Part Two

Fundamentals
of Financial
Markets
Chapter 3

What Do Interest
Rates Mean
and What Is
Their Role
in Valuation?
 Chapter Preview

• Interest rates are among the most closely

watched variables in the economy. It is
imperative that what exactly is meant by
the phrase interest rates is understood.
In this chapter, we will see that a concept
known as yield to maturity (YTM) is the
most accurate measure of interest rates.

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 3-3

 Chapter Preview

• Any description of interest rates entails an

understanding certain vernacular and
definitions, most of which will not only
pertain directly to interest rates but will also
be vital to understanding many other
foundational concepts presented later in
the text.

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 3-4

 Chapter Preview

• So, in this chapter, we will develop a better

understanding of interest rates. We examine the
terminology and calculation of various rates, and
we show the importance of these rates in our lives
and the general economy. Topics include:
– Measuring Interest Rates
– The Distinction Between Real and Nominal
Interest Rates
– The Distinction Between Interest Rates and Returns

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 3-5

 Present Value Introduction

• Different debt instruments have very different

streams of cash payments to the holder (known
as cash flows), with very different timing.
• All else being equal, debt instruments are
evaluated against one another based on the
amount of each cash flow and the timing of each
cash flow.
• This evaluation, where the analysis of the amount
and timing of a debt instrument’s cash flows lead
to its yield to maturity or interest rate, is called
present value analysis.
Copyright © 2009 Pearson Prentice Hall. All rights reserved. 3-6
 Present Value

• The concept of present value (or present

discounted value) is based on the
commonsense notion that a dollar of cash flow
paid to you one year from now is less valuable to
you than a dollar paid to you today. This notion is
true because you could invest the dollar in a
savings account that earns interest and have
more than a dollar in one year.
• The term present value (PV) can be extended to
mean the PV of a single cash flow or the sum of a
sequence or group of cash flows.
Copyright © 2009 Pearson Prentice Hall. All rights reserved. 3-7
 Present Value Applications

• There are four basic types of credit

instruments which incorporate present
value concepts:
1. Simple Loan
2. Fixed Payment Loan
3. Coupon Bond
4. Discount Bond

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 3-8

 Present Value Concept:
Simple Loan Terms

• Loan Principal: the amount of funds the lender provides to

the borrower.
• Maturity Date: the date the loan must be repaid; the Loan
Term is from initiation to maturity date.
• Interest Payment: the cash amount that the borrower
must pay the lender for the use of the loan principal.
• Simple Interest Rate: the interest payment divided by the
loan principal; the percentage of principal that must be
paid as interest to the lender. Convention is to express on
an annual basis, irrespective of the loan term.

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 3-9

 Present Value Concept: Simple Loan

Simple loan of $100

Year: 0 1 2 3 n
$100 $110 $121 $133 100(1+i)n

$1
PV of future $1=
1+ i n

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 3-10

 Present Value Concept:
Simple Loan (cont.)

• The previous example reinforces the

concept that $100 today is preferable to
$100 a year from now since today’s $100
could be lent out (or deposited) at 10%
interest to be worth $110 one year from
now, or $121 in two years or $133 in
three years.

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 3-11

 Yield to Maturity: Loans

• Yield to maturity = interest rate that equates

today's value with present value of all
future payments
1. Simple Loan Interest Rate (i = 10%)

$100  $110 1  i  
$110 $100 $10
i   .10  10%
$100 $100
Copyright © 2009 Pearson Prentice Hall. All rights reserved. 3-12
Present Value of Cash Flows: Example
 Present Value Concept:
Fixed-Payment Loan Terms

• Simple Loans require payment of one

amount which equals the loan principal plus
the interest.
• Fixed-Payment Loans are loans where the
loan principal and interest are repaid in
several payments, often monthly, in equal
dollar amounts over the loan term.

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 3-14

 Present Value Concept:
Fixed-Payment Loan Terms

• Installment Loans, such as auto loans and

home mortgages are frequently of the
fixed-payment type.

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 3-15

 Yield to Maturity: Loans

2. Fixed Payment Loan (i = 12%)

$126 $126 $126 $126

$1000   2  3  ...
1 i 1  i 1 i 1 i25

FP FP FP FP
LV   2  3 ...
1  i 1 i 1 i 1 in

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 3-16

 Yield to Maturity: Bonds

3. Coupon Bond (Coupon rate = 10% = C/F)

$100 $100 $100 $100 $1000
P  2  3  ... 10 
1 i 1  i 1 i  1 i 1  i10
C C C C F
P  2  3  ... n 
1 i 1  i 1 i 1 i 1  in
Consol: Fixed coupon payments of $C forever
C C
P i
i P
Copyright © 2009 Pearson Prentice Hall. All rights reserved. 3-17
 Yield to Maturity: Bonds

4. One-Year Discount Bond (P = $900, F = $1000)

$1000
$900  
1  i
$1000 $900
i  .111 11.1%
$900
FP
i
P
Copyright © 2009 Pearson Prentice Hall. All rights reserved. 3-18
 Relationship Between Price
and Yield to Maturity

• Three interesting facts in Table 3-1

1. When bond is at par, yield equals coupon rate
2. Price and yield are negatively related
3. Yield greater than coupon rate when bond price
is below par value
Copyright © 2009 Pearson Prentice Hall. All rights reserved. 3-19
 Relationship Between Price
and Yield to Maturity
• It’s also straight-forward to show that the value of
a bond (price) and yield to maturity (YTM) are
negatively related. If i increases, the PV of any
given cash flow is lower; hence, the price of the
bond must be lower.

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 3-20

 Current Yield

C
ic 
P
• Current yield (CY) is just an approximation for
YTM – easier to calculate. However, we should
be aware of its properties:
1. If a bond’s price is near par and has a long
maturity, then CY is a good approximation.
2. A change in the current yield always signals
change in same direction as yield to maturity

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 3-21

Bond Page of the Newspaper
 Global perspective

• In November 1998, rates on Japanese 6-

month government bonds were negative!
Investors were willing to pay more than
they would receive in the future.
• Best explanation is that investors found the
convenience of the bills worth something –
more convenient than cash. But that can
only go so far – the rate was only slightly
negative.

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 3-23

 Distinction Between Real
and Nominal Interest Rates

• Real interest rate

1. Interest rate that is adjusted for expected
changes in the price level
ir  i   e

2. Real interest rate more accurately reflects

true cost of borrowing
3. When the real rate is low, there are greater
incentives to borrow and less to lend

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 3-24

 Distinction Between Real
and Nominal Interest Rates

Real interest rate

ir  i   e

We usually refer to this rate as the ex ante real

rate of interest because it is adjusted for the
expected level of inflation. After the fact, we
can calculate the ex post real rate based on the
observed level of inflation.

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 3-25

 Distinction Between Real
and Nominal Interest Rates (cont.)

• If i = 5% and πe = 0% then

ir  5% 0% 5%
• If i = 10% and πe = 20% then

ir  10% 20% 10%

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 3-26

 U.S. Real and Nominal Interest Rates

Sample of current rates and indexes

Copyright © 2009 Pearson Prentice Hall. All rights reserved. http://www.martincapital.com/charts.htm 3-27
 Distinction Between Interest Rates
and Returns

• Rate of Return: we can decompose returns

into two pieces:
C  Pt 1  Pt
Return   ic  g
Pt
C
where ic  = current yield, and
Pt
Pt 1  Pt
g = capital gains.
Pt

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 3-28

 Key Facts about the Relationship
Between Rates and Returns

Sample of current coupon rates

and yields on government bonds
Copyright © 2009 Pearson Prentice Hall. All rights reserved. http://www.bloomberg.com/markets/iyc.html 3-29
 Maturity and the Volatility
of Bond Returns

• Key findings from Table 3-2

1. Only bond whose return = yield is one with
maturity = holding period
2. For bonds with maturity > holding period, i  P 
implying capital loss
3. Longer is maturity, greater is price change
associated
with interest rate change

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 3-30

 Maturity and the Volatility
of Bond Returns (cont.)

• Key findings from Table 3-2 (continued)

4. Longer is maturity, more return changes with
change in interest rate
5. Bond with high initial interest rate can still have
negative return if i 

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 3-31

 Maturity and the Volatility
of Bond Returns (cont.)

• Conclusion from Table 3-2 analysis

1. Prices and returns more volatile for long-term
bonds because have higher interest-rate risk
2. No interest-rate risk for any bond whose
maturity equals holding period

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 3-32

 Reinvestment Risk

1. Occurs if hold series of short bonds over

long holding period
2. i at which reinvest uncertain
3. Gain from i , lose when i 

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 3-33

 Calculating Duration
i =10%, 10-Year 10% Coupon Bond

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 3-34

 Calculating Duration
i = 20%, 10-Year 10% Coupon Bond

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 3-35

 Formula for Duration

n n
DUR   t 
CPt CPt
t 1 1  i t 1 1  i
t t

• Key facts about duration

1. All else equal, when the maturity of a bond
lengthens, the duration rises as well
2. All else equal, when interest rates rise, the
duration of a coupon bond fall

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 3-36

 Formula for Duration

1. The higher is the coupon rate on the bond,

the shorter is the duration of the bond
2. Duration is additive: the duration of a
portfolio of securities is the weighted-
average of the durations of the individual
securities, with the weights equaling the
proportion of the portfolio invested in each

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 3-37

 Duration and Interest-Rate Risk

i
%P  DUR 
1 i
• i  10% to 11%:
– Table 3-4, 10% coupon bond

0.01
%P  6.76 
1  0.10
%P  0.0615 6.15%
Copyright © 2009 Pearson Prentice Hall. All rights reserved. 3-38
 Duration and
Interest-Rate Risk (cont.)

• i  10% to 11%:
– 20% coupon bond, DUR = 5.72 years

0.01
%P  5.72 
1  0.10
%P  0.0520 5.20%

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 3-39

 Duration and
Interest-Rate Risk (cont.)

• The greater is the duration of a security, the

greater is the percentage change in the
market value of the security for a given
change in interest rates

• Therefore, the greater is the duration of a

security, the greater is its interest-rate risk

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 3-40

 Chapter Summary

• Measuring Interest Rates: We examined

several techniques for measuring the
interest rate required on debt instruments.

• The Distinction Between Real and Nominal

Interest Rates: We examined the meaning
of interest in the context of price inflation.

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 3-41

 Chapter Summary (cont.)

• The Distinction Between Interest Rates and

Returns: We examined what each means
and how they should be viewed for asset
valuation.

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 3-42