Understanding interest

rate
 Definition of interest rate

An interest rate is the percent of principal

charged by the lender for the use of money.

In simple word interest rate is the cost of

borrowing money .
Definition of Bond
 Bonds are loans made to large organizations. These
include corporations, cities and national governments.
A bond is a piece of a massive loan. That’s because the
size of these entities requires them to borrow money
from more than one source.
 The borrowing organization promises to pay the bond
back at an agreed-upon date. Until then, the borrower
makes agreed-upon interest payments to the
bondholder.
Types of bonds
 Government bond: Government bonds can be issued
by national governments as well as lower levels of
government.
 A municipal bond is a debt security issued by a state,
municipality or county to finance its capital
expenditures, including the construction of highways,
bridges or schools. Municipal bonds are exempt from
federal taxes and most state and local taxes, making
them especially attractive to people in high income tax
brackets
Types of Bond
 Corporate bond: The other major issuer of bonds are
corporations, and corporate bonds make up a large portion
of the overall bond market. Large corporations have a great
deal of flexibility as to how much debt they can issue.

 The limit is generally whatever the market will bear.

 Corporate bonds are characterized by higher yields than

government securities because there is a higher risk of a
company defaulting than a government.
Types of bond
 A convertible bond is a type of debt security that can
be converted into a predetermined amount of the
underlying company's equity at certain times during
the bond's life.

 A callable bond is a bond that can be redeemed by the

issuer prior to its maturity
Types of bond
 Asset-Backed Securities
Another category of bonds is issued by banks or other
financial sector participants and are referred to
as asset-backed securities or ABS.
Types of bond
 Fixed Rate Bonds:
 In Fixed Rate Bonds, the interest remains fixed
through out the tenure of the bond. Owing to a
constant interest rate.
 Floating Rate Bonds
 Floating rate bonds have a fluctuating interest rate
(coupons) as per the current market reference rate.
Types of bond
 Zero Interest Rate Bonds
Zero Interest Rate Bonds do not pay any regular
interest to the investors. In such types of bonds,
issuers only pay the principal amount to the bond
holders.
 Inflation Linked Bonds
Bonds linked to inflation are called inflation linked
bonds. The interest rate of Inflation linked bonds is
generally lower than fixed rate bonds.
Types of bond
 Perpetual Bonds
Bonds with no maturity dates are called perpetual
bonds. Holders of perpetual bonds enjoy interest
throughout.
 Bearer Bonds
Bearer Bonds do not carry the name of the bond
holder and anyone who possesses the bond certificate
can claim the amount. If the bond certificate gets
stolen or misplaced by the bond holder, anyone else
with the paper can claim the bond amount.
Types of bond
 War Bonds
War Bonds are issued by any government to raise
funds in cases of war.
 Serial Bonds
Bonds maturing over a period of time in installments
are called serial bonds.
 Climate Bonds
Climate Bonds are issued by any government to raise
funds when the country concerned faces any adverse
changes in climatic conditions.
Features of bond
 Maturity
Maturity is the time at which the bond matures and the
holder receives the final payment of principal and interest.
The "term to maturity" is the amount of time until the
bond actually matures. There are 3 basic classes of
maturity:

A. Short-Term Maturity - One to five years in length.

B. Intermediate-Term Maturity - Five to twelve years in
length
C. Long-Term Maturity - Twelve years or more in length
Features of bond
ParValue
Par value is the amount the holder will receive at the
bond's maturity. It can be any amount but is typically
$1,000 per bond. Par value is also known as principle,
face, maturity or redemption value. Bond prices are
quoted as a percentage of par.
Features of bond
 CouponRate
A coupon rate states the interest rate the bond will pay
the holders each year. To find the coupon's dollar
value, simply multiply the coupon rate by the par
value. The rate is for one year and payments are usually
made on a semi-annual basis.
Features of bond
 Currency Denomination

Currency denomination indicates what currency the

interest and principle will be paid .
Premium bond
 A bond that is trading above its par value in the
secondary market is a premium bond. A bond will
trade at a premium when it offers a coupon (interest)
rate that is higher than the current prevailing interest
rates being offered for new bonds. This is because
investors want a higher yield, which such a bond gives
them, and thus they will pay more for it.
Discount bond
 A bond currently trading for less than its par value in
the secondary market is a discount bond. A bond will
trade at a discount when it offers a coupon rate that is
lower than prevailing interest rates. Since investors
always want a higher yield, they will pay less for a bond
with a coupon rate lower than the prevailing rates.
YTM
 Yield to maturity (YTM) measures the annual return
an investor would receive if he or she held a
particular bond until maturity.

 coupon is the amount of fixed interest the bond will

earn each year.
 Yield to maturity is the expected return if the bond is
held until maturity.
Zero-coupon bond
 Make no periodic interest payments (coupon rate =
0%)
 Entire yield-to-maturity comes from the difference
between the purchase price and the par value (capital
gains)
 Cannot sell for more than par value
 Sometimes called zeroes, or deep discount bonds
 Treasury Bills and U.S. Savings bonds are good
examples of zeroes
Difference b/w YTM and interest
rate
 Yield commonly refers to the dividend, interest or
return the investor receives from a security like a stock
or bond, and is usually reported as an annual figure.

 Interest rate generally refers to the interest charged by

a lender such as a bank on a loan, and is typically
expressed as an annual percentage rate (APR).
Difference b/w interest rate and
return
 The rate of return is a specific way of expressing
the total return of an investment that shows the
percentage increase over the initial investment cost.

 Yield shows how much income has been returned

from an investment based on initial cost, but it does
not include capital gains in its calculation.
Price of bond
Valuation of bond
 The present value of expected cash flows is added to the
present value of the face value of the bond as seen in the
following formula:
 Where C = future cash flows, that is, coupon payments
 r = discount rate, that is, yield to maturity
 F = face value of bond
 t = number of periods
 T = time to maturity

Valuation of bond
 find the value of a corporate bond with annual interest rate of 5%, making semi-annual
interest payments for 2 years, after which the bond matures and the principal must be
repaid. Assume a YTM of 3%.
 F = $1000 for corporate bond
 Coupon rate annual = 5%, therefore, Coupon rate semi-annual = 5%/2 = 2.5%
 C = 2.5% x $1000 = $25 per period
 t = 2 years x 2 = 4 periods for semi-annual coupon payments
 T = 4 periods
 Present value of semi-annual payments = 25/(1.03)1 + 25/(1.03)2 + 25/(1.03)3 + 25/(1.03)4
 = 24.27 + 23.56 + 22.88 + 22.21
 = 92.93
 Present value of face value = 1000/(1.03)4
 = 888.49
 Therefore, value of bond = $92.93 + $888.49 = $981.42

Components of intetrest rate
 Real Risk-Free Rate - This assumes no risk or
uncertainty, simply reflecting differences in timing:
the preference to spend now/pay back later versus lend
now/collect later.
Inflation rate
 Expected Inflation - The market expects aggregate
prices to rise, and the currency's purchasing power is
reduced by a rate known as the inflation rate. Inflation
makes real dollars less valuable in the future and is
factored into determining the nominal interest rate
(from the economics material: nominal rate = real rate
+ inflation rate).
 Default-Risk Premium - What is the chance that the
borrower won't make payments on time, or will be
unable to pay what is owed? This component will be
high or low depending on the creditworthiness of the
person or entity involved.
 Liquidity Premium- Some investments are highly
liquid, meaning they are easily exchanged for cash
(U.S. Treasury debt, for example). Other securities are
less liquid, and there may be a certain loss expected if
it's an issue that trades infrequently. Holding other
factors equal, a less liquid security must compensate
the holder by offering a higher interest rate.
 Maturity Premium - All else being equal, a bond
obligation will be more sensitive to interest rate
fluctuations the longer to maturity it is.
 1) FV = PV * (1 + r)N
(2) PV = FV * { 1 }
(1 + r)NWhere: FV = future value of a single sum of
money,
PV = present value of a single sum of money, R =
annual interest rate,
and N = number of years

 At an interest rate of 8%, we calculate that $10,000 five
years from now will be:
 FV = PV * (1 + r)N = ($10,000)*(1.08)5 = ($10,000)*(1.469328)
 FV = $14,693.28
 At an interest rate of 8%, we calculate today's value that
will grow to $10,000 in five years:
 PV = FV * (1/(1 + r)N) = ($10,000)*(1/(1.08)5) =
($10,000)*(1/(1.469328))
 PV = ($10,000)*(0.680583) = $6805.83

Nominal interest rate
 A nominal interest rate is the interest rate that does
not take inflation into account. It is the interest rate
that is quoted on bonds and loans. The nominal
interest rate is a simple concept to understand; for
example, if you borrow $100 at a 6% interest rate, you
can expect to pay $6 in interest without taking
inflation into account. The disadvantage of using the
nominal interest rate is that it does not adjust for the
inflation rate.
Real interest rate
 real interest rate is the interest rate that does take
inflation into account. As opposed to the nominal
interest rate, the real interest rate adjusts for the
inflation and gives the real rate of a bond or a loan. To
calculate the real interest rate, you first need the
nominal interest rate. The calculation used to find the
real interest rate is the nominal interest rate minus the
expected or actual inflation rate. This rate gives the
real rate that lenders or investors are receiving after
inflation is factored in; it gives them a better idea of
the rate at which their purchasing power is increasing
or decreasing.