8/8/2017

What is Interest Rate

Topic 2 Obama borrow $100 from Agribank for one
year
Understanding Obama will have to pay $100 plus $10 on the
maturity day
Interest Rates For Obama, $10 is the price he has to pay to
use $100 for one year
Instructor: Lai T. Hoang
$10 is called interest, and $100 is called
principal

What is Interest Rate Present Value & Future Value

Interest is the price of credit, i.e. what Does $1 today has the same value with
you have to pay for borrowing money $1 after one year?
Interest A dollar deposited today can earn
Interest rate = 100% interest and become $1(1+i) after one
Principal year
The real-estate rental is also interest. (interest rate = i%/year)
Yes or No?

Present & Future Value Present Value & Future Value

Assume that Obama borrow Agribank
$100 for 2 years, with the interest rate
is 10%/year
How much will Obama have to pay
Clinton after 2 year?
What if 5 years, n years?
We can say $100 today has the same
value with $100*(1+0.1)n n years from
now
You consider borrowing some money. You
expect that you will marry a millionaire,
then divorce and get $1000,000 from his
wealth 20 years from now to pay your
debt. How much you can borrow now?

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Four Types of Credit Market

Present & Future Value Instruments
Discounting the future: the process of Simple Loan
calculating todays value of dollars received
in the future Fixed Payment Loan
$1000,000 FVn Coupon Bond
PV
(1 0.1) 20
(1 i ) n Discount Bond
where PV Present Value
FVn Future Value at time n
i interest rate

Yield to Maturity (YTM) Simple Loan

Yieldto maturity is the interest rate that equates PV = amount borrowed = $100
the present value of cash flow payments received CF = cash flow in one year = $110
from a debt instrument with its value today. n = number of years = 1
When economists use the word interest rate $100 =
$110
they often mean the yield to maturity. (1 + i )1
In some other contexts, yield to maturity is also (1 + i ) $100 = $110
called internal rate of return. (1 + i ) =
$110
$100
Q: How to calculate yield to maturity of the four i = 0.10 = 10%
types of debt instruments mentioned in previous
slide For simple loans, the simple interest rate equals the
yield to maturity

Fixed Payment Loan Coupon Bond

Using the same strategy used for the fixed-payment loan:
The same cash flow payment every period throughout P = price of coupon bond
the life of the loan C = yearly coupon payment
LV = loan value F = face value of the bond
FP = fixed yearly payment n = years to maturity date
C C C C F
n = number of years until maturity P= . . . +
1+i (1+i ) 2 (1+i )3 (1+i) n (1+i ) n
FP FP FP FP
LV = ...+ C 1 F Important!
1 + i (1 + i ) 2 (1 + i )3 (1 + i ) n P 1
i (1 i) n (1 i) n
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Yields to Maturity on a 10%-Coupon-Rate

Coupon Bond Price and YTM - Bond Maturing in Ten Years (Face Value =
Examples $1,000)
A 10% coupon-rate bond with a face value of $1,000
matures in ten years. What is its price if the yield to
maturity is 8.48%?
10% 1,000 1 1,000
P 1
10
1,100
(1 8.48%) (1 8.48%)
10
8.48%
What is its yield to maturity if the price is $900?
100 1 1000 When the coupon bond is priced at its face value,
900 1 i 11.75%
i (1 i)10 (1 i)10 the yield to maturity equals the coupon rate.
Trial and error/financial calculator/EXCEL IRR
The price of a coupon bond and the yield to
The calculation of YTM is not required in exam.
maturity are negatively related.
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Consol or Perpetuity Discount Bond

A bond with no maturity date and does not repay For any one year discount bond
principal but pays fixed coupon payments forever.
F-P
i=
P C / ic P
Pc price of the consol F = Face value of the discount bond
C yearly interest payment P = current price of the discount bond
ic yield to maturity of the consol The yield to maturity equals the increase
in price over the year divided by the initial price.
can rewrite above equation as this : ic C / Pc
As with a coupon bond, the yield to maturity is
negatively related to the current bond price.
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The Distinction Between Real

and Nominal Interest Rates Fisher Equation
So far, we have ignored the effect of If the bank offers you 10% interest rate in
inflation on interest the next year, but the price is expected to
rise by 7%, how much you actually earn?
Nominal interest rate makes no allowance
for inflation. Fisher Equation: =
Real interest rate is adjusted for changes where - real interest rate
in price level so it more accurately reflects - nominal interest rate
the cost of borrowing.
- inflation rate

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Real and Nominal Interest Rates (Three-

Fisher Equation Month Treasury Bill), 19532011
Can real interest rate be negative?
What is real interest rate if the
nominal interest rate is 8% and the
expected inflation rate is 10%?

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Homework
Question 1, 2, 4, 6, 11, 20, 22, 25
(Chapter 4)
Reading: Chapter 5