08/11/2019

MONEY AND BANKING

Tran Thi Minh Tram

Email: tramttm@ftu.edu.vn

Chapter 32.1
Understanding
interest rate

Assigned reading: chapter 4

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LEARNING OBJECTIVES
• After studying this chapter you should be able to
1. Understand what interest rate is
2. Explain how the interest rate links present value with
future value
3. Know that the yield to maturity is the most accurate
measure of interest rates
4. Explain the difference between interest rates and rates
of return
5. Understand different kinds of interest rates
6. Explain the relationship between the yield to maturity on
a bond and its price
7. Understand the inverse relationship between bond
prices and bond yields

Content

INTEREST RATES: INTERPRETATION

INTEREST RATE AND TIME VALUE OF MONEY

INTEREST RATE AND YIELD TO MATURITY

INTEREST RATE AND RATE OF RETURN

TYPES OF INTEREST RATE

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INTEREST RATES: INTERPRETATION

• Interest represents the return, or
compensation, a lender demands before
agreeing to lend money.
• Interest is normally expressed in
percentage terms, called the interest rate
(denoted r or i)

Why do lenders charge interest rates on loans?

bsp: basic point (1% = 100bsp)

Interest rates: interpretation

• Example 2.1.1:
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– if you lend $100 for one year
– the return you require for doing so is $10
– The interest rate you are charging for the loan
is: $10/$100=.10 or 10%

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Interest rates: interpretation

• Note:
– When mentioned, interest rates are usually
quoted as annually interest rates.
– The interest rate, in any situation, is called
the nominal interest rate.
• Ex: if the bank say the interest rate for a
home loan is 12%, it means:
– the interest rate is 12% per year and
– it is nominal interest rate.

Interest rates: interpretation

• What does interest rate mean?
– The price demanded by the lender from the
borrower for the use of borrowed money
– From a borrower’s perspective: cost of capital -
the cost that a borrower has to incur to have
access to funds.
– From the lenders’ perspective: earnings or "rent
of money"

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Interest rate: Interpretation

• Interest rates can be thought in three ways:
– Required rates of return: the minimum rate of
return an investor must receive in order to
accept the investment.
– Discount rates: the rate used to discount the
future amount to find its value today.
– Opportunity costs: the value the investor forgo
by choosing a particular course of action.

Interest rate: Interpretation

• Example 2.1.2: You agree to lend $9,500
now and receive back $10,000 a year later.
– If $9,500 today and $10,000 a year later are
equivalent in value, then $10,000 - $9,500 =
$500 is the required compensation for
receiving $10,000 in one year later than now.
– The interest rate – the required compensation
stated as a rate of return – is: $500/$9,500 =
0.0526 or 5.26%

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Interest rate: Interpretation

• Example 2.1.2 (cont):
• $500/$9,500 = 5,26%
– Is the Required rates of return that the investor
agree for his investment.
– Is the Discount rates at which we discount the
$10,000 future amount to find its present
value.
– Is the Opportunity costs as if the investor does
not lend $9,500 but use it today, he would have
forgone earning 5.26% on the money.

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Why do we need interest rate?

• Lenders do not give credit for free:
– Because of:
• Opportunity cost
• Default risk
• Inflation
– How can they charge borrowers?
• Most financial transactions involve payments in the
future.
– For instance, suppose that you need to borrow $15,000 from
your bank to buy a car. Consider two loans:
• Loan A, which requires you to pay $366.19 per month for 48 months IRR = 6.66
• Loan B, which requires you to pay $318.71 per month for 60 months IRR = 8.33
• Which loan would you prefer?
– How is it possible to compare different transactions?

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Why do we need interest rate?

• Interest rate provides a means of
answering questions like these because it
provides:
– a link between the financial present and the
financial future (a measure of an Intertemporal
Price)

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2 INTEREST RATE AND TIME VALUE OF

MONEY
• Economists refer to the way that the value of
a payment changes depending on when the
payment is received as the time value of
money.
• The time value of money reflects as Future
value and Present value.
– Future value is the value at some future time of an
investment made today.
– Present value is the value today of funds that will be
received in the future.
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Relationship between FV and PV

• There is a close relationship between the
Present Value and its Future Value.
– Principle to find FV: compound the value of
money today (PV) to have its Future Value.
– Principle to find PV: discount the value of FV to its
today value.

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Compounding
• Consider an example of compounding.
– Suppose that you deposit $1,000 in a bank
certificate of deposit (CD) that pays an
interest rate of 5%.What will be the future
value of this investment?

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Compounding
• Future value refers to the value at some
future time of an investment made today.
o FV1 = 1000 + (1000 x .05) = 1050
o FV1 = Principal + (Principal x Interest Percentage)
o FV1 = Principal (1 + i)

• In which:
– i = the interest rate
– Principal = the amount of your investment (your original $1,000)
– FV1 = the future value (what your $1,000 will have grown to in one year)

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Compounding
• Compounding for More Than One Period
– Suppose that at the end of one year, you decide to
reinvest in—or roll over—your CD for another year.
– If you reinvest your $1,050 for a second year, you will
not only receive interest on your original investment
of $1,000, you will also receive interest on the $50 in
interest you earned the first year.
• Economists refer to the process of earning
interest on interest as savings accumulate over
time as compounding.

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Compounding
• Use the interest rate to link the financial
future with the financial present
– In general, we use compounding to find future
value of an amount of money:
FV = PV * (1+i)n
• In which:
– i = the interest rate
– PV = the present value
– FV = the future value

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Frequency of compounding
• General Formula:

FVn,m= PV0(1 + [i/m])mn

 n: Number of Years
 m: Compounding Periods per Year
 i: Annual Interest Rate
 FVn,m: FV at the end of Year n
 PV0: PV of the Cash Flow today

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Discounting
• Consider an example of discounting
– How much would you be willing to pay the bank
today if it promised to pay you $1,050 in one
year?

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Discounting
• Funds in the future are worth less than funds
in the present, so funds in the future have to
be reduced, or discounted, to find their
present value.
• The present value is the value today of funds
to be received in the future.
• To carry out this discounting, we reverse the
compounding process we just discussed.

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Discounting
• Use the interest rate to link the financial
future with the financial present
– We use discounting to find present value of a
future value:
PV = FV / (1+i)n
• In which:
– i = the interest rate
– PV = the present value
– FV = the future value ($1,050 you will in one year)

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Time value of money

1. Present value is sometimes referred to as
“present discounted value.”
2. The further in the future a payment is to be
received, the smaller its present value.
3. The higher the interest rate used to discount
future payments, the smaller the present value
of the payments.
4. The present value of a series of future payment
is simply the sum of the discounted value of
each individual payment.
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Discounting and the Prices of

Financial Assets
• Discounting gives us a way of determining the
prices of financial assets
• The price of a financial asset is equal to the
present value of the payments to be received
from owning it

𝒏 1000
Price= 𝒌=𝟎 𝑷𝑽 𝒐𝒇 𝒂𝒍𝒍 𝒕𝒉𝒆 𝒑𝒂𝒚𝒎𝒆𝒏𝒕𝒔
80 80
8%
Face value = $1000 25 3
Price = $1050 1050
=> Why P > Par?
Because the discount rate higher than 8% (coupon rate)
-> calculate the price -> lower than 1000
8/11/2022

3 INTEREST – YIELD TO 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 YTM ~ r (mau so) ~ IRR
• Whenever participants in financial markets refer
to the interest rate on a financial asset, the
interest rate is the yield to maturity.
• Calculating yields to maturity for alternative
investments allows savers to compare different
types of debt instruments.

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Yield to maturity
• Debt instruments: (also known as credit
market instruments or fixed income assets)
Methods of financing debt, including simple
loans, discount bonds, coupon bonds, and
fixed payment loans.
• Equity: A claim to part ownership of a firm;
common stock issued by a corporation.

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Four types of credit instruments

1. Simple loan:
• Principal + Interest paid to lender at given maturity date
2. Fixed-payment loan:
• Fixed payment (incorporating part of the principal and
interest payment) paid over a period of time
3. Coupon bond:
• Pays owner of bond a fixed (coupon) payment, until
maturity when it pays off face (par) value
4. Discount (zero coupon/ discounted bond)
• Bought at price below face value (discounted), and face
value repaid at maturity

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Simple loan

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Simple loan - Yield to Maturity

• PV = amount borrowed
• FV = amount paid after 1 year

𝐹𝑉 − 𝑃𝑉
𝑖=
𝑃𝑉

For a simple loan, the simple interest rate

equal the yield to maturity

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Simple loan - Yield to Maturity

• Example 2.1.3:
• For the one-year loan we discussed, today's
value is $ 100, and the payments in one years
time would be $ 110 (the repayment of $ 100
plus the interest payment of $ 10). Calculate
yield to maturity of this loan?

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Discount bond
buy at discount, no coupon

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Discount bond—Yield to Maturity

For any one year discount bond
F-P
i=
P
F = Face value of the discount bond
P = current price of the discount bond
The yield to maturity equals the increase
in price over the year divided by the initial price.
As with a coupon bond, the yield to maturity is
negatively related to the current bond price.

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Discount bond—Yield to Maturity

• Example 2.1.4:
• Suppose that Nate’s Nurseries issues a
$10,000 one-year discount bond. If Nate’s
Nurseries receives $9,200 today from selling
the bond, calculate the yield to maturity of
this bond?

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Fixed payment loan

PV(OA) = A/i (1- 1/(1+i)^n))

compouding monthy

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Fixed payment loan - Yield to Maturity

The same cash flow payment every period throughout
the life of the loan
LV = loan value
FP = fixed yearly payment
n = number of years until maturity
FP FP FP FP
LV =  2
 3
 ...+
1 + i (1 + i ) (1 + i ) (1 + i ) n

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Fixed payment loan - Yield to Maturity

• Example 2.1.5:
• Suppose that Nate’s Nurseries borrows
$100,000 to buy a new warehouse by taking
out a mortgage loan from a bank. Nate’s has
to make annual payments of $12,731. After
making the payments for 20 years, Nate’s will
have paid off the $100,000 principal of the
loan. Calculate the yield to maturity?
YTM = 11.2%
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Coupon bond

1000= 100/ (1+YTM) ....+ 1100/(1+YTM)^30

hoac dung cong thuc nien kim ( cong PV cua 1000 o cuoi)
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Fiat money : tien dinh danh

Coupon bond - Yield to Maturity

Using the same strategy used for the fixed-payment loan:
P = price of coupon bond
C = yearly coupon payment
F = face value of the bond
n = years to maturity date
C C C C F
P=    . . . + 
1+i (1+i) 2 (1+i)3 (1+i) n (1+i ) n

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Coupon bond - Yield to Maturity

• Example 2.1.6:
• Which is a better investment,
– (1) a three-year, $1,000 face value coupon bond
with a price of $1,050 and a coupon rate of 8% or
– (2) a two-year, $1,000 face value coupon bond
with a price of $980 and a coupon rate of 6%?

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Consol or Perpetuity
• A bond with no maturity date that does not repay
principal but pays fixed coupon payments forever

Pc = C/ic
• Where:
 Pc = price of the consol
 C = yearly interest payment
 ic = yield to maturity of the consol

• Can rewrite above equation as ic= C/ Pc

 For coupon bonds, this equation give current yield an easy-to-
calculate approximation of yield to maturity
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Approximation to YTM
• Current Yield
Pc = C/ic
– Two Characteristics
1. Is better approximation to yield to maturity, nearer price is to par
and longer is maturity of bond
2. Change in current yield always signals change in same direction as
yield to maturity
• Yield on a Discount Basis

– Two Characteristics
1. Understates yield to maturity
2. Change in discount yield always signals change in same direction as
yield to maturity

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Relationship between bond prices

and bond yields

Three Interesting Facts in Table 1

1. When bond is at par, yield equals coupon rate
2. Price and yield are negatively related
3. Yield greater than coupon rate when bond price is below par value

What happens to bond prices when interest rates change?

Yields to maturity and bond prices move in opposite directions.

Relationship between bond prices

and bond yields
• The prices of securities should adjust so that investors
receive the same yields on comparable securities.
• To calculate the price, we need to know what yield to
maturity to use.
• If the price of an asset increases, it is called a capital
gain. If the price of the asset declines, it is called a
capital loss.
– Capital gain An increase in the market price of an asset.
– Capital loss A decrease in the market price of an asset.

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4 INTEREST RATES AND RATE OF RETURNS

• Return: The total earnings from a security; for
a bond, the coupon payment plus the change
in the price of the bond.
• Rate of return, R: The return on a security as a
percentage of the initial price; for a bond, the
coupon payment plus the change in the price
of a bond divided by the initial price.

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YTM: giu den khi dao han

HPR: ban giua chung

Interest rates and rate of returns

• Rate of return:
– The payments to the owner plus the change in value
expressed as a fraction of the purchase price
C  Pt 1  Pt
RET   ic  g
Pt
– RET = return of holding the bond from time t to t+1:
C
where: ic = = current yield
Pt

Pt+1 – Pt
g= = capital gain
Pt 46

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Exercise: Understanding returns

• Example 2.1.7
• Question: What is the return on a 5% coupon
bond that initially sells for $1000 and sells for
$960 next year?
• Answer:

1%

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mu 29 vi da huong coupon 1 lan

-> huong 1 lan nen moi tinh duoc REF
Relationship
between Interest rates and Returns

4-48

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Key findings
(generally true of all bonds)
• The only bond whose return equals the initial yield to maturity is
one whose time to maturity is the same as the holding period (see
the last bond in Table 2)
• 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 period.
• The more distant a bond's maturity, the greater the size of the
percentage 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 .

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Which one?
• Interest rate?
• Yield to maturity?
• Rate of return?

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5 TYPES OF INTEREST RATE

• Based on Inflation:
– nominal and real i
• Based on Compounding method:
– simple and compound i
• Based on Maturity short term - long term
• Based on Regulations
• Based on Bank’s operations

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REAL VS NOMINAL INTEREST RATE

• Nominal interest rate: An interest rate that is not
adjusted for changes in purchasing power.
• Real interest rate: An interest rate that is
adjusted for changes in purchasing power.
1+ir
=1+𝑖 ⇒ ir = i – e
1+e

• In which:
– ir : real interest rate
– i: nominal interest rate
– e: expected inflation

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Real vs nominal interest rate

Real Interest Rate
Interest rate that is adjusted for expected changes in the price
level
ir = i – e
1. Real interest rate more accurately reflects true cost of
borrowing
2. When real rate is low, greater incentives to borrow and less to
lend

if i = 5% and e = 3% then: ir = 5% – 3% = 2%
if i = 8% and e = 10% then: ir = 8% – 10% = –2%

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Real vs nominal interest rate

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Real vs nominal interest rate

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The Fisher effect

• Fisher effect: The assertion by Irving Fisher
that the nominal interest rises or falls point-
for-point with changes in the expected
inflation rate.
• The Fisher equation: i = r + π
– Hence, an increase in π causes an equal increase in
i.
– This one-for-one relationship is called the Fisher
effect
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SIMPLE VS COMPOUND INTEREST RATE

• Simple return:
– Return only earned on investment
• Compound return:
– Return earned on investment and accrued
interest

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Assumptions
• Investment $1000
• Interest rate 6%
• Number of years 3

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Assumptions
• Invest $1,000 and earn 6,0% simple interest
for 3 years.
• Invest $1,000 and earn 6,0% compound
interest for 3 years.

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Simple interest
Year Original Annual Cumulative
principal interest interest
1 $1,000 $60 $60
2 $60 $120
3 $60 $180

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Compound interest
Year Original Annual Cumulative
principal interest interest
1 $1,000 $60 $60
2 $1,060 $63.60 $123.6
3 $1,123.6 $67.42 $191.02

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Compound interest
• The value of total amount $1,123.60 at the end
of year 2 could be break into 3 components:
Beginning amount (principal) $1,000
Interest for 1st year based on principal 60
(1,000*0.06)
Interest for 2nd year based on principal 60
(1,000*0.06)
Interest for 2nd year based on interest earned 3.60
in the 1st year (60*0.06)
Total of principal and interest after year 2 $1,123.60
(1,000*(1+0.06)*(1+0.06))
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Simple vs compound interest

• If earnings are paid out, the investor must
reinvest the cash outflows at the same rate to
get the compound interest.
• If earnings are reinvested in the investment,
the investment is said to earn a compound
rate of return.

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The frequency of compounding

• Interest of investments can be paid more than

once a year.

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The frequency of compounding

• Example 2.1.8:
• You have a credit card that carries a rate of
interest of 18% per year compounded
monthly. What is the interest rate
compounded annually?
• That is, if you borrowed $1 with the card,
what would you owe at the end of a year?

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The frequency of compounding

• The year is the macroperiod, and the month is
the microperiod
• In this case there are 12 microperiods in one
macroperiod.
• If the interest rate is 18% annually, then the
monthly interest rate is 18%/12=1.5%.
• The bank charges interest on principal and
interest on monthly basis at the rate of 1.5%.

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APR & EAR

• Interest rates on loans and saving accounts are
usually stated in the form of an annual
percentage rate (APR), (e.g. 6% per year) with
a certain frequency of compounding.
• Because the frequency of compounding can
differ, it is important to have a way of making
interest rates comparable.
• This is done by computing an effective annual
rate (EFF or EAR), defined as the equivalent
interest rate, if compounding were only once
per year.

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APR & EAR

• The general formula for the effective annual
rate is:
m
 APR 
EAR  1   1
 m 

• In which:
– EAR: Effective annual rate
– APR: Annual percentage rate
– m: the number of compounding periods per year.

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APR & EAR

• Back to example 2.1.8:
• The credit card require an APR of 18% per year
compounded monthly.
• Calculate EAR?

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APR & EAR

Annual Frequency of Annual
Percentage rate Compounding Effective Rate

18 1 18.00
EAR of an APR of 18%

18 2 18.81

18 4 19.25

18 12 19.56

18 52 19.68

18 365 19.72

18 Continuous 19.72

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APR & EAR

• A bank determines that it needs an effective
rate of 12% on car loans to medium risk
borrowers
• What annual percentage rates may it offer?

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APR & EAR

m
 APR 
1  EAR  1  
 m 

 1  EAR m
APR
1
1

m

APR  m * 1  EAR m  1
1


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APR & EAR

Annual Compounding Annual
Effective Rate Frequency Percentage Rate
12 1 12.00
APR of an EAR of 12%

12 2 11.66

12 4 11.49

12 12 11.39

12 52 11.35

12 365 11.33

12 Infinity 11.33

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Compounding summary
If stated Annual interest rate is 8% but the
frequency of compounding is different, the result
for Future Value of $1 investing is as below:
Frequency r/m m*n Future value of $1
Annual 8%/1=8% 1x1=1 $1.00(1.08)=$1.08
Semiannual 8%/2=4% 2x1=2 $1.00(1.04)2 =$1.081600
Quarterly 8%/4=2% 4x1=4 $1.00(1.02)4 =$1.082432
Monthly 8%/12=0.6667% 12x1=12 $1.00(1.006667)12
=$1.083000
Daily 8%/365=0.0219% 365x1=365 $1.00(1.000219)365
=$1.083278
Continuously $1.00(e)0.08(1) =$1.083287

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Summary
• Interest rate is price/ fee/ return
• There are
– Real interest and nominal interest
– Simple interest and compound interest
– Annual Percentage Rate (APR) and Effective
Annual Rate (EAR)

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Summary
• The Interest Rate, Present Value, and Future Value Explain how the
interest rate links present value with future value.
• Debt Instruments and Their Prices Distinguish among different
debt instruments and understand how their prices are determined.
• Bond Prices and Yield to Maturity Explain the relationship between
the yield to maturity on a bond and its price.
• The Inverse Relationship Between Bond Prices and Bond Yields
Understand the inverse relationship between bond prices and bond
yields.
• Interest Rates and Rates of Return Explain the difference between
interest rates and rates of return.
• Nominal Interest Rates Versus Real Interest Rates Explain the
difference between nominal interest rates and real interest rates.
• How to measure interest rates and where an investor can find
information about interest rates

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ASSIGNMENT OF CHAPTER 2.1

1. SELF-TEST
2. REVIEW QUESTIONS
3. PROBLEMS

 DO IT BY YOURSELF FIRST
 ASK IN LATER CLASS IF YOU COULD NOT FINISH

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PREPARE FOR CHAPTER 2.2

1. How can interest rate be determined?

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