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ABA203 Money and Banking Lecture 4: Understanding Interest Rates

This document is a lecture on understanding interest rates. It defines interest and interest rates, and discusses concepts like present value, future value, yield to maturity, and types of financial instruments involving interest rates like simple loans, fixed payment loans, coupon bonds, and discount bonds. It also covers topics such as the relationship between interest rates and bond prices, rates of return, interest rate risk, and the distinction between real and nominal interest rates.

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Charles MK Chan
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42 views

ABA203 Money and Banking Lecture 4: Understanding Interest Rates

This document is a lecture on understanding interest rates. It defines interest and interest rates, and discusses concepts like present value, future value, yield to maturity, and types of financial instruments involving interest rates like simple loans, fixed payment loans, coupon bonds, and discount bonds. It also covers topics such as the relationship between interest rates and bond prices, rates of return, interest rate risk, and the distinction between real and nominal interest rates.

Uploaded by

Charles MK Chan
Copyright
© Attribution Non-Commercial (BY-NC)
Available Formats
Download as PDF, TXT or read online on Scribd
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ABA203 Money and Banking

Lecture 4 Understanding Interest Rates

ABA203 Money and Banking

Lecture 4 Understanding Interest Rates

ABA203 Money and Banking

Lecture 4 Understanding Interest Rates

What is Interest?

Concept of Interest Rate


In a sample loan, lender provides the borrower with an amount of funds (principal), which must be repaid at a specified future date (maturity date), with an additional payment (interest). For example, if you lend $100 to your friend for one year with an additional payment for interest, $10. i = $10/$100 = 10%

ABA203 Money and Banking Lecture 4: Understanding Interest Rates


Senior Lecturer Mr. Aries Wong M.Phil., M.Sc., CPA, CFA [email protected] http://arieswong.weebly.com/

Concept of interest rate originated from cash flows with different timing. A dollar paid to you one year from now is less valuable than a dollar paid to you today. Why?

you can earns return from saving the money now, or


you can consume immediately and it is better than consumer one year later (time preference)

Chu Hai College of Higher Education ABA203 Money and Banking

Aries Wong Lecture 4 Understanding Interest Rates

Chu Hai College of Higher Education ABA203 Money and Banking

Aries Wong Lecture 4 Understanding Interest Rates

Chu Hai College of Higher Education ABA203 Money and Banking

Aries Wong Lecture 4 Understanding Interest Rates

Future Value and Compound Interest


Let i = .10 In one year $100 X (1+ 0.10) = $110 In two years $110 X (1 + 0.10) = $121 or 100 X (1 + 0.10)2 In three years $121 X (1 + 0.10) = $133 or 100 X (1 + 0.10)3 In n years $100 X (1 + i )n
Chu Hai College of Higher Education ABA203 Money and Banking Aries Wong Lecture 4 Understanding Interest Rates

Present Value, Future Value and Interest Rate


PV = today's (present) value CF = future cash flow (payment) i = the interest rate CF PV = (1 + i) n

Yield to Maturity
In a simple loan with one cash inflow and one cash outflow, the calculation of interest rate is straight forward.
In other cases with multiple cash flows, difference in borrowed amount and principal, yield to maturity is commonly used to represent interest rates. Yield to maturity is the interest rate that equates the present value of cash flow payments received from debt instrument with its value (i.e. the price) today.

Chu Hai College of Higher Education ABA203 Money and Banking

Aries Wong Lecture 4 Understanding Interest Rates

Chu Hai College of Higher Education ABA203 Money and Banking

Aries Wong Lecture 4 Understanding Interest Rates

Simple LoanYield to Maturity


PV = amount borrowed = $100 CF = cash flow in one year = $110 n = number of years = 1 $110 (1 + i )1 (1 + i ) $100 = $110 $110 (1 + i ) = $100 i = 0.10 = 10% $100 = For simple loans, the simple interest rate equals the yield to maturity
Chu Hai College of Higher Education Aries Wong

Fixed Payment Loan


Fixed Payment Loan is also called annuity.
Lender provides the borrower certain amount of funds, which is repaid by making same amount of payment every period (i.e. installment). Interest is charged on the outstanding amount of principal. Each installment consists both interest and repayment of the principal.

Fixed Payment LoanYield to Maturity


The same cash flow payment every period throughout the life of the loan LV = loan value FP = fixed yearly payment n = number of years until maturity LV = FP FP FP FP + + + ...+ 1 + i (1 + i) 2 (1 + i)3 (1 + i) n

Mortgages, auto loans are typical examples of fixed payment loan.

Chu Hai College of Higher Education

Aries Wong

Chu Hai College of Higher Education

Aries Wong

ABA203 Money and Banking

Lecture 4 Understanding Interest Rates

ABA203 Money and Banking

Lecture 4 Understanding Interest Rates

ABA203 Money and Banking

Lecture 4 Understanding Interest Rates

Coupon Bond
A coupon bond pays the holder of the bond a fixed interest payment (coupon) at certain time interval (e.g. every year, every 6-month, etc) until the maturity date, and a lump sum amount (face value or par value) at the maturity date. Coupon rate equals to the dollar amount of the yearly coupon payment over the face value of the bond.

Coupon BondYield to Maturity


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 P= C C C C F + + +. . . + + 1+i (1+i ) 2 (1+i )3 (1+i ) n (1+i ) n

Bond Price, Face Value, Coupon Rate and YTM

*Coupon payment = Coupon rate x Face value


Chu Hai College of Higher Education ABA203 Money and Banking Aries Wong Lecture 4 Understanding Interest Rates Chu Hai College of Higher Education ABA203 Money and Banking Aries Wong Lecture 4 Understanding Interest Rates

The price of a coupon bond and the yield to maturity are negatively related. When the coupon bond is priced at its face value, the yield to maturity equals the coupon rate. The yield to maturity is greater than the coupon rate when the bond price is below its face value, vice versa.
Chu Hai College of Higher Education ABA203 Money and Banking Aries Wong Lecture 4 Understanding Interest Rates

Consol or Perpetuity
A bond with no maturity date that does not repay principal but pays fixed coupon payments forever.

Discount BondYield to Maturity


A discount bond pays no interest but only the face value at the maturity date. So, it is also called zero-coupon bond.

Bond Price and Market Interest Rate: A Short Summary


Many loans/bonds are fixed-rate, that is, the amount of coupons/future repayments are fixed when they are initially sold.

Pc = C / ic Pc = price of the consol C = yearly interest payment ic = yield to maturity of the consol Can rewrite above equation as ic = C / Pc For coupon bonds, this equation gives current yield an easy-to-calculate approximation of yield to maturity

For any one year discount bond F-P P F = Face value of the discount bond i= 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.

The interest rate required by investors, however, always changes over time in the financial markets.
When market interest rate rises (falls) after the fixed-rate securities are sold, the attractiveness of such securities reduce (increases). Therefore, a bonds price and market interest rate are negatively related. When the interest rate rises, the price of the bond falls, and vice versa.

Chu Hai College of Higher Education ABA203 Money and Banking

Aries Wong Lecture 4 Understanding Interest Rates

Chu Hai College of Higher Education ABA203 Money and Banking

Aries Wong Lecture 4 Understanding Interest Rates

Chu Hai College of Higher Education ABA203 Money and Banking

Aries Wong Lecture 4 Understanding Interest Rates

Rate of Return
The payments to the owner plus the change in value expressed as a fraction of the purchase price P -P C + t +1 t RET = 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

Maturity and Rate of Return

Market Interest Rate, Rate of Return and YTM


A rise in market interest rates is associated with a fall in bond prices, resulting in a capital loss if holding period is shorter than maturity. The more distant a bonds maturity, the greater the size of the percentage price change associated with an interest-rate change. Thus, the lower the rate of return the 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. The return on a bond does not necessarily equal the yield to maturity. Return equals the YTM only if the holding period equals the time to maturity (i.e. the bond is redeemed with the face value).

Chu Hai College of Higher Education

Aries Wong

Chu Hai College of Higher Education

Aries Wong

Chu Hai College of Higher Education

Aries Wong

ABA203 Money and Banking

Lecture 4 Understanding Interest Rates

ABA203 Money and Banking

Lecture 4 Understanding Interest Rates

ABA203 Money and Banking

Lecture 4 Understanding Interest Rates

Interest-Rate Risk
Fluctuation of an assets return that results from interest-rate changes is called interest rate risk. Long-term bonds have higher interest-rate risk than those for shorter-term bonds.

Real and Nominal Interest Rates


Nominal interest rate makes no allowance for inflation. So, getting a positive nominal interest rate does not mean an increase in purchasing power. 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.

Fisher Equation
i = ir + p e i = nominal interest rate ir = real interest rate

There is no interest-rate risk for any bond whose time to maturity matches the holding period.

p 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.

Chu Hai College of Higher Education ABA203 Money and Banking

Aries Wong Lecture 4 Understanding Interest Rates

Chu Hai College of Higher Education

Aries Wong

Chu Hai College of Higher Education

Aries Wong

Chu Hai College of Higher Education

Aries Wong

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