The meaning of interest rates

(Monetary Economics)

Manish K. Singh
mks@hs.iitr.ac.in

Department of Humanities and Social Sciences

Indian Insititute of Technology Roorkee

February 14, 2024

Outline

Measuring interest rates

Different credit market instruments

Application

Distinction between interest rates and returns

Real vs nominal interest rates

References and reading material

Introduction
So many rates!

Personal finance:
1. Education loan;
2. Savings and Fixed deposit rates;
3. Auto loan rates;
4. Housing loan rates;
5. Consumer loan (to buy TV, fridge, AC, etc.).
Firms:
1. Bank loan;
2. Commercial paper;
3. Bonds and debentures; etc.
Government:
1. T-bill rates;
2. Treasury bonds;
3. Inflation indexed treasury securities; etc.
Measuring interest rates
Present value (PV) or present discounted value

Is based on the common-sense notion that a dollar paid to you one

year from now is less valuable than a dollar paid to you today;
How do I calculate the present value of expected future cash flow?
Opportunity cost: You can’t use a dollar that you have lent to me;
Additional risk:
1. Credit risk;
2. Market risk;
3. Operational risk.
Measuring interest rates
Present value (PV): Loans & Bonds

Loan: Principal, Interest rate, and Maturity.

• The market:
1. PV of loan;
2. Principal; and
3. Maturity date.
4. You calculate the interest rate.
CFt
For single payment (PV) =
(1 + i)t
n
X CFt
For multiple payment (PV) =
t=1
(1 + i)t
5. i is known as yield to maturity
Bonds: Face value, Coupon, and Maturity.
• Face value → Principal
• Coupon → Interest rate
Some questions

1. What is the present value of 10,00,000 rupess to be paid at the end

of five years if the interest rate is 12%?
2. Challenging problem: Talk to your classmate/s who has/have
taken a student loan to study at IIT Roorkee. Can you calculate the
interest rate on his/her student loan based on the payment
schedule? (Ignore the interest rate in the offer document.)
3. Assume that you just won 1 crore prize in Dream11, which promises
you a payment of 10 lakhs every year for the next 10 years. Is your
winning really a crore?
Four types of credit market instruments

1. Simple loan
• Repayment of interests at regular interval + payment of principal at
the maturity date.
2. Fixed payment loans or fully-amortized loan
• Fixed amount of repayment every period (such as a month) for a set
number of years;
• EMI on consumer loan/credit card;
• Auto/Housing loans in India.
3. Coupon bonds
• Fixed interest payment (coupon payment) every year until the
maturity date, when a specified final amount (face value or par
value) is repaid.
4. Discount bonds or zero-coupon bonds
• Repayment of face value at the maturity date.
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;
The most common and important measure of interest rate.
Yield to maturity
Calculation

1. Simple loans:
• The simple interest rate will equal to the yield to maturity;
• PV = nt=1 IR/(1 + i)t + F /(1 + i)n
P

2. Fixed-payment loans:
• Loan value (LV) = nt=1 FVt /(1 + i)t ; solve for i
P
• Challenging question: Ask your parents about their auto/home loan
amount and the monthly installment payment. Now solve for the
yield to maturity. Compare this to what interest they think they pay.
3. Coupon bonds:
Pn
• Price (P) = t=1 C /(1 + i)t + F /(1 + i)n ; solve for i
• Perpetuity:
▶ Maturity = ∞
▶ Price (P) = C /i (Derive this equation)
4. Zero-coupon bonds
• P = F /(1 + i)n
Challenging questions

1. Open https://groww.in/calculators
• Given your current understanding, how many calculators you can
build from this list?
• If you will build more than 10 of them with a web interface, I will
fund and host this under your name as a ”Public Goods” project.
Application

Interest rate is on the rise

• 22 May 2020 - 4%
• 7 Dec 2022 - 6.25%
Inflation around 6-7%
Look at the bank balance sheet
Assets Liabilities
GoI Bonds Public Deposits
When Interest Rates ↑
GoI Bonds ↓ Deposit Interest Rates ↑
Government balance sheet
• Interest cost on new issues ↑
• Rolling over the old debt → Interest rates ↑
• Together: Fiscal deficit ↑ → Debt ↑
• However, if you are running a surplus → this is a good time to retire
your debt.
Distinction between interest rates and returns

Returns and yield to maturity are two different things!

Returns are defined as:

Pt+1 − Pt Intermediate Payment (C)

R= +
Pt Pt
where,
R = return from holding the bond from time t to time (t + 1)
C = coupon payment
Pt = price of the bond at time t
Pt+1 = price of the bond at time t + 1
On the right side, the first term is known as the rate of capital
gain. The second term is current yield.
Think about a house. Rent income is current yield while
appreciation in house value is capital gain.
Similarly, dividend income is current gain while stock price
appreciation is capital gain.
Some key findings
1. 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 their holding periods.
n
X
P= C /(1 + i)t + FV /(1 + i)n
t=1
• i ↑→ P ↓
• i ↓→ P ↑
• Prices and returns for long-term bonds are more volatile than those
for shorter-term bonds (known as Interest rate risk in literature)
2. The more distant a bond’s maturity date, the greater the size of the
percentage price change associated with an interest rate change.
3. The more distant a bond’s maturity date, the lower the rate of
return that occurs as a result of an increase in the interest rate.
4. Even though a bond may have a substantial initial interest rate, its
return can turn out to be negative if interest rates rise.
5. The only bonds whose returns will equal their initial yields to
maturity are those whose times to maturity are the same as their
holding periods.
Real vs nominal interest rates

Real vs nominal interest rates (IR):

• Nominal IR (i) = Real IR (r ) + Inflation (π)
Fisher equation:
• Nominal IR (i) = Real IR (r ) + Expected Inflation (π e )
• But in reality, you only observe i at the time of contracting and have
estimates of π
• Real return (r ) = Nominal IR (i) - Real inflation (π)
Who benefits when?
• π e > π: Lender will benefit. Real returns are higher for lender.
• π e < π: Borrower will benefit. Real returns are lower than expected.
Real vs nominal interest rates
Application

What if government is a big borrower in the economy?

Real vs nominal interest rates
Application

What if government is a big borrower in the economy?

• π e < π: High inflation environment is default setup.
Real vs nominal interest rates
Application

What if government is a big borrower in the economy?

• π e < π: High inflation environment is default setup.
Look at the fixed deposit rates being offered by Indian banks
• 5-year FD rate - HDFC: 7%
• Historical inlfation: 5.5% - 6%
• Real returns:
Real vs nominal interest rates
Application

What if government is a big borrower in the economy?

• π e < π: High inflation environment is default setup.
Look at the fixed deposit rates being offered by Indian banks
• 5-year FD rate - HDFC: 7%
• Historical inlfation: 5.5% - 6%
• Real returns: 7% - 5.5% = 1.5%
Real vs nominal interest rates
Application

What if government is a big borrower in the economy?

• π e < π: High inflation environment is default setup.
Look at the fixed deposit rates being offered by Indian banks
• 5-year FD rate - HDFC: 7%
• Historical inlfation: 5.5% - 6%
• Real returns: 7% - 5.5% = 1.5%
7 (1 - 0.3) - 5.5 = 4.9 - 5.5 = - 0.6%
Real vs nominal interest rates
Application

What if government is a big borrower in the economy?

• π e < π: High inflation environment is default setup.
Look at the fixed deposit rates being offered by Indian banks
• 5-year FD rate - HDFC: 7%
• Historical inlfation: 5.5% - 6%
• Real returns: 7% - 5.5% = 1.5%
7 (1 - 0.3) - 5.5 = 4.9 - 5.5 = - 0.6%
Negative real return: Financial repression!
Real vs nominal interest rates

Real interest rates are better indicator of the incentives to borrow

and lend (they reflect the real cost of borrowing);
When the real interest rate is low, there are greater incentives to
borrow and fewer incentives to lend;
Application: Japan
• Short term IR: -0.1%
• 10-year bond yield: 0%
References

The Economics of Money, Banking and Financial Markets (Global

Edition - 2019) by Frederic S. Mishkin
• Chapter 4: The meaning of interest rates
Questions!