Chapter 8

Time Value of Money

Road Map

Part A Introduction to Finance.

Part B Valuation of assets, given discount rates.

Part C Determination of discount rates.

• Historical asset returns.

• Time value of money.
• Risk.
• Portfolio theory.
• Capital Asset Pricing Model (CAPM).
• Arbitrage Pricing Theory (APT).

Part D Introduction to corporate.

Main Issues
• Theroy of Real Interest Rates

• Nominal Interest Rates

• Term Structure Hypotheses

8-2 Time Value of Money Chapter 8

Contents
1 Theory of Real Interest Rates . . . . . . . . . . . . . . . . . 8-3
2 Nominal Interest Rates . . . . . . . . . . . . . . . . . . . . . 8-7
3 Term Structure Hypotheses . . . . . . . . . . . . . . . . . . 8-8
3.1 Expectations Hypothesis . . . . . . . . . . . . . . . . . . . . . . 8-8
3.2 Liquidity Preference Hypothesis . . . . . . . . . . . . . . . . . . . 8-10
4 Homework . . . . . . . . . . . . . . . . . . . . . . . . . . . 8-13

15.407 Lecture Notes Fall 2003

c Jiang Wang
Chapter 8 Time Value of Money 8-3

1 Theory of Real Interest Rates

Real interest rates are determined by supply and demand of funds
in the economy.

Three factors in determining real interest rates:

1. Aggregate endowments

2. Aggregate investment opportunities

3. Aggregate preferences for different consumption path.

Dollars, date 1

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HH
HH
HH u(c0 , c1 ) ≥ u
6 H
H
HH
HH
HH
H
payoff HH
HH
 HH
e1 (e0 , e1 ) HH −(1+r)
invest HH
HH
H
Dollars, date 0
e0

c Jiang Wang Fall 2003 15.407 Lecture Notes
8-4 Time Value of Money Chapter 8

Consider a representative investor:

• has endowment of (e0, e1)

• faces a bond market with interest rate r.

He maximizes his utility over his consumption now and later:

max u(c0) + ρu(c1)
s.t. c0 = e0 − b
c1 = e1 + (1 + r)b

where b is his bond holding, u > 0 and u < 0.

The optimality condition is

u (c0 ) = (1 + r)ρu (c1)

or (for c1 = c0 + dc)


u (c0) 1 1 c0 u (c0) dc
r= −1≈ −1 − .
ρu (c1) ρ ρ u (c0) c0

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c Jiang Wang
Chapter 8 Time Value of Money 8-5

Thus, the real interest rate is given by

  

1 1 c0u (c0) dc
r= −1 + −  .
ρ ρ u (c0) c0

The interest rate is determined by

1. Investors’ time-impatience coefficients ρ

2. Rate of consumption growth

3. Relative sensitivity of marginal utility to consumption.

The interest rate is higher if

• investors are less patient for future consumption (smaller ρ)

• consumption grows faster

• marginal utility diminishes faster as consumption increases.

The real interest rate can be negative if consumption is expected

to decrease significantly.

c Jiang Wang Fall 2003 15.407 Lecture Notes
8-6 Time Value of Money Chapter 8

More generally, consumption growth can be uncertain. Investors

maximize their expected utility over many periods:
 T 

max E ρt u(ct)
t=0
s.t. c0 = e0 − b1 − b2 − · · · bT
ct = et + (1 + rt)bt, t = 1, . . . , T

where (b1, . . . , bT ) is his holdings of discount bonds, (e1, . . . , eT )

future endowments, (c1, . . . , cT ) his future consumption, both
can be uncertain.

We then have

 (c )

u 0
rt = ρ−t E −1
u (ct)

where t = 1, 2, . . .

{r1, r2, . . . , rT , . . .} gives the term structure of interest rates.

Thus, the term structure of interest rates is determined by

• Investors’ impatience for future consumption

• Expected consumption growth at different horizons

• Their sensitivity of marginal utility to consumption growth.

15.407 Lecture Notes Fall 2003

c Jiang Wang
Chapter 8 Time Value of Money 8-7

2 Nominal Interest Rates

Coupon payments and principal payments on bonds are often in
nominal terms. The interest rates bonds offer are then in nominal
terms.

The link between is given by the following relation:

1 + rnominal = (1 + rreal ) (1 + i)

where i is the rate of inflation.

Thus, two factors determine nominal interest rates:

1. Real interest rates

2. Expectations of future inflation.

The two factors are not necessarily independent.

Real interest rates can be negative. How about nominal rates?

c Jiang Wang Fall 2003 15.407 Lecture Notes
8-8 Time Value of Money Chapter 8

3 Term Structure Hypotheses

3.1 Expectations Hypothesis

Expectations Hypothesis: Forward rates are unbiased predictors

of expected future spot rates.

ft = E [r1(t)] .

Implications of Expectations Hypothesis:

• Slope of the term structure reflects the market’s expectations

of future short-term interest rates.
- Upward slopping term structure reflects market expectations
of increasing short-term interest rates over time.
- Downward slopping term structure reflects market expecta-
tions of decreasing short-term interest rates over time.

• Expected rate of return on rolling over short bonds equals

return on long bonds.

15.407 Lecture Notes Fall 2003

c Jiang Wang
Chapter 8 Time Value of Money 8-9

Example. Suppose that the current spot rates are:

Maturity 1 2 3 4 ···
Spot interest rate 0.030 0.040 0.045 0.050
Forward interest rates 0.030 0.050 0.055 0.060

The term structure of interest rates is upward slopping.

Under Expectations Hypothesis, an upward-slopping yield curve

implies market’s expectation of future increases in interest rates.

(1) What is the (locked-in) return on a 2-year bond?

(1+r2 (0))2 − 1 = (1.04)2 − 1 = 8.16%.

(2) What is the expected return of rolling over 1-year bonds?

E [(1+r1 (0))(1+r1 (1))] − 1 = (1+r1 (0))(1+ E[r1 (1)]) − 1

= (1+r1 (0))(1+f2 (0)) − 1

= (1.03)(1.0501) − 1 = 8.16%.

Rolling over short bonds gives the same expected rate of return
as holding long bonds.

c Jiang Wang Fall 2003 15.407 Lecture Notes
8-10 Time Value of Money Chapter 8

3.2 Liquidity Preference Hypothesis

Liquidity Preference Hypothesis: Investors regard long bonds

as riskier than short bonds.

The forward rates (or long bond yields) contain a risk premium:

ft = E[r1 (t)] + πt

where πt is the risk premium for discount bonds maturing at t.

Implications of Liquidity Preference Hypothesis:

• Investors in long bonds expect, and on average receive, higher

returns than investors in short bonds.

• Forward rate on average “overpredict” future short-term rates.

• Term structure reflects (a) expectations of future interest rates

and (b) risk premium demanded by investors on long bonds.

• The term structure will slope upward even when future short-
term rates are expected to be constant.

15.407 Lecture Notes Fall 2003

c Jiang Wang
Chapter 8 Time Value of Money 8-11

Yield curves with different expectations of future short rates

Term structure of interest rates Term structure of interest rates

0.08 0.08

forward rates
0.07 0.07

0.06 0.06 yield curve upward slopping

yield curve upward slopping

0.05 0.05
interest rate

interest rate
0.04 0.04
expected short rates constant
forward rates

0.03 0.03

0.02 0.02
expected short rates decreasing

0.01 0.01

0 0
0 5 10 15 20 25 30 35 40 0 5 10 15 20 25 30 35 40
time to maturity time to maturity (years)

Term structure of interest rates Term structure of interest rates

0.08 0.08

forward rates
0.07 forward rates 0.07

yield curve upward slopping

0.06 yield curve upward slopping 0.06

0.05 0.05
expected short rate increasing
interest rate

interest rate

0.04 0.04

expected short rates decreasing

0.03 0.03

0.02 0.02

0.01 0.01

0 0
0 5 10 15 20 25 30 35 40 0 5 10 15 20 25 30 35 40
time to maturity (years) time to maturity (years)

c Jiang Wang Fall 2003 15.407 Lecture Notes
8-12 Time Value of Money Chapter 8

Treasury yield curves

January 1st, 1995 January 1st, 1996 January 1st, 1997

8.5 8.5 8.5

8 8 8

7.5 7.5 7.5

7 7 7

6.5 6.5 6.5

yield
yield

yield
6 6 6
5.5 5.5 5.5
5 5 5
4.5 4.5 4.5
4 4 4
3M 6M 1Y 2Y 5Y 10Y 30Y 3M 6M 1Y 2Y 5Y 10Y 30Y 3M 6M 1Y 2Y 5Y 10Y 30Y
maturity marurity maturity

January 1st, 1998 January 1st, 1999 January 1st, 2000

8.5 8.5 8.5

8 8 8

7.5 7.5 7.5

7 7 7

6.5 6.5 6.5

yield

yield

yield
6 6 6

5.5 5.5 5.5

5 5 5

4.5 4.5 4.5

4 4 4
3M 6M 1Y 2Y maturity 5Y 10Y 30Y 3M 6M 1Y 2Y 5Y 10Y 30Y 3M 6M 1Y 2Y 5Y 10Y 30Y
maturity maturity

July 1st, 2000 January 1st, 2001 January 18th, 2001

8.5 8.5 8.5

8 8 8

7.5 7.5 7.5

7 7 7

6.5 6.5 6.5

yield

yield
yield

6 6 6

5.5 5.5 5.5

5 5 5
4.5 4.5 4.5
4 4 4
3M 6M 1Y 2Y maturity 5Y 10Y 30Y 3M 6M 1Y 2Y maturity 5Y 10Y 30Y 6M 1Y 2Y maturity 5Y 10Y 30Y
3M

Average rates of return on treasuries, 1926 – 1996

(Source: Ibbotson Associates, 1997 Yearbook)

Long-term Bills
Nominal 5.4% 3.8%
Real 2.4% 0.7%

(Inflation is 3.2%.)

15.407 Lecture Notes Fall 2003

c Jiang Wang
Chapter 8 Time Value of Money 8-13

4 Homework
Readings:

• BKM Chapter 5.1, 15.3, 15.4.

• BM Chapter 24.1, 24.4.

Assignment:

• Problem Set 6.

c Jiang Wang Fall 2003 15.407 Lecture Notes