Chapter 4

The Meaning of Interest Rates

University of Kurdistan- Hewler

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 Chapter 4
The Meaning of
Interest Rates

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• Before we can go on with the study of money, banking, and

financial markets, we must understand exactly what the phrase
interest rates means.
• In this chapter, we see that a concept known as:
the yield to maturity is the most accurate measure of interest rate.

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 Learning Objectives

• Calculate the present value of future cash flows and the yield to
maturity on the four types of credit market instruments.

• Recognize the distinctions among yield to maturity, current yield,

rate of return, and rate of capital gain.

• Interpret the distinction between real and nominal interest rates.

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 Measuring Interest Rates

Present value:

a dollar paid to you one year from now is less valuable

than a dollar paid to you today.

 Why: a dollar deposited today can earn interest and become

$1 x (1+i) one year from today.

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 Present Value

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 Simple Present Value

PV = today's (present) value

CF = future cash flow (payment)
i = the interest rate
CF
PV = n
(1 + i )

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 Simple Present Value
 The process of calculating today’s value of dollars received
in the future, is called discounting the future

$100 $100 $100 $100

Year 0 1 2 n

PV 100 100/(1+i) 100/(1+i)2 100/(1+i)n

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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

FV
PV  n
(1  i )
Interest rate = Yield to maturity

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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
The lender provides the borrower with an amount of funds, which
must be repaid to the lender at the maturity date along with an
additional payment for the interest

PV = amount borrowed = $100

CF = cash flow in one year = $110
n = number of years = 1
$110
$100 =
(1 + i )1
(1 + i ) $100 = $110
$110
(1 + i ) =
$100
i = 0.10 = 10%
For simple loans, the simple interest rate equals the
yield to maturity

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 EXERCISE 4.1

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 ANSWER 4.1

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 Fixed-Payment Loan(Fully Amortized Loan)

Lender provides borrower with amount of funds , which must be repaid by making
the same payment every period consisting of part of principle and interest for a set
number of years. Such as instalment loans for car or mortgages.

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
FP FP FP FP
LV =  2
 3
 ...+
1 + i (1 + i ) (1 + i ) (1 + i) n

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Example:
Suppose , a loan is $1,000 and the yearly payment is $126 for the
next 25 years.
Find yield to maturity or interest rate:

126 126 126

1000  1   ...... 
(1 i ) (1 i ) 2 (1 i ) 25

i  12.6%

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 Coupon Bond
Pays the owner of the bond a fixed interest payment (coupon payment) every year
until the maturity date, when a specified final amount (face value or par value) is
repaid.
A coupon bond should have three pieces of information:
1)The corporation or government agency which issued the bond
2)The maturity date of bond
3)The bond’s coupon rate

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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 EXAMPLE : COUPON BOND

What is the present value of a $1,000-face-value bond with 10 years

to maturity and a 10% coupon rate :

C C F
P  1   ...... 
(1 i ) (1 i ) 2 (1 i )10
P = Present Value
C = yearly Coupon payment (1000 * 0.10 = 100)
F = face value or Par Value
i = Yield to maturity
100100 1000
1000  1   ...... 
(1 i ) (1 i ) 2 (1 i )10

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

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 Coupon Bond
• Perpetuity:
 A bond with no maturity date that does not repay principal but pays
fixed coupon payments forever
P  C / ic
Pc  price of the consol
C  yearly interest payment
ic  yield to maturity of the consol
can rewrite above equation as this : ic  C / Pc
For coupon bonds, this equation gives the current yield, an easy to
calculate approximation to the yield to maturity

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 Discount Bond

The bond would sale at a discount. For example a bond with a

par value 1000$ would sale at 900$

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.

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EXERCISE 4.2

Would a dollar tomorrow be worth more to you

today when the interest rate is 20% or when it
is 10%?

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 ANSWER 4.1

It would be worth 1/(1 + 0.20) = $0.83 when the

interest rate is 20%,
rather than 1/(1 + 0.10) = $0.91 when the
interest rate is 10%.

Thus, a dollar tomorrow is worth less with a

higher interest rate today.

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EXERCISE 4.3

If the interest rate is 10%, what is the present

value of a security that pays you $1,100 next
year, $1,210 the year after, and $1,331 the year
after that?

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 ANSWER 4.3

PV= $1,100/(1 + 0.10) + $1,210/(1 +

0.10)2 + $1,331/(1 + 0.10)3 = $3,000.

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 ASSIGNMENT 2 FOR WEEK 4

1. What is the yield to maturity on a $1,000-face-value

discount bond maturing in one year that sells for $800?

2. Write down the formula that is used to calculate the

yield to maturity on a 20-year 10% coupon bond with
$1,000 face value that sells for $2,000

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End of Chapter 2