9/09/2023

BỘ GIÁO DỤC VÀ ĐÀO TẠO

TRƯỜNG ĐẠI HỌC KINH TẾ - TÀI CHÍNH
THÀNH PHỐ HỒ CHÍ MINH

The Economics of Money, Banking,

and Financial Markets

Chapter 5: The Meaning of Interest Rates

TRẦN NGỌC THANH

thanhtn@uef.edu.vn

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Đại học Kinh tế - Tài chính thành phố Hồ Chí Minh
www.uef.edu.vn
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Learning 0bjectives

● Calculate the present value of cash flows and the yield to

maturity on the four types of credit market instruments.
● Recognize the distinction among yield to maturity, current
yield, rate of return, and rate of capital gain.
● Interpret the distinction between real and nominal interest
rates.

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Table of contents

01 Present Value 02 Yield to maturity

Distinction between Distinction between

03 interest rates and
rates of returns
04 nominal and real
interest rates

Present value

Would you prefer to receive $100 today OR $100 in one year?

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Present value
Would you prefer to receive $100 today or $100 in one year?
10% interest per year: i = 0.1

● In one year: $100 × (1 + 0.10) = $110

● In two years: $110 × (1 + 0.10) = $121
or $100 × (1 + 0.10)2
● In n years: $100 × (1 + i)n

Present value
10% interest per year: i = 0.1

=> The $110 is called the one-year future value of $100 today
=> The $100 is called the Present Value of receiving $110 in one year

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Present value

● Present value principle: a dollar paid to you one year from now
is …… valuable than a dollar paid to you today.
● Because: a dollar deposited today can earn interest and become
$1×(1+i) one year from today
where:
PV = present value
FV = Future value
i = the interest rate

Cash Flows
● Principle of any investment: Paying some amount of money today to
receive some amount(s) of money at some future point(s) in time.
● Each payment of money is called a “cash flow”.
● Different investment has a different streams of cash flows.

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Rules of Time value of money

● You can only compare values at the same point in time.

● To move a cash flow forward in time, you must compound it.
● To move a cash flow backward in time, you must discount it.

Practice 1:

If the interest rate is 10%, what is the present value of an

investment that pays you $1,100 next year, $1,210 the year after,
and $1,331 the year after that? Drawing the cashflow stream.

If the market price of this investment is $4000, do you invest in it?

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Practice 2:

Today, your brother borrows 10 millions VND from Vietcombank at

11 percent interest to pay tuition fees. What is the amount payable
after a 3-year period? Drawing the cashflow stream.

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Yield to maturity

● Yield to maturity is the overall interest rate earned by an

investor who buys a bond at the market price and holds it until
maturity.
● YTM is the interest rate that equates the present value of cash
flow payments received from a debt instrument with its value
today.
● Present value of cash flows = Its current market price

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Practice 3
You have $2000 in savings; you have 2 options as follows:
• Option 1: You deposit $2000 in a People’s credit union that pays
you 9% interest rate.
• Option 2: You lend company A $2000, and company A will repay
you $4,000 after 5 years.

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Credit market instruments

CREDIT MARKET
INSTRUMENTS

Fixed Payment
Simple Loan Coupon Bond Discount Bond
Loan

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Simple Loan
● A simple loan: the lender provides the borrower with an amount of funds
that must be repaid at the maturity date, along with an additional
payment for the interest.

19 20 Maturity Date

Loan Value = PV FP FP FP FP Loan Value + Interest = FV

LV = loan value
i = YTM
n = number of years until maturity

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Practice 4
If Peter borrows $100 from his sister and next year she will pay back that
$100 and add $10 in interest.
• What is the simple interest rate on this loan?
• What is the yield to maturity on this loan?

Today Year 1

+$100 -$110

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Fixed-payment Loan

● A fixed-payment loan: The same fixed payment every period throughout the
life of the loan. (ie. mortgage)
● You decide to purchase a new home and need a $100,000 mortgage. You
take out a loan from the bank and promise to pay off the loan in 20 years (by
paying same small amounts every year).

19 20

LV = PV FP FP FP FP

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Fixed-payment Loan

19 20

LV = PV FP FP FP FP LV = loan value

FP = fixed yearly payment

i = YTM

n = number of years until

maturity

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Practice 4
You decide to purchase a new home and need a $100,000 mortgage.
You take out a loan from the bank and promise to pay off the loan in 20
years. And YTM is 7%, what is your yearly payment?

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Practice 5:

A lottery claims its grand prize is $10 million, payable over

5 years at $2,000,000 per year. If the first payment is
made immediately, what is this grand prize really worth?
Use an YTM of 6%.

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Coupon Bond

● A coupon bond: paying a fixed interest payment (coupon payment) every

year until the maturity date
● On the maturity date, a specified final amount (face value or par value) is
repaid.

P = price of coupon bond

FV = face value of the bond

C C C C + FV C = yearly coupon payment

n = years to maturity date

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Coupon Bond

A coupon bond is identified by

four pieces of information:

1.Face value

2.Agencies that issue this bond

3.Maturity date

4.Coupon rate (%)

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Coupon Bond

• Face value = …. AUD

• Coupon rate = …. %

• Coupon payment

= Face value/ Coupon rate

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Coupon Bond

C C C C + FV
P = price of coupon bond

FV = face value of the bond

C = yearly coupon payment

n = years to maturity date

i = YTM

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Practice 6

● Find the price of a 10% coupon bond with a face value of $1000, a 12.25%
yield to maturity, and eight years to maturity.
Face value (FV) = $1000
Yearly coupon payment (C) = %1000 * 10% = $100
YTM = 12.25%
n=8
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$100 $100 $100 $100 + $1000

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Practice 7:
● Find the price of a 10% coupon bond with a face value of $1000, a
10% yield to maturity, and eight years to maturity.

● Find the price of a 10% coupon bond with a face value of $1000, a
8.48% yield to maturity, and eight years to maturity.

● Find the price of a 10% coupon bond with a face value of $1000, a
11.75% yield to maturity, and eight years to maturity.

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Coupon Bond
Table 1: Yields to Maturity on a 10%-Coupon-Rate Bond Maturing
in Ten Years (Face Value = $1,000)

● When the price of coupon bond is at its face value, the YTM equals the coupon
rate.
● The YTM is greater than the coupon rate when the bond price is below its face
value.
=> The price of a coupon bond and the yield to maturity are negatively related.
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Consol or perpetuity
● A special coupon bond with no maturity date and no repayment of principal
that makes fixed coupon payments of $C forever

P = price of coupon bond

C = yearly coupon payment

n = years to maturity date

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Practice 8:
What is the price of a perpetuity that has a coupon of $50 per
year and a yield to maturity of 2.5%? If the yield to maturity
doubles, what will happen to the perpetuity price?

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Discount Bond

● Discount bound is a zero-coupon bond, not make any interest payments;

● Bought at a price below its face value and the face value is repaid at the
maturity date.

P < FV FV

P = price of coupon bond

FV = face value of the bond
n = years to maturity date

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Discount Bond

P < FV FV

where:
For any one year discount bond: P = price of coupon bond
FV = face value of the bond
i = yield to maturity (interest rate)

● The yield to maturity equals the increase in price over the year divided
by the initial price.
● Similar to coupon bond, the yield to maturity is negatively related to the
current bond price.

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Practice 9:

What is the yield to maturity on a $1,000-face-

value discount bond maturing in one year that
sells for $800?

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Rate of return
● Rate of returns: the payment to the owner plus the change in the
security’s value, expressed as a fraction of its purchase price.

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Practice 10a
We bought a one-year coupon bond with a coupon rate of 10% and a
face value of $1000. Last year, we bought this coupon for $1000.

• What is the yield to maturity on this loan?

And now we sold it at $1200.

• What is the rate of returns of this transaction?

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Practice 10a
We bought a one-year coupon bond with a coupon rate of 10% and a
face value of $1000. Last year, we bought this coupon for $1000.
• YTM = 10%
And now we sold it at $1200.
• Rate of return

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Practice 10b
We bought a one-year coupon bond with a coupon rate of 10% and a
face value of $1000. Last year, we bought this coupon for $1000.

• We hold the coupon bond until maturity date. What is the rate of
returns of this transaction?

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Practice 10c
We bought a one-year coupon bond with a coupon rate of 10% and a face
value of $1000. Last year, we bought this coupon for $1000.

• The marker rates rises from 10% to 20%. We hold the coupon bond in 2
years and 5 years. What is the rate of returns of these transactions?

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Example: We bought a one-year coupon bond with a coupon rate of 10% (YTM =
10%) and a face value of $1000. Last year, we bought this coupon for $1000 and
now the interest rates rises from 10% to 20%.

● A rise in interest rates is associated with a fall in bond prices, resulting in a

capital loss if time to maturity is longer than the holding period.

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Example: We bought a one-year coupon bond with a coupon rate of 10% (YTM =
10%) and a face value of $1000. Last year, we bought this coupon for $1000 and
now the interest rates rises from 10% to 20%.

=> Prices and returns for long-term bonds are more volatile than those for shorter-term
bonds.

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Example: We bought a one-year coupon bond with a coupon rate of 10% (YTM =
10%) and a face value of $1000. Last year, we bought this coupon for $1000 and
now the interest rates rises from 10% to 20%.

● Interest-rate risk: Changes in interest rates lead to capital gains and losses that
produce different returns.
● There is no interest-rate risk for any bond whose time to maturity matches the
holding period.

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The Distinction Between Real and

Nominal Interest Rates
● Nominal interest rate makes no allowance for inflation.
● Real interest rate is adjusted for inflation 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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The Distinction Between Real and

Nominal Interest Rates
i = Nominal interest rates
r = Real interest rates
= expected inflation rate

● Higher inflation => lower real interest rates => greater incentive
to borrow
● The real interest rate is a better indicator of the incentives to
borrow.

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Practice 5:

If you expect the inflation rate to be 12 percent next year

and a one - year bond has a yield to maturity of 7 percent,
then the real interest rate on this bond is?

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The Distinction Between Real and

Nominal Interest Rates

Sources: Nominal rates from Federal Reserve Bank of St. Louis FRED database: http://research.stlouisfed.org/fred2/
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THANK YOU FOR

LISTENING!
Do you have any questions?
thanhtn@uef.edu.vn

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