EFIN 519: BANK FUND

MANAGEMENT

MANAGING INTEREST RATE RISK

Pricing Fixed Income Securities
What is Interest Rate?
 The interest rate is the amount a lender charges for
the use of assets
 Expressed as a percentage (%) of the principal
 The interest rate is typically noted on an annual basis known as
the annual percentage rate (APR)
 The price of the borrowing or renting the use of the fund
 The price or cost of credit
 There are many different interest rates
 Interest on mortgages, treasury bills, commercial papers, bonds issued
by corporations or governments
Simple Interest vs. Compounding Interest

 Simple interest is interest that is paid only on the

initial principal invested
Simple Interest = Principal × i × n
 Compound interest is interest paid on the
outstanding principal plus any interest that has been
earned but not paid out
𝑖
Compound Interest = (1 + )𝑚 −1
𝑚
Nominal vs. Real Interest Rate
 A nominal interest rate is the actual interest rate
that takes inflation into account
 It is the interest rate that is quoted on bonds and loans
 A real interest rate is the interest rate that does not
take inflation into account
 As opposed to the nominal interest rate, the real
interest rate reflects the rate of interest in a sustained
era of zero inflation
𝒓 = 𝒊 − 𝒊𝒏𝒇𝒍𝒂𝒕𝒊𝒐𝒏
Changes in Interest Rate
 Changes in interest rates have important implications on
 Level of investment spending,
 Consumer expenditures on durable goods
 The redistribution of wealth between borrowers and lenders
 The price of key financial assets as stocks, bonds or currencies
 The multitude of interest rates at any given time is
accounted for
 Differences in default risk, tax considerations, marketability and
liquidity, and length of time to maturity among various instruments
Loanable Funds Model
 Sources of the loanable funds:
 Personal savings, increases in the money supply and foreign lending

 Demanders of the loanable funds:

 Government, municipalities and business firms
Factors Shifting Supply of and Demand
for Loanable Funds
 Factors shifting supply of loanable funds:
 Household thriftiness increases, banks tighten their
lending standards, central bank increases money supply
 Factors shifting demand for loanable funds:
 Consumer confidence improves, government eliminates
budget deficit, stock market declines results impairing
business confidence
Present Value and Interest Rate

 Present value (PV) of the asset represents the annual

return expected from the asset in future while interest
rate is used to discount these expected future returns
expressed as:
𝐶𝐹1 𝐶𝐹2 𝐶𝐹𝑛
𝑃𝑉 = + 2
+ …..+
(1 + 𝑖) (1 + 𝑖) (1 + 𝑖)𝑛
 The present value of the asset depends both on the
level of the interest rate used to discount the
payments and on the number of years
Major Determinants of Interest Rates
 Inflation Expectations:
 The level of the interest rates strongly tends to rise in periods to
which the expected rate of inflation increases
 Fisher Effect:
 A change in expected inflation applies on the level of the interest
rate
𝒊 = 𝒓 + 𝜷𝒑𝒆

𝑖 = 𝑡ℎ𝑒 𝑛𝑜𝑚𝑖𝑛𝑎𝑙 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒

𝑟 = 𝑡ℎ𝑒 𝑟𝑒𝑎𝑙 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒, 𝑡ℎ𝑒 𝑟𝑎𝑡𝑒 𝑡ℎ𝑎𝑡 𝑤𝑜𝑢𝑙𝑑
𝑝𝑟𝑒𝑣𝑎𝑖𝑙 𝑖𝑛 𝑎 𝑒𝑟𝑎 𝑜𝑓 𝑧𝑒𝑟𝑜 𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛
𝑝𝑒 = 𝑡ℎ𝑒 𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑟𝑎𝑡𝑒 𝑜𝑓 𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛
𝛽 = 𝑡ℎ𝑒 𝑒𝑥𝑡𝑒𝑛𝑡 𝑡𝑜 𝑤ℎ𝑖𝑐ℎ 𝑛𝑜𝑚𝑖𝑛𝑎𝑙 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒𝑠 𝑎𝑑𝑗𝑢𝑠𝑡
𝑡𝑜 𝑐ℎ𝑎𝑛𝑔𝑒𝑠 𝑖𝑛 𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛
Major Determinants of Interest Rates

 Policy of Central Bank:

 Centralbank uses certain policy tools to influence the
availability of loans through commercial banks
 The Business Cycle:
 Interestrate rises during the expansion phase of the
business cycle and falls during periods of economic
contraction (recession or depression)
 Budget Deficit:
 An increase in the government budget deficit results rise
in interest rates
The Relationship between Interest Rates and
Option-Free Bond Prices

 Bond prices and interest rates vary inversely

 Maturity influences bond price sensitivity

 The size of coupon influences bond price sensitivity

1. Bond prices and interest rates vary
inversely

 Consider a bond with $ 10,000 face value that makes semi-

annual coupon payments of $ 470 and matures in exactly
three years. If the current market interest rate equals to 4.7%
(9.4% annually), then the prevailing price of the bond equals
to $ 10,000.
 If the annual market interest rate increases to 10%
immediately (5% semiannually), what would be the bond’s
price?
 If the annual market interest rate fell to 8.8%, what would be
the bond’s price?
Interest Rate and Security Prices

$940 $940 $940 + $10,000

𝑃𝑉 @10% = + +
(1 + .10) (1 + .10)2 (1 + .10)3

= $9850.79

$940 $940 $940 + $10,000

𝑃𝑉 @8.8% = + +
(1 + .088) (1 + .088)2 (1 + .088)3

= $10152.42
2. Maturity influences bond price sensitivity

 Consider another bond with the same coupon

payments with a maturity of six years.

The effect of maturity on the relationship between price and interest rate on
option-free bonds with 3-years and 6-years maturities
Market Interest Rates
5% 4.4%
Price of 3 year’s bond $ 9,847.73 $ 1,0155.24
Price of 6 year’s bond 9,734.10 10,275.13
3. The size of coupon influences bond price sensitivity

 Two identical bonds with three years maturity, one is

zero coupon bond and another is a coupon bond.
Coupon bond has the same features mentioned in the
first example.
The effects of coupon on the relationship between price and interest rate of
option-free bonds

Market Rate Price of 9.4% Bond Price of Zero Coupon

Bond
8.8% $ 10,155.24 $ 7,723.20
10% 9,847.73 7,462.15
Duration and Price Volatility
 Duration is a measure of effective maturity that
incorporates the timing and size of security’s cash
flows
 It captures the overall impact of market rates, the size of all
payments and maturity on a security’s price volatility
 There are two important interpretations of duration
analysis:
 Duration is a measure of how price sensitivity of a security to a change
in interest rates
 The greater (shorter) is duration, the greater (lesser) is price sensitivity
Measuring Duration
 Duration is measured in units of time and represents a
security’s effective maturity
 It is the weighted average of time until expected cash
flows from a security will be received, relative to the
current price of the security. The weights are the present
values of each cash flow divided by the current price.
 Macaulay’s duration (D) is:
𝑛 𝐶𝐹𝑡 (𝑡)
𝑡=1 (1+𝑖)𝑡
𝐷= 𝑛 𝐶𝐹𝑡
𝑡=1(1+𝑖)𝑡
Measuring Duration
 Example: Consider a three years coupon bond with
a face value of $ 10,000 and the semi-annual
coupon rate is 4.7%. What would be the duration if
annual market rate is 10%?

+ +
𝐷=
+ +
Money Market Yield
 Many short-term consumers and commercial loans have maturities
less than one year
 The effective annual rate of interest depends on the term of the loan
and the compounding frequency
 Suppose, a one-year loan that requires monthly interest payments at
12% annually carries an effective yield of 12.68%.
 Suppose, the same loan was made for 90 days at an annualized
rate of 12%. This is now more than one compounding period in one
year. Then the effective annual yield assuming 365-day year is:
𝑖
𝑖∗ = [1+ 365 ]365/ℎ - 1
ℎ
Year = 360 days vs. 365 days

 To convert a 360-day rate to a 365-day rate can

be done by using the following formula:

365
𝑖365 = 𝑖360 ( )
360
Discount Yield
 Yields on discounting instruments are calculated and
quoted on a discount basis assuming a 360-day year. The
pricing equation for discount instruments is:
𝑃𝑓 −𝑃𝑜 360
𝑖𝑑𝑟 = [ ][ ]
𝑃𝑓 ℎ
 In order to obtain an effective yield, the formula must be
modified to reflect a 365- day year. This modified yield
is called bond equivalent rate
𝑃𝑓 −𝑃𝑜 365
𝑖𝑏𝑒 = [ ][ ]
𝑃𝑓 ℎ
Calculating Discounting Yield
 Example: consider a $ 1 million par value treasury
bill with exactly 182 days to maturity, priced at $
964,500. What would be the discount yield and
bond equivalent rate?

Any question?
Thank you.