AF5425 FIM Week 2 3 Interest Rates and Their Role in Valuation 1

Financial Institutions & Markets
AF5425
Week 2 & Week 3

Interest Rates & Their Role in Valuation
1
Mishkin & Eakins, FMI, 7th Edition
Objectives
• Explain the importance of interest rates to an economy
• Define various concepts such as interest rates, yield to
maturity, time value of money, present value, future value,
duration
• Calculate interest rates, yield to maturity, present value,
future value, duration for bond and expected return on
various portfolios
• Distinguish between real and nominal interest rates,
interest rates and returns, and interest rate risk and
reinvestment risk
2
Overview
• Importance of Interest Rates
• Interest Rate Fundamental
• Time Value of Money and Interest Rates
• Calculation of Simple Interest
• Calculation of Compound Interest
• Concept of Present Value
• Concept of Future Value
• Present Value vs Future Value
• Relationship between Interest Rates and Present Value
and Future Value
• Four Types of Credit Market Instruments 3
Overview (Cont’d)
• Yield to Maturity
 Calculation w.r.t. Simple Loan
 Calculation w.r.t. Fixed-payment Loan
 Calculation w.r.t. Coupon Bond & Different Bond
Prices
 Calculation w.r.t. Perpetuity
 Calculation w.r.t. Discount Bond
• Distinction between Real & Nominal Interest Rates
• Distinction between Interest Rates & Returns
4
Overview (Cont’d)
• Key Findings on Bonds
• Interest Rate Risk and Reinvestment Risk
• Concept of Duration
 Calculation
 Facts
 More Example on Calculation
5
Importance of Interest Rates
• It directly affects our everyday lives.
 Personal decisions such as:
- Consume or save, purchase a house, purchase
bonds or put funds into a savings account, etc
 Economic decisions such as:
- To invest in new non-current assets or save, etc
• It has important consequences for the health of
the economy.
6
Interest Rate Fundamental
• Interest rate is defined as the cost of borrowing or the
price paid for the rental of funds.
• It is usually expressed as a percentage per year.
• Nominal interest rates is the rate actually observed
in financial markets.
 directly affect the value (price) of most securities
traded in the market
 affect the relationship between spot and forward
foreign exchange rates
7
Time Value of Money &
Interest Rates
• Assumes the basic notion that a dollar received
today is worth more than a dollar received at some
future date.
• Simple interest
 Interest earned on an investment is not
reinvested
• Compound interest
 Interest earned on an investment is reinvested
8
Calculation of Simple
Interest
Value = Principal + Interest
Example 1:
$1 000 invest for a period of two years at 12%
Value = $1 000 + $1 000 × 12% × 2 years

= $1 240
9
Calculation of Compound
Interest
Value = Principal + All compounded interest
Value = $1000 + $1000×12% + [($1000 + $1000× 12%) × 12%]

= $1000 + $1000 × 12% + $1000 × 12% + $1000 × 12%2
= $1000 + $1000 × 12% × 2 + $1000 × 12%2
= $1000 (1 + 0.12 × 2 + 0.122)
= $1000 (1 + 0.12)2
= $1000 (1.12)2
= $1 254.40
10
Concept of Present Value
• How much you get right now
• Also known as “present discounted value”
• Based on the notion that a dollar of cash flow paid
to an individual one year from now is less valuable
than a dollar paid today
• Why?
• Because an individual can deposit a dollar in a
savings account that earns interest and have more
than a dollar in a year
11
(Cont’d)
• PV function converts cash flows received over a future
investment horizon into an equivalent (present) value
by discounting future cash flows back to present using
current market interest rate.
 lump sum payment
- a single cash payment received at the end of some
investment horizon
 annuity
- a series of equal cash payments received at fixed
intervals over the investment horizon
12
(Cont’d)
• This concept is extremely useful because it
allows an individual or an entity to compare
the value of different market instruments
with very different timing of their cash flows
at today’s value.
• Present values  as interest rates .
13
Concept of Future Value
• The amount an individual will receive in the future
• Discounting the future means the process of
calculating today’s value of dollars received in the
future.
• Formula:
FV = PV (1 + i)n
where FV = Future value
PV = Present value
i = interest rate per period
n = number of compounding period
14
Present Value vs Future Value
Using the previous example,
• PV is $1 000
• FV is either $1 240 or $1 254.40 (depending on the
types of interest applied)
• Normally tend to use compound interest rates
15
(Cont’d)
Example 2:
$1 000 invest for a period of n years at 10%
Year 1 = $1 000 (1 + 0.10)1 = $1 100
Year 2 = $1 000 (1 + 0.10)2 = $1 210
Year 3 = $1 000 (1 + 0.10)3 = $1 330
.
Year n = $1 000 (1 + 0.10)n
Today YearYear Year Year
0 1 2 3 n
$1 000 $1 100 $1 210 $1 330 $1 000 (1 + 0.10)n

This timeline implies that one can work backward from FV to the
present. 16
(Cont’d)
Example 3:
$34 invest for a period of 5 years at 5%
Solution:
FV = $34(1 + 0.05)5 = $43.39  $34 =
That is,
FV = PV (1 + i)n
PV = or
17
(Cont’d)
Example 4:
What is the present value of $1 000 to be paid
in 5 years if the interest rate is 6%?
Solution:
PV = = $747.38
That is, if a person invests $747.38 today, he or
she will receive $1 000 in 5 years at the interest
rate of 6%.
18
(Cont’d)
Example 5:
What is the present value of $250 to be paid in
2 years if the interest rate is 15%?
Solution:
PV = = $189.04
Today 0 Year 1 Year 2
$189.04 $250
19
Relation between Interest Rates
& Present Value, & Future Value
Based on the formula, one can observe:-
• Present values  as interest rates 
• FV  with both the time horizon and the interest
rate
PV FV
Interest rate Interest rate

Four Types of Credit Market
Instruments
Instruments Explanation Example
Simple loan Lender provides borrower with an amount of Commercial loans to businesses
funds, which must be repaid to the former at
the maturity date along any additional payment
for the interest
Fixed-payment Lender provides borrower with an amount of Loan of $1 000 may require
loan (also known as funds, which must be repaid by making the payment of $126 every year for 25
fully amortized same payment every period, consisting of part years
loan) of the principal and interest for a set number of
years
Coupon bond A fixed interest payment (coupon payment) is A coupon bond with $1 000 face
made annually till the maturity date when a value might pay $100 per year for
specified final amount (face value/par value) is 10 years and at the maturity date,
repaid face value amount of $1 000 is
paid
Discount bond Purchase at a price below its face value (at a A discount bond with a face value
(also known as zero- discount). It does not make any interest of $1 000 may be bought for $900.
coupon bond) payments. It just pays off the face value at the
maturity date.
• Mishkin & Eakins, FMI, 7 th Edition 21
Yield to Maturity
• The interest rate that equates the present value of
cash flows received from a debt instrument with its
value today
• That is, it equates today’s value of the debt
instrument with the present value of all of its
future cash flow payments.
22
Calculation of Yield to
Maturity for a Simple Loan
Example 6:
If Pete borrows $100 from his sister and next year she
wants $110 back from him, what is the yield to maturity
on this loan?
Solution:
PV = where PV = $100, CF = $110, n = 1
$100 =  $100 (1 + i) = $110  i = 10%
Note:
For simple loan, yield to maturity = simple interest rate
23
Calculation of Yield to Maturity
for a Fixed-Payment Loan
For a fixed-payment loan,
LV = + + + … +
where LV = Loan value

FP = Fixed yearly cash flow payment
n = number of years until maturity
i = yield to maturity (unknown)
24
Calculation of Yield to Maturity for
a Fixed-Payment Loan (Cont’d)
Example 7:
What is the yield to maturity on a loan of $1 000 with
the yearly cash flow payment of $85.81 for the next
25 years?
Solution:
$1 000 = + + … +
Solving the above equation will give the yield to
maturity is 7%.
25
Calculation of Yield to Maturity for
a Fixed-Payment Loan (Cont’d)
Example 8:
What is the yearly payment to the bank to pay off a $100
000 mortgage of 20 years at an interest rate of 7%?
Solution:
$100000=
Solving the above equation will give the fixed yearly
payment as $9 439.29.
26
Calculation of Yield to
Maturity for a Coupon Bond
For any coupon bond,
P=
where P = Price of coupon bond

C = Yearly coupon payment
FV = Face value of the bond
n = years to maturity date
27
Calculation of Yield to Maturity
for a Coupon Bond (Cont’d)
Example 9:
Find the price of a 10% coupon bond with a face value of
$1 000, a 12.25% yield to maturity and 8 years to
maturity.
Solution:
P=+
Solving the above will give the price of bond as $889.20.

Can use similar equation to work out the yield to maturity
if only that rate is unknown. That is, only i is unknown.
28
Yield to Maturity for
Different Bond Prices
• Assume a 10% Coupon Rate (CR) Bond maturing in 10
years with a face value of $1 000:-
Price of Bond ($) Yield to Maturity (%)
1 200 7.13
1 100 8.48
1 000 10.00
900 11.75
800 13.81
• Three interesting facts based on the above table:

 When Pbond is priced at its face value, YTM = CR
 Pbond and the YTM are negatively related
 YTM  CR when Pbond is  Face Value 29
Yields to Maturity for a
Perpetual Bond
Perpetuity (Consol)
• A perpetual bond with no maturity date and no
repayment of principal
• It makes fixed coupon payments of $C forever.
• Formula for a price of a perpetuity:-
Pc = where Pc = Price of perpetuity (consol)
C = Yearly payment
YTM of the perpetuity
• Based on the formula, it is observed that there is
an inverse relationship between Pc and .
30
Perpetual Bond (Cont’d)
Example 10:
What is the yield to maturity on a bond that has
a price of $2 000 and pay $100 annually
forever?
Solution:
$2 000 =  = × 100 = 5%
31
Discount Bond
• It is similar to that of a simple loan.
• For any one-year discount bond,
where
F = Face value of the discount bond
P = Current price of the discount bond
• Based on the formula, it indicates that the YTM is
negatively related to the current bond price.
32
Distinction between Nominal
and Real Interest Rates
Nominal Interest Rate
• The interest rate that makes no allowance for
inflation
Real Interest Rate
• The interest rate that is adjusted for inflation
Formula:
where = nom. interest rate
= real interest rate
= exp rate of inflation
= -
33
Distinction between Nominal and
Real Interest Rates (Cont’d)
Example 11:
What is the real interest rate if the nominal rate is 5%
and the expected inflation rate is 3% over the course
of a year?
Solution:
= 5% – 3% = 2%
This means the interest rate an individual expects to
earn in terms of real goods and services is 2%.
34
Distinction between Nominal and
Real Interest Rates (Cont’d)
Example 12:
What is the real interest rate if the nominal rate is 8%
and the expected inflation rate is 10% over the course
of a year?
Solution:
= 8% – 10% = –2%
This means the interest rate an individual expects to
earn in terms of real goods and services is –2%.
35
Important to Distinguish between
Nominal & Real Interest Rates
• Real interest rate reflects the real cost of
borrowing. Thus, a better indication of the
incentives to borrow and lend.
• When real interest rate is low, there are
greater incentives to borrow and fewer
incentives to lend.
36
Real & Nominal Interest Rates
(3-mth TB), 1953 – 2015
37
Distinction between Interest
Rates and Returns
Rate of Return
• It is defined as the payments to the owner plus the change
in its value expressed as a fraction of its purchase price.
• Formula:
R = where
R = return from holding the bond from time t to time t+1
price of bond at time t
= price of bond at time t+1
C = coupon payment
Þ R = + where 1st term is current yield
2nd term is rate of capital gain
38
Rates and Returns (Cont’d)
Example 13:
What would the rate of return be on a bond
bought for $1 000 and sold for $1 200? The
bond has a face value of $1 000 and a coupon
rate of 10%.
Solution:
R = = 0.3 or 30%
39
Rates and Returns (Cont’d)
Example 14:
What would the rate of return be on a bond
bought for $1 000 and sold for $800? The bond
has a face value of $1 000 and a coupon rate of
8%.
Solution:
R = = -0.12 or -12%
40
One-year Returns on Different Maturity
10% Coupon Rate Bonds when Interest Rates
rise from 10% to 20%
Years to Initial Initial Price Price next Rate of Capital Rate of
Maturity Current ($) year* ($) Gain (%) Return (%)
when bond Yield (%)
is purchased
30 10 1 000 503 - 49.7 - 39.7

20 10 1 000 516 - 48.4 - 38.4
10 10 1 000 597 - 40.3 - 30.3
5 10 1 000 741 - 25.9 - 15.9
2 10 1 000 917 - 8.3 + 1.7
1 10 1 000 1 000 0 + 10.0
*Calculated with a financial calculator

Rate of return (R) = Initial Current Yield + Rate of Capital Gain
41
Key Findings on Bonds
• When time of maturity = holding period, R = initial
YTM.
• 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 price change associated with an interest 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.
42
Interest Rate Risk &
Reinvestment Risk
Interest rate risk
• Occurs for bonds whose term to maturity is longer than the
holding period
• Changes in interest rates lead to capital gains and losses that
produce substantial differences between the return and the
yield to maturity known at the time the bond is purchased
• Can be determined using the concept of duration
Reinvestment risk
• Occurs for bonds whose term to maturity is shorter than the
holding period
• Occurs because the proceeds from the short-term bond need to
be reinvested at a future interest rate that is uncertain 43
Concept of Duration
Duration
• The average lifetime of a debt security’s stream of
payments
• The weighted average of the maturities of the cash
payments
• It measures how quickly a bond will repay its true
cost. The longer it takes, the greater exposure the
bond has to changes in the interest rate
environment.
Mishkin & Eakins, FMI, 7th Edition 44
Concept of Duration (Cont’d)
Duration
• Formula:
DUR = where
DUR = duration
t = years until cash payment is made
CPt = cash payment (interest plus principal) at time t
i = interest rate
n = years to maturity of the security
Mishkin & Eakins, FMI, 7th Edition 45

Calculation of Duration
• Calculation of duration on a $1 000 ten-year 10% Coupon Bond
when its interest rate is 10%
Year Cash payments (Zero- Present Value of Cash Weights (% of total PV Weighted Maturity (Yr ×
Coupon Bonds) ($) Payments (i = 10%) ($) = PV/$1 000) (%) Weights)/100 (Years)
1 100 90.91 9.091 0.09091
2 100 82.64 8.264 0.16528
3 100 75.13 7.513 0.22539
4 100 68.30 6.830 0.27320
5 100 62.09 6.209 0.31045
6 100 56.44 5.644 0.33864
7 100 51.32 5.132 0.35924
8 100 46.65 4.665 0.37320
9 100 42.41 4.421 0.39789
10 100 38.55 3.855 0.38550
10 1 000 385.54 38.554 3.85500
Total 1 000.00 100.000 6.75850
46
Facts on Concept of Duration
All else being equal,
• the longer the term to maturity of a bond, the longer its
duration (takes more time to receive full payment)
• when interest rates rise, the duration of a coupon bond falls
• the higher the coupon rate on the bond, the shorter the bond’s
duration (since it will pay back its original cost quicker)
• The duration of a portfolio of the securities is just the weighted
average of the durations of the individual securities, with the
weights reflecting the proportion of the portfolio invested in
each.
• Bonds with higher durations carry more risk and have higher
price volatility than bonds with lower durations.
47
More Example on Calculation of
Duration
Example 15:
A manager of a financial institution is holding 25% of
a portfolio in a bond with a five-year duration and
75% in a bond with a ten-year duration. What is the
duration of the portfolio?
Solution:
DUR = (25% × 5) + (75% × 10) = 1.25 + 7.5 = 8.75 yrs
48
References
• Mishkin F.S. and Eakins S.G. (2012) Financial Markets and
Institions. 7th edition. US: Pearson
• www.bloomberg.com/markets/
• www.teachmefinance.com
• http://www.investopedia.com/university/advancedbond/a
dvancedbond5.asp
(Accessed on 1 July 2013)
• http://beginnersinvest.about.com/lw/Business-Finance/Per
sonal-finance/Understanding-Bond-Duration.htm
(Accessed on 1 July 2013)
49
• Mishkin & Eakins, FMI, 7 th Edition

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Financial Institutions & Markets

Week 2 & Week 3

Value = $1 000 + $1 000 × 12% × 2 years

Value = $1000 + $1000×12% + [($1000 + $1000× 12%) × 12%]

$1 000 $1 100 $1 210 $1 330 $1 000 (1 + 0.10)n

Interest rate Interest rate

where LV = Loan value

where P = Price of coupon bond

Solving the above will give the price of bond as $889.20.

• Three interesting facts based on the above table:

30 10 1 000 503 - 49.7 - 39.7

*Calculated with a financial calculator

Mishkin & Eakins, FMI, 7th Edition 45

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