The meaning of

Interest rate

Lecture 10.1

Cecchetti, Chapter 7

Mishkin, Chapter 2

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 Content

• Introduction
• Interest rates defined
• Commonly used interest rate measures
• Bond valuation
• Interest rate risk
• Reinvestment risk
• Real and nominal interest rates

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 Introduction

• Interest rates are among the most closely watched variables in the economy. Their
movements are reported almost daily by the news media, because they directly affect
our everyday lives and have important consequences for the health of the economy

• An interest rate is the price paid by a borrower to a lender for the use of resources that
will be used during some time period then returned

• Interest rates

• Link the present to the future

• Tell the future reward for lending today

• Tell the cost of borrowing now and repaying later

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 Interest rate

• Basis Point: A unit that is equal to 1/100th of 1%, and is used to denote the
changes in interest rates or differences in interest rates between various debt
instruments.

• The relationship between interest rate changes (or differentials) and basis
points can be summarized as follows: 1% change (or difference) = 100 basis
points.

• Example 1: If Bond A’s yield increases from 5% to 6.5%, then Bond A’s
yield increased 150 basis points.

• Example 2: If Bond B’s yield falls from 7.00% to 6.93%, then Bond B’s
yield decreased 7 basis points.

• Example 3: If Bond C has a yield of 6% and Bond D a yield of 2%, then

Bond C is 400 basis points more than Bond D.

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 Commonly used interest rate measures

There are four important ways of measuring (and reporting)

interest rates on financial instruments. These are:
• Coupon Yield: The “promised” annual percent return on a coupon
instrument.

• Current Yield: Bond’s annual coupon payment divided by its current

market price.

• Yield to Maturity: The interest rate that equates the future payments
to be received from a financial instrument (coupons plus maturity
value) with its market price today (i.e., to its present value).

• Discount Yield and Investment Yield: These are yields on short

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term (one year or less) debt instruments that have no coupon
 Coupon yield

• Coupon yield is the annual interest rate which was promised by the
issuer when a bond was first sold.

• Coupon information is found in the bond’s indenture (legal contract).

Indenture will state the coupon payment (as a percent of the bond’s
par value) and the schedule of payments (semi-annual or annual).

• The coupon yield on a bond will not change during the lifespan of the
bond.

• Note: U.S. Treasuries, 12 months and less have no coupons. Same

is true for short term government bonds in other countries.

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 Current yield

• The current yield (or flat yield, or interest yield) is

the coupon expressed as a percentage of the current
price; this is the simplest of all return measures

• This provides us with a measure of the “current”

interest yield obtained at the bond’s current market
price (i.e., cost associated with investing in a particular
bond).

• Current yield = annual coupon payment / market price

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 Current yield

• Premium bonds: The current yield on these bonds will always be

below the coupon yield.

• Current Yield = Annual coupon payment/>$1,000

• Using the 1.5% coupon bond:

• Current yield = $15.00/1,003.75 = 1.4944%

• Discount bonds: The current yield on these bonds will always be

above the coupon yield (assume a market price of $985).

• Current Yield – Annual coupon payment/<$1,000

• Current yield = $15.00/$985 = 1.5228%

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 Yield to Maturity

• 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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 Four Types of Credit Market
Instruments
• Simple Loan

• Fixed Payment Loan

• Coupon Bond

• Discount Bond

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Yield to Maturity on a Simple Loan

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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
+. . . + +
1+ i (1+ i ) (1+ i ) (1+ i ) (1+ i )n
n

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 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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 Yield to Maturity on Coupon Bond

The yield-to-maturity is the rate of return on the bond to an investor

given 3 critical assumptions:

• The investor holds the bond to maturity.

• The issuer makes all of the coupon and principal payments in the
full amount on the scheduled dates. Therefore, the yield-to-
maturity is the promised yield - the yield assuming the issuer does
not default on any of the payments.

• The investor is able to reinvest coupon payments at that same

yield.

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Market Yield vs. Bond Value for an 8% Coupon
Bond

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 Coupon Bond

• 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.

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

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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

• Consol or perpetuity: a bond with no maturity date

that does not repay principal but pays fixed coupon
payments forever
Type equation here.
P = C / ic
Pc = price of the consol
C = yearly interest payment
ic = yield to maturity of the consol
We can rewrite the equation as: ic = C / Pc

For coupon bonds, this equation gives the current yield, 18

 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. 19
 What Changes The Yield to Maturity?

• Think of the yield to maturity as the “required return on an

investment.”
Since the required return changes over time, we can
expect these changes to produce inverse changes in the
prices on outstanding (seasoned) bonds.

• Why will the required return change over time?

• Changes in inflation (inflationary expectations).

• Changes in the economy’s credit conditions resulting from

change in business activity.

• Changes in central bank policies. 20

• Changes in the assumptions about credit risk and announced

 Discount yields and investment yields

• Discount yields and investment yields are calculated for

U.S. T-bills and other short term money market
instruments (e.g., commercial paper and bankers’
acceptances) where there are no stated coupons (and
thus the assets are quoted at a discount of their maturity
value).

• The discount yield relates the return to the instrument’s

par value (or face or maturity). The discount yield is
sometimes called the bank discount rate or the discount
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rate.
 Discount yields and investment yields

• The investment yield relates the return to the instrument’s current

market price.

• The investment yield is sometimes called the coupon equivalent

yield, the bond equivalent rate, the effective yield or the interest
yield.

• The investment yield is generally calculated so that we can

compare the return on T-bills to “coupon” investment options

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 Discount yields and investment yields

• What is the discount yield for a 182-day T- bill, with a market price of
$965.93 (per $1,000 par, or face, value)?

• What is the investment yield for a 182-day T-bill, with a market price
of $965.93 (per $1,000 par, or face, value)?

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 Risk free and risk-adjusted interest rates

• When cash flows are riskless (lenders can receive for sure), the
appropriate interest rate (or discount rate) is the risk-free rate, often
denoted Rf

• When cash flows are not certain, i.e. when they are risky, investors
generally demand a higher interest rate that reflects the risk

• An interest rate that reflects the risk of the cash flows is known as a
risk-adjusted interest rate, or a risk-adjusted discount rate

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 Risk free and risk-adjusted interest rates

• We can think of the risk-adjusted interest rate as being equal to the

risk-free rate plus a risk premium

• For example, suppose that the risk free rate is 5.5%, but the
appropriate risk premium for an investment is 2.1%, the risk-adjusted
discount rate to be used to discount the cash flows from this
investment would be 5.5% + 2.1% = 7.6%

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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 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.

• The more distant a bond’s maturity, the greater the size of the
percentage price change associated with an interest-rate change.

• Interest rates do not always have to be positive as evidenced by

recent experience in Japan and several European states.

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 The Distinction Between Interest Rates
and Returns
• The more distant a bond’s maturity, 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.

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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
• The sensitivity of the price of a bond to the interest rate is known
as interest rate risk, and is captured by the slope of the price-yield
curve

• We have seen that, for a given coupon rate, bonds with long
maturities have greater interest rate risk than bonds with short
maturities; similarly, for a given maturity, bonds with low coupons
have greater interest rate risk than bonds with high coupons

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 Maturity and the Volatility of Bond
Returns: 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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 Maturity and the Volatility of Bond
Returns: Interest-Rate Risk
• Essentially, the interest rate risk of a bond is
determined by how long you have to wait ‘on average’
to receive the bond’s cash flows;

• This concept is encapsulated in the bond’s duration,

which is defined as (the negative of) the weighted
average time to maturity of the bond’s cash flows, with
weights proportional to the present value of the bond’s
cash flows; It is straightforward to show that duration is
(the negative of) the first derivative of the bond’s price
yield curve 32
 Reinvestment risk

• Reinvestment risk occurs because of the need to “roll over”

securities at maturity, i.e., reinvesting the par value into a new
security.

• Problem for bond holder: The interest rate you can obtain at roll
over is unknown while you are holding these outstanding
securities.

• Issue: What if market interest rates fall?

• You will then re-invest at a lower interest rate then

• the rate you had on the maturing bond.

• Potential reinvestment risk is greater when holding 33

 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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 Figure 1. Real and Nominal Interest
Rates (Three-Month Treasury Bill),
1953–2017

Sources: Nominal rates from Federal Reserve Bank of St. Louis FRED database:
http://research.stlouisfed.org/fred2/. The real rate is constructed using the procedure outlined in
Frederic S. Mishkin, “The Real Interest Rate: An Empirical Investigation,” Carnegie-Rochester
Conference Series on Public Policy 15 (1981): 151–200. This procedure involves estimating expected
inflation as a function of past interest rates, inflation, and time trends, and then subtracting the 36
expected inflation measure from the nominal interest rate.
1. A portfolio manager is considering the purchase of a bond with a
5.5% coupon rate that pays interest annually and matures in three
years. If the required rate of return on the bond is 5%, the price of the
bond per 100 of par value is closest to:

A. 98.65.

B. 101.36.

C. 106.43.

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38
2. An investor who owns a bond with a 9% coupon rate that pays
interest semiannually and matures in three years is considering its
sale. If the required rate of return on the bond is 11%, the price of the
bond per 100 of par value is closest to:

A. 95.00.

B. 95.11.

C. 105.15.

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40
3. A zero-coupon bond matures in 15 years. At a market discount
rate of 4.5% per year and assuming annual compounding, the price
of the bond per 100 of par value is closest to:

A. 51.30.

B. 51.67.

C. 71.62.

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42
4. Consider the following two bonds that pay interest annually:

At a market discount rate of 4%, the price difference between Bond A and
Bond B per 100 of par value is closest to:

A. 3.70.

B. 3.77.

C. 4.00.

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44
5. Which bond offers the lowest yield-to-maturity?

A. Bond A

B. Bond B

C. Bond C

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A is correct. Bond A offers the lowest yield-to-maturity. When a bond
is priced at a premium above par value the yield-to-maturity (YTM),
or market discount rate is less than the coupon rate. Bond A is priced
at a premium, so its YTM is below its 5% coupon rate. Bond B is
priced at par value so its YTM is equal to its 6% coupon rate. Bond C
is priced at a discount below par value, so its YTM is above its 5%
coupon rate.

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6. An analyst observes a 20-year, 8% option-free bond with
semiannual coupons. The required yield-to-maturity on a semiannual
bond basis was 8%, but suddenly it decreased to 7.25%. As a result,
the price of this bond:

A. increased

B. decreased

C. stayed the same

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7. A $1,000, 5%, 20-year annual-pay bond has a YTM of 6.5%. If the
YTM remains unchanged, how much will the bond value increase
over the next three years?

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8. Which of these $100 face value one-year bonds will have the
highest yield to maturity and why?

A. 6 percent coupon bond selling for $85.

B. 7 percent coupon bond selling for $100.

C. 8 percent coupon bond selling for $115. 


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9. Not long after the United Kingdom’s vote to leave the European
Union, the yields on some British Government bonds (called gilts)
turned negative. Assuming that these bonds were issued with a
positive coupon rate, would you expect their market prices to be
above, below, or equal to their face value? Explain your choice. 


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