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, among the most commonly
used concepts, a concept known as yield to maturity (YTM) is
the most accurate measure of interest rates. Superior to:
– Coupon rate
– Current yield – Annual interest/coupon payment divide by Current
market price
• YTM has its limits – do not account for taxes, purchasing or selling costs ignorance
• IRR concept

3-2
 Chapter Preview
• 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

3-3
 Present Value (PV) 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.

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 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 Bird in Hand Theory in Finance – MM vs Gordon –
Lintner theory (H.W)
• 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.
e.g., cash flow receive from project A or cash flow receive
from project A, B, ……….., Z

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 Why Calculate Present Values?
• Financial assets are claims on cash flows (Financial
assets?) e.g.,
• Real assets are tangible and have tangible value (Real
assets?) e.g.,
• So, financial assets can be accurately valued by
calculation of the value of cash flows while real
assets may have value in other ways
• This makes valuation of financial assets somewhat
straightforward comparatively
• Present value techniques merely adjust for the
timing of the cash flows the asset can produce
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 Present Value Applications
• 4 basic types of credit market instruments
which incorporate present value concepts:

1. Simple Loan
2. Discount Bond
3. Fixed Payment Loan
4. Coupon Bond

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 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.

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 Present Value Concept: Simple Loan

The following chart from the the text can be confusing

Note that it is representing a series of simple loans
The loan is not a simple loan of there are interim cash flows
Simple loans pay all principal and interest in one payment at maturity.

Simple loan of $100

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

$1
PV of future= $1 n
(1+i)
YTM is a perfect measure of return for true simple loans.
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 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.

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 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=$1101+i
i= $110−$100= $10 =.10=10%
$100 $100
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Present Value of Cash Flows: Example
 Yield to Maturity: Discount Bonds
4. One-Year Discount Bond (P = $900, F = $1000)

$900= $1000 
(1+i)
i= $1000−$900=.111=11.1%
$900
i= F−P
P
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 Examples Side by side
• A 1-yr simple loan of $100 and 10% interest rate
– Beginning value = $100 and ending value =$110, so
– $dollar return =$110-$100 =$10
– % return = $ return / beginning value = $10/$100 = 10%
– $100 grew to $110 – that requires a 10% return
• A 1-yr $100 discount bond sells at $90.91
– $ return = $100 - $90.91 = $9.09
– % return = $ return / beginning value = $9.09/$90.91 = 10%
• If you have $100 to invest, you could buy $110 par of the discount bond,
then:
– Investment (beg bal) = $110 x .9091 = 100
– $ return = $ return / beginning value = $10/$100 = 10%
– Hmmmm ….. Doesn’t that look like the simple loan?

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 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
(theoretically/formula yearly), in equal dollar
amounts (equal payments) over the loan term.
e.g., EMI 3-15
 Present Value Concept:
Fixed-Payment Loan Terms
• Installment Loans, such as auto loans and
home mortgages are frequently of the fixed-payment type.
• Fixed payment loans are almost always ordinary annuities.
– An ordinary annuity pays the first payment at the end of the first period
– An annuity due pays the first payment at the beginning of the first period
– We will almost always be dealing with ordinary annuities, but I will show you
how to convert from one to the other – just be sure you know which you are
dealing with!

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Fixed payment loan: Example

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 Coupon bonds: credit market instrument
Pay coupon per term and the principal at the time of maturity
date.
Terminologies of coupon bond:

- Face value (FV)

- Maturity date (N)
- Interest rate/discount rate/Yield to maturity (i/YTM)
- Coupon rate (C/CR)
- Current market price (P0 )

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 Coupon bond: Example
Formula:
P/VB =

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 YTM calculation
Formula:

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 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. When bond is at premium, yield less than coupon rate
3. When bond is at discount, yield greater than coupon rate

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 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.

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 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 

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 Distinction Between Real
and Nominal Interest Rates
• Real interest rate
1. Interest rate that is adjusted for expected changes in the

ir =i−
price level 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

i =i− e
ir =i−
Note
r that = expected (ex ante) inflation
e
ir =i−
= market yield of nominal bond
e
= expected real interest rate

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 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.

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 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%

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