PRINCIPLES OF FINANCIAL MARKET

Chapter 4: interest rate

 objectives

 Understand principles of interest rate and Fisher

equation
 Understand and apply methods of valuating interest
rate
 Understand factors affecting interest rate
 Understand principles of interest rate ‘s term and
risk structure
 1. Definition

 Interest rate is the price of using a unit of loan

(usually money) over a given period of time.
 2. classification

2.1. Based on banking business:

▪ Deposit rate (saving rate)
▪ Rate for loan (borrowing rate)
▪ Discount rate
▪ Rediscount rate
▪ Interbank interest rate
▪ Basic interest rate
 2. classification

2.2. Based on the value of interest:

 Nominal interest rate: The interest rate account for
the nominal value of the currency, not including the
inflation rate. Often published officially in credit
contracts or on debt instruments.
 Real interest rate: the interest rate adjusted by
change in expected inflation rate.
 2. classification

2.2. Based on the value of interest : (cont.)

 The relationship between nominal and real interest
rate is expressed by Fisher equation:
i = ir + πe
Where, i: nominal interest rate
ir : real interest rate
πe : expected inflation rate(*)
 When real iterest rate is low, borrower will have
more incentive to borrow and lender will have less
incentive to lend
 2. classification

2.3. Based on the flexibility of interest rate:

▪ Fixed rate
▪ Floating rate
2.4. Based on types of currency for lending:
▪ Domestic currency interest rate
▪ Foreign currency interest rate
2.5. Based on the credit source:
▪ Domestic rate
▪ International rate
 3. Valuating interest rate

3.1. Instruments of credit market:

3.1.1. Simple loan: A loan as a borrower will pay
the lender the principal and an interest as the cost of
using the loan at maturity..
Example: borrow 100mil for 1 year, 10%/yr
borrowing rate. After 1 year, you have to pay
110mil (100mil as the principle and 10mil as
interest)
 3.1. Instruments of credit market

3.1.2. Fixed repayment loan: is the loan method by

which the borrower repays the loan by paying the
fixed amount after a fixed period of time throughout
the loan period.
Example: you borrow the bank 1bil to buy house for
15 years and each year you have to repay the bank
150mil (including part of principle and interest)
 3.1. Instruments of credit market

3.1.3. Coupon bond: Bond that pay interest as a

coupon periodically until the maturity. At maturity,
the bondholder will receive the face value of the bond
Example: Tinh Viet bond has a face value of 100tr,
10%/yr coupon rate, paid annually.
 3.1. Instruments of credit market

3.1.3. Discound bond (zero cpupon bond): a bond is

sold at a price lower than the face value. At maturity,
the bondholder will receive the face value. This kind
of bond does not pay coupon.
Example: Treasury bond has a face value of 10mil,
sold at a price of 9mil, 1 year maturity.
 3. Valuating interest rate

3.2Time value of money:

3.2.1. Simple interest:
 The interest rate is calculated on the principal only. The
interest is not included to the principle to calculate interest for
the next period.
 Used for credit contract with 1 year maturity or shorter.
 Since simple rate is usually in the form of % per annum, you
want to calculate the interest rate for a given term, first
calculate the term in how much part of a year then multiply it
with the simple rate.
For example: if the simple rate is 16%/yr then the simple rate
for 2-year is 32%, 6-month is 8%.
 3. Valuating interest rate
3.2. Time value of money:
3.2.1. Simple interest (cont.):
 Formula:
FV = P x (1 + i.t)
Where,
P: present value
FV: future value
i: simple rate (%/yr)
t: the maturity in term of year
Example:
a. A credit contract has a value of 100mil, 10%/yr simple interest rate. Calculate the
future value of the contract at maturity if the maturity is 3-year, 3-month, 9-month.
b. Calculate the simple interest rate applied for the credit contract with the value of
10mil. Known that the future value of the contract at maturity is 12tr. The maturity is
6-month and 1-year
c. Calculate the present value od the credit contract, known that the future value is
50mil, 12%/year simple interest rate. The maturity is 1-month.
 3. Valuating interest rate
3.2. Time value of money:
3.2.2. Compound interest:
 When loan contract has multiple periods of interest, the interest accrued in
the preceding period is added to the principal for interest calculation for the
next period, the method of calculating such interest is called the compound
interest rate.
 Usually applied for long term contract (longer than 1 year)
 Formula:
FV = P x (1 + i/n)n.t
Where,
P: present value
FV: future value
i: compound interest rate (%/year)
t: the maturity in term of year
n: the number of periods interest paid in one year
 3. Valuating interest rate

3.2. Time value of money :

3.2.2. Compound interest
Example:
a. A customer buy a bond with 2-year maturity,
12%/year compound interest rate. Interest is
paid each 6-month. What is the future value
the customer receive?
b. If you want to have 1bil after 30 years, how
much you have to save today. Known that the
compound interest rate of the bank is
10%/year.
 3. Valuating interest rate
3.2. Time value of money :
3.2.3. Effective interest rate:
 The real interest rate arises in a year, depending on the nominal
interest rate stated in the contract and the number of period
interest paid in one year
 Formula:
ief = (1+i/n)n -1
Where,
ief: effective interest rate (%/year)
i : nominal interest rate(%/year)
Example: Calculate the effective interest rate if the
interest is paid each 6-month, 3-month, 1-month known
that the nominal interest rate stated in the contract is
12%/year.
 3. Valuating interest rate

3.3. Yield to maturity:

An interest rate that makes the present value of
future income (including principal an interest) equal to the
price of an instrument.
3.3.1. Yield to maturity of simple loan:
- For compound interest: yield to maturity equal to nominal
interest rate of the loan.
- For simple interest:
(1 + i.t) = (1 + i*)
Where,
i: nominal interest rate
i*: yield to maturity
 3. Valuating interest rate

3.3. Yield to maturity:

3.3.2. Yield to maturity of fixed repayment
loan:
P = C/i* x [ 1 – 1/(1+i*)t ]
Where,
P: present value
C: fixed repayment annually
i*: yield to maturity
t: maturity
 3. Valuating interest rate

3.3. Yield to maturity:

3.3.2. Yield to maturity of coupon bond:
P = C/i* x [ 1 – 1/(1+i*)t ] + FV/(1+i*)t
Where,
P: price of bond (present value)
C: coupon
i*: yield to maturity
t: maturity
FV: face value of bond
 3. Valuating interest rate

3.3. Yield to maturity:

3.3.2. Yield to maturity of coupon bond :
 Perpeptuity:
i* = C/P
 Note: nominal rate of bond calculated as follow
i = C/FV
 3. Valuating interest rate

3.3. Yield to maturity:

3.3.3. Yield to maturity of zero coupon bond
(discounted bond):

FV = P (1 + i*)t
Where,
FV: face value of bond
P: discounted price of bond
i*: yield to maturity
t: maturity