Chapter 4

Understanding
InterestRates
Present Value
FourTypesofCreditInstruments
1. Simpleloan
2. Fixedpaymentloan
3. Couponbond
4. Discount(zerocoupon)bond
ConceptofPresentValue
Simpleloanof$1at10%interest
Year 1 2 3 n
$1.10 $1.21 $1.33 $1x(1+i)n
$1
PVoffuture$1=
(1+i)n
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Yield to Maturity: Loans
Yieldtomaturity=interestratethatequatestodaysvaluewith
presentvalueofallfuturepayments
1. SimpleLoan(i=10%)
$100=$110/(1+i)
$110$100 $10
i= = =0.10=10%
$100 $100

2. Fixed Payment Loan (i = 12%)

$126 $126 $126 $126
$1000 = + + + ... +
(1+i) (1+i) 2
(1+i) 3
(1+i)25
FP FP FP FP
LV = + + + ... +
(1+i) (1+i) 2
(1+i) 3
(1+i)n
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 Yield to Maturity: Bonds
3. Coupon Bond (Coupon rate = 10% = C/F)
$100 $100 $100 $100 $1000
P= + + + ... + +
(1+i) (1+i)2 (1+i)3 (1+i)10 (1+i)10
C C C C F
P= + + + ... + +
(1+i) (1+i)2 (1+i)3 (1+i)n (1+i)n

Consol: Fixed coupon payments of $C forever

C C
P= i =
i P
4. Discount Bond (P = $900, F = $1000), one year
$1000
$900 =
(1+i)
$1000 $900
i= = 0.111 = 11.1%
$900
FP
i=
P
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 Consol (or Perpetuity)
Aperpetualbondwithnomaturitydateandnorepaymentof
principalthatmakesfixedcouponpaymentsof$Cforever.

FirstsoldduringtheNapoleonicWars(17991815)bythe
BritishTreasury.

P=C/i
Theformulaofinfinitesum

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Relationship Between Price
and Yield to Maturity

ThreeInterestingFactsinTable1
1. Whenbondisatpar,yieldequalscouponrate
2. Priceandyieldarenegativelyrelated
3. Yieldgreaterthancouponratewhenbondpriceisbelowparvalue
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Current bond prices and interest rates are
negatively related

Whentheinterestraterises,
thepriceofbondfalls

Whentheinterestratefalls,
thepriceofbondrises.

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Distinction Between Interest Rates
and Returns

RateofReturn
C+Pt+1Pt
RET= =ic+g
Pt

C
where: ic = = current yield
Pt

Pt+1 Pt
g= = capital gain
Pt
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Key Facts about Relationship
Between Interest Rates and Returns

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Maturity and the Volatility
of Bond Returns
KeyFindingsfromTable2
1. Onlybondwhosereturn=yieldisonewithmaturity=holdingperiod
2. Forbondswithmaturity>holdingperiod,iPimplyingcapitalloss
3. Longerismaturity,greateris%pricechangeassociatedwithinterest
ratechange
4. Longerismaturity,morereturnchangeswithchangeininterestrate
5. Bondwithhighinitialinterestratecanstillhavenegativereturnifi
ConclusionfromTable2Analysis
1. Pricesandreturnsmorevolatileforlongtermbondsbecausehave
higherinterestraterisk
2. Nointerestrateriskforanybondwhosematurityequalsholdingperiod

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 Distinction Between Real
and Nominal Interest Rates
RealInterestRate
Interestratethatisadjustedforexpectedchangesinthepricelevel
ir=ie i
(1+i)=(1+ )(1+ e)
r

1. Realinterestratemoreaccuratelyreflectstruecostofborrowing
2. Whenrealrateislow,greaterincentivestoborrowandlesstolend
ifi=5%and e=3%then:
ir=5%3%=2%

ifi=8%and e=10%then
ir=8%10%=2%

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U.S. Real and Nominal Interest Rates

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