Tutorial 5

TA: Nagah Ashraf

 ECO303 : Calculating Interest
Rates
• Simple Loan
• Fixed Payment Loan
• Coupon Bond
• Discount Bond
  PV =
 LV =  used to get ytm
Simple Loan  Regarding Loans, when PV > LV  then YTM must be
higher to decrease PV
Fixed Payment  PV =

Loan  LV =  used to get ytm

  PV =
 Such that C = coupon rate * Face Value
 Price =  used to get ytm
 ic=
 Return=
Coupon Bond  Regarding coupon bond, If the coupon rate is equal to the
interest rate then the Present value of a bond is equal to the
Face value of the bond.
 Regarding coupon bond, When P>PV, then YTM must be
lower to increase PV
 Regarding coupon bond, When P<PV, then YTM must be
higher to decrease PV
  1 year bond  i=
 6 month bond  isix=  YTM= (isix +1)2 -1
Discount Bond  3 month bond  ithree=  YTM=(ithree +1)4 -1
  Real interest rate= nominal interest rate – inflation rate

Interest rate  A borrower prefers a lower real interest rate

 A lender prefers a higher real interest rate
  Calculate the present value for the following payments:
$600 four years from now when the interest rate is 6%
Question(1) $800 three years from now when the interest rate is 7%

Rule used: PV = =
  FV = $600, i= 0.06, n= 4, PV=?
PV = = = 475.256
Answer  FV = $800, i= 0.07, n= 3
PV = = = 653.038

Rule used: PV =
  What is the yield to maturity on a simple loan for $1 million
that requires repayment of $1.25 million in 2 years?

Question(2) LV = $1 million
FV = $1.25 million

Rule used: LV =
  FV = $1.25, i= ?, n= 2, LV= $1

Answer  LV =  i=0.118= 11.8%

Rule used: LV =
  Suppose you are offered a fixed payment loan of $5000 that
requires to make payments of $2000 for the next 3 years.

Question(3) (a) Calculate the present value when the interest rate is 10%
(b) Must be the yield to maturity be above or below 10%

PV =
 (a) Calculate the present value when the interest rate is 10%
 FV= 5000, FP=2000, n=3
 PV= = 4973.7039
(b) YTM must be below 10%

Answer

PV =
  Suppose you are offered a $1000 face value coupon bond with
a coupon rate of 10%, a maturity of three at a price of $1079. 

Question(4) (a) Calculate the present value when the interest rate is 8%
(b) Should the yield to maturity be above or below 8%? Why?

PV =
 (a) CF= 0.1*1000= 100
PV== 1051.54
(b)Since PV < P  YTM must be below 8%

Answer

PV =
  Write down the formula used to calculate the yield to maturity
on 20-year 10% coupon bond with $1000 face value that sells
Question(5) for $2000.

Price =
  2000=

Answer

Price =
Question(6):For discount bonds with a face value of $1000. Fill the following table

Price of discount bond Maturity YTM

900 1 year 11%

950 6 month 10.8%

Question(6) 975 3 month 10.7%

Rules used  , ((1+isix)2-1) and ((1+ithree)4-1)

  Suppose that you want to invest $1000 in a security, which of
the following would you rather invest in? A one year maturity

Question(7) 10% coupon bond with a face value of $1000 selling for $900
or A one-year discount bond with a face value of $1000 selling
for $800
  Rule used: Price =
 Price= $900 , n=1, C= 1000*0.1= 100
 Price =  900=  Same denominator common
denominator
 900=  1100 = 900 +900 I  22.22%

Answer
 Rule used: YTM=
 YTM = = 25%
 Calculate the current yield Ic for:
 a $5000 face value, 10% coupon bond selling for $4000
 a $10000 face value, 10% coupon bond selling for $9500?

Question(8)

ic =
  First case  ic=  ic=  12.5%

 Second case  ic=  ic=  10.5%

Answer
ic=
  What is the return on a $1000 , 15% coupon bond that initially
sells for $1000 and sells for $800 next year.

Question(9)

Return=
  Return= = = -0.05 = -5%

Answer

Return=
 In which of the following situations would you rather be
borrowing and in which would you rather invest in:
 The interest rate is 20%and the expected inflation is 15% 

Question(10) real interest rate = 20% -15% = 5%

 The interest rate is 10% and the expected inflation is 12% 
real interest rate = 10% -12% = -2%

Rule used: real interest rate= nominal

interest rate – inflation rate
  Real interest rate = 20%-15% = 5%  I’d rather invest

Answer  Real interest rate = 10%-12%= -2%  I’d rather borrow

Rule used: real interest rate= nominal

interest rate – inflation rate
  Calculate the future value of $10000 received today and
deposited for six years in an account which pays an interest of
12%
 FV = 10000
Question (11)  N=6
 i = 0.12
  PV =  FV= PV(1+i)n  FV= 10000(1.12)6= 1973.882
Answer
  Would it make sense to buy a house when mortgage rate are

Question(12) 14% and expected inflation is 15%? Explain your answer

  Yes it would make sense as the real interest rate is very low 

Answer 1%
  If the interest rate is 5% what is the present value of a security
that pays you $1050 next year, $1102.5 two years from now? If
Question(13) this security sold for $2200, is the yield to maturity greater or
less than 5%
Answer  i=5% Cf1 =1050 CF2 = 1102.5  PV= =
 ECO303: The behavior of
Interest rates
• The Loanable Funds “The Demand and Supply of Bonds” Framework
 Supply and
Demand
framework of
bonds
 DEMAND OF BONDS
 Demand curve  Downward Sloping
 Change in price  movement along the curve
 When a factor increases demand  Demand curve shifts to the right
The Loanable  When a factor decreases demand  Demand curve shifts to the left
Funds FACTORS THAT AFFECT DEMAND OF BONDS

Framework  Wealth (+ve)  an increase in it  shift Bond demand to the right

 Expected Return (+ve)  an increase in it  shift Bond demand to the right
(Demand)  Relation between i and expected return
 Expected inflation (-ve )  an increase in it  shift Bond demand to the left
 Risk of bond (-ve)  an increase in it  shift Bond demand to the left
 Risk of other asset(+ve)  an increase in it  shift Bond demand to the right
 Liquidity of bond (+ve)  an increase in it  shift Bond demand to the right
 Liquidity of other asset  (-ve )  an increase in it  shift Bond demand to the left
 SUPPLY OF BONDS
 Supply curve  Upward Sloping
 Change in price  movement along the curve
 When a factor increases supply  Supply curve shifts to the right
The Loanable  When a factor decreases supply  Supply curve shifts to the left
Funds
Framework FACTORS THAT AFFECT SUPPLY OF BONDS
(Supply)  Expected Profitability(+ve)  an increase in it  shift Bond supply to the
right
 Expected Inflation (+ve)  an increase in it  shift Bond supply to the
right why..? real interest decreases
 Government activities
Questions
 Using the supply and demand for bonds framework (loanable
funds framework), explain and show on a separate graph what
would happen to the equilibrium interest rate and equilibrium
quantity supplied and demanded for bonds in the following
situations:
a) The inflation rate is expected to fall
b) A new brokerage commission is issued on the sale and

Question (1) purchases of stocks

c) Gold prices become less volatile
d) A boom and business cycle expansion were experienced in the
economy
e) Stocks became more liquid
f) There is a budget deficit
(a) The inflation rate is
expected to fall
Supply or Demand or both?
Model used
Demand Curve  Shift to the right
Supply Curve  Shift to the left
Because real interest = nominal interest – inflation
Lower inflation  higher real interest
 (b) A new brokerage commission is
issued on the sale and purchases of stocks
Supply or Demand or both?
Model used
Demand Curve  Shifts to the
right
People will switch to buying bonds
(c)Gold prices become less
volatile
Supply or Demand or both?
Model used
Demand Curve  Shifts to the left
People will switch their funds from bonds to gold.
(d) A boom and business cycle expansion
were experienced in the economy
Supply or Demand or both?
Model used
 Demand Curve  Shift to the right
Supply Curve  Shift to the right
However businesses respond faster. So, the shift in supply will be more than the shift in
demand
(e) Stocks became more liquid
Supply or Demand or both?
Model used
Demand Curve  Shifts to the
left
People will switch to buying stocks
(f) There is a budget deficit
Supply or Demand or both?
Model used
Supply Curve  Shifts to the
right
The government will borrow more
  The central bank of Egypt announced “inflation targeting”, an
anti-inflation program to fight high inflation rates. Predict what
Question(2) will happen to interest rates if public believe it.
 Answer

As inflation is expected to fall: Demand will increase and

Demand and supply shift in opposite Supply will decrease. Demand curve will shift to the right and
direction. However, the shift’s Supply curve will shift to the left. Price will increase (P1 to
magnitude of both curves are equal P2) Interest will decrease (i1 to i2). Quntity will remain the
same