: 15