Money and Banking – ECO 233

Lecture 4
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. The coupon rate

Source: https://en.wikipedia.org/wiki/United_States_Treasury_security

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Coupon Bond
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
• The present value of a $1,000-face-value bond with ten
years to maturity and yearly coupon payments of $100 (a
10% coupon rate) can be calculated as follows:

• The coupon payment, the face value, the years to

maturity, and the price of the bond are known quantities,
and only the yield to maturity is not.
• Hence we can solve this equation for the yield to
maturity i.

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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)

Price of Bond ($) Yield to Maturity (%)

1,200 7.13
1,100 8.48
1,000 10.00
900 11.75
800 13.81

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Coupon Bond
• When the coupon bond is priced at its face value, the yield
to maturity equals the coupon rate.

• The price of a coupon bond and the yield to maturity are

negatively related.

• The yield to maturity is greater than the coupon rate when

the bond price is below its face value.

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Coupon Bond
• When you put $1,000 in a bank account with an interest
rate of 10%, you can take out $100 every year and you will
be left with the $1,000 at the end of ten years.
• This is similar to buying the $1,000 bond with a 10%
coupon rate analysed in Table 1, which pays a $100
coupon payment every year and then repays $1,000 at the
end of ten years.
• If the bond is purchased at the par value of $1,000, its
yield to maturity must equal 10%, which is also equal to
the coupon rate of 10%.

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Coupon Bond
• Why the bond price falls when the interest rises?
• A higher interest rate implies that the future coupon
payments and final payment are worth less when
discounted back to the present
• Hence, the price of the bond must be lower.

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Coupon Bond
• Consol or perpetuity: a bond with no maturity date that
does not repay principal but pays fixed coupon payments
forever

= price of the consol

= yearly interest payment
= yield to maturity of the consol
One can rewrite the equation as:
For coupon bonds, this equation gives the current yield, an
easy to calculate approximation to the yield to maturity

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Coupon Bond
• One nice feature of consols is that you can immediately
see that as i goes up, the price of the bond falls.
• For example, if a consol pays $100 per year forever and
the interest rate is 10%,
• Price will be $1,000 = $100/0.10.

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Discount Bond
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
• Let us consider a discount bond, which pays off a face value of $1,000
in one year’s time.

• If the current purchase price of this bill is $900

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The Distinction Between Interest Rates and
Returns
• Many people think that the interest rate on a bond tells
them all they need to know about how well off they are as
a result of owning it.
• How well a person does by holding a bond or any other
security over a particular time period is accurately
measured by the return, or, in more precise terminology,
the rate of return.

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The Distinction Between Interest Rates and
Returns
• Let us see what the return would look like for a $1,000-
face-value coupon bond with a coupon rate of 10% that is
bought for $1,000, held for one year, and then sold for
$1,200.
• The payments to the owner are the yearly coupon
payments of $100, and the change in its value is
• $1,200 - $1,000 =$200.
• Adding these together and expressing them as a fraction
of the purchase price of $1,000 gives us the one-year
holding-period return for this bond

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The Distinction Between Interest Rates and
Returns
• The one-year holding-period return for this bond

• The return that we have calculated equals 30%,

• The yield to maturity was only 10 percent.
• This demonstrates that the return on a bond will not
necessarily equal the interest rate on that bond.

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The Distinction Between Interest Rates and
Returns
• Rate of Return:
The payments to the owner plus the change in value
expressed as a fraction of the purchase price
C P  Pt
RET = + t 1
Pt Pt
RET = return from holding the bond from time t to time t + 1
Pt = price of bond at time t
Pt 1 = price of the bond at time t + 1
C = coupon payment
C
= current yield = ic
Pt
Pt 1  Pt
= rate of capital gain = g
Pt
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The Distinction Between Interest Rates and
Returns
• The return on a bond is the current yield ic plus the rate of
capital gain g.
• The return equals the yield to maturity only if the holding
period equals the time to maturity.
• 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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The Distinction Between Interest Rates and
Returns
• 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 an increase in the interest
rate.
• Even if a bond has a substantial initial interest rate, its
return can be negative if interest rates rise.

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The Distinction Between Interest Rates and
Returns
Table 2 One-Year Returns on Different-Maturity 10%-Coupon-
Rate Bonds When Interest Rates Rise from 10% to 20%
(1) (2) (3) (4) (5) (6)
Years to Maturity Initial Initial Price Rate of Rate of Return
When Bond Is Current Price Next Capital Gain [col (2) + col (5)]
Purchased Yield (%) ($) Year* ($) (%) (%)
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 0.0 +10.0

*Calculated with a financial calculator, using Equation 3.

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Maturity and the Volatility of Bond
Returns: Interest-Rate Risk
• If an individual does not sell the bond, his capital loss is
often referred to as a “paper loss.”
• This is a loss nonetheless because if he had not bought
this bond and had instead put his money in the bank, he
would now be able to buy more bonds at their lower price
than he presently owns.
• Prices and returns for long-term bonds are more volatile
than those for shorter-term bonds.
• 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 changes in price level 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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Fisher Equation
i  ir   e
i = nominal interest rate
ir = real interest rate
 e = expected inflation rate
When the real interest rate is low,
there are greater incentives to borrow and fewer incentives to lend.
The real interest rate is a better indicator of the incentives to
borrow and lend.

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Fisher Equation

• Let us first consider a situation in which you have made

a one-year simple loan with a 5% interest rate (i = 5%)
and you expect the price level to rise by 3% over the
course of the year (3%).

• As a result of making the loan, at the end of the year you

will have 2% more in real terms,

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Fisher Equation

• Now if the interest rate rises to 8%, but you expect the
inflation rate to be 10% over the course of the year?

• Although you will have 8% more dollars at the end of the

year, you will be paying 10% more for goods;

• The result is that you will be able to buy 2% fewer goods

at the end of the year and you are 2% worse off in real
terms.

• When the real interest rate is low, there are greater

incentives to borrow and fewer incentives to lend.
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Fisher Equation
• A similar distinction can be made between nominal returns and real
returns.

• Nominal returns, which do not allow for inflation, are what we have
been referring to as simply “returns.”

• When inflation is subtracted from a nominal return, we have the real

return, which indicates the amount of extra goods and services that
can be purchased as a result of holding the security.

• The distinction between real and nominal interest rates is important

because the real interest rate, which reflects the real cost of
borrowing, is likely to be a better indicator of the incentives to borrow
and lend.

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The Economics of Money, Banking, and
Financial Markets
Twelfth Edition, Global Edition

Chapter 5
The Behavior of Interest
Rates

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Preview
• In this chapter, we examine how the overall level of
nominal interest rates is determined and which factors
influence their behavior.

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Learning Objectives (1 of 2)
• Identify the factors that affect the demand for assets.
• Draw the demand and supply curves for the bond market
and identify the equilibrium interest rate.
• List and describe the factors that affect the equilibrium
interest rate in the bond market.

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Learning Objectives (2 of 2)
• Describe the connection between the bond market and the
money market through the liquidity preference framework.
• List and describe the factors that affect the money market
and the equilibrium interest rate.
• Identify and illustrate the effects on the interest rate of
changes in money growth over time.

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Determinants of Asset Demand
• Economic agents hold a variety of different assets. What
are the primary assets you hold?
• An asset is anything that can be owned and has value.

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Determinants of Asset Demand
• Wealth: the total resources owned by the individual,
including all assets
• Expected Return: the return expected over the next
period on one asset relative to alternative assets
• Risk: the degree of uncertainty associated with the return
on one asset relative to alternative assets
• Liquidity: the ease and speed with which an asset can be
turned into cash relative to alternative assets

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Theory of Portfolio Choice
Holding all other factors constant:
1. The quantity demanded of an asset is positively
related to wealth
2. The quantity demanded of an asset is positively
related to its expected return relative to alternative
assets
3. The quantity demanded of an asset is negatively
related to the risk of its returns relative to alternative
assets
4. The quantity demanded of an asset is positively
related to its liquidity relative to alternative assets
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Theory of Portfolio Choice (2 of 2)
Summary Table 1
Response of the Quantity of an Asset Demanded to Changes in Wealth,
Expected Returns, Risk, and Liquidity
Variable Change in Variable Change in Quantity
Demanded
Wealth ↑ ↑
Expected return relative to other assets ↑ ↑
Risk relative to other assets ↑ ↓
Liquidity relative to other assets ↑ ↑

Note: Only increases in the variables are shown. The effects of decreases in the variables on the quantity demanded
would be the opposite of those indicated in the rightmost column.

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