Professional Documents
Culture Documents
Understanding
Interest Rates
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Quick Check!
Whats the PV of a Loan that has to be paid
($250) in two years, if the interest rate is
15%?
PV = $250 / (1 + 0.15) = $250 /1.3225 =
= $ 189.04
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Time Line
Year
PV
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$100
$100
$100
$100
100
100/(1+i)
100/(1+i)2
100/(1+i)n
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Yield to Maturity
The interest rate that equates the
present value of cash flow payments
received from a debt instrument with
its value today
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Differences/Similarities
Simple loans and discount bonds make
payment ONLY at their maturity dates.
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Simple Loan
PV = amount borrowed = $100
CF = cash flow in one year = $110
n = number of years = 1
$110
(1 + i )1
(1 + i ) $100 = $110
$100 =
$110
$100
i = 0.10 = 10%
For simple loans, the simple interest rate equals the
(1 + i ) =
yield to maturity
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...+
2
3
n
1 + i (1 + i ) (1 + i)
(1 + i)
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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=
. . . +
2
3
n
1+i (1+i ) (1+i )
(1+i) (1+i ) n
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When the coupon bond is priced at its face value, the yield to maturity equals
the coupon rate
Your book (confusing): The price of a coupon bond and the yield to
maturity are negatively related.
My own opinion: Price of a coupon bond and YTM have an inverse
relationship
The yield to maturity is greater than the coupon rate when the bond price is
below its face value
Consol or Perpetuity
A bond with no maturity date that does not repay
principal but pays fixed coupon payments forever
P C / ic
Pc price of the consol
C yearly interest payment
ic yield to maturity of the consol
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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Interest-Rate Risk
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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Fisher Equation
i ir e
i = nominal interest rate
ir = real interest rate
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Problems Assigned
Page 91: 1, 2, 3, 4, 5, 6, 7, 11, 12
Enjoy this Homework! We will go over them
during next class!
These Questions/Problems are brought to
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