Topic 2: Interest Rates I

Interest rates influence our everyday life:

They affect personal decisions such as whether:
- To consume or save
- To buy a house
- To purchase bonds
- To put funds into a saving account
Affect economic decisions of businesses and households whether:
- To use their funds to invest in new equipment for factories
- To save their money in a bank
Forecasting Interest rates:
Interest rates are difficult to forecast since they fluctuate constantly and are influenced by a
wide range of factors, from country regimes to banks’ lending practices.
The current interest rates for borrowing money are known as spot interest rates. Spot
interest rates are observed in market and are available via a number of interest rates
providers. Spot rates are also known as zero rates and are computed from zero coupon bond
returns.
Forward rates are calculated by extrapolating current spot rates. Forward rates are also
known as future implied spot rates. They are computed such that the future interest rates do
not introduce arbitrage opportunities. Forward rates are the agreed interest rates. If someone
wants to borrow money in future for a specified amount of time then forward rate is used.
Price of transactions that require delivering currency or commodity in near future is based on
forward rates.
• Financial economists are hired (sometimes for high salaries) to forecast interest
rates.
• These predictions help forecast the strength of the economy, profitability of
investments, expected inflation, etc.

1. A quick recap of time value of money and computing present value of cash flows.

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 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.
PV = present value, what value futures cash flows are worth today.
FV = future values, what cash flows are worth in the future
R = interest rate, rate of return, or discounted rate per period typically, but not always one
year.
T = Number of periods typically, but not always the number of years
C = Cash amount
- Future value of C invested at r percent per period for t periods:

FV = C × (1 + r) ᵗ

The term (1 + r) ᵗ is called the future value factor.

- Present value of C to be received in t periods at r percent per period:
C
PV =
( 1+ r )t

The term 1/ (1 + r) ᵗ is called the present value factor.

- The basic present value equation giving the relationship between present and
future value is:
FV
PV =
( 1+ r )t

SUMMARY OF ANNUITY AND PERPETUITY

CALCULATIONS
- Future value of C invested per period for t periods at r percent per period

[ (1+r )t−1]
FV =C ×
r

A series of identical cash flows paid for a set number of periods called annuity, and
the term [(1 + r) ᵗ - 1]/r is called the annuity future value factor.
- Present value of C per period for t periods at r percent per period
1

PV =C ×
1−
[ ]
(1+r )t
r

The annuity present value factor.

- Present value of a perpetuity of C per period
C
PV =
r
EXAMPLE: what is the present value of $250 to be paid in two years if the
interest rate is 15%?
C = 250
R = 0.15
T=2
C
PV =
( 1+ r )t
250
PV =
( 1+ 0.15 )2
250
PV =
1.3225

= $ 189.0359

APPLICATIONS OF PRESENT VALUE:

There are four basic types of credit instruments which incorporate present value concepts:
- Simple loan
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/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.
- Fixed payment loan
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, in equal dollar amounts over the loan term:
- Coupon bond
Coupon bond
C
i=
P
Perpetuity bond
Zero-coupon bond/One-year discount bond
F ( face value )−P( price of the bond)
i=
P
- Discount bond
2. Why and how do interest rates change?

DETERMINING ASSET DEMAND

An asset is a piece of property that is a store of value.
When faced with the question of whether to buy and hold an asset or whether to buy one asset
rather than another, an individual must consider the following factors:
- Wealth: the total resources owned by the individual, including all assets. Holding
everything else constant, an increase in wealth raises the quantity demanded of an
asset.
- The expected return: the return expected over the next period on one asset relative to
alternative assets. An increase in an asset’s E (R) relative to an alternate asset, holding
everything else equal, raises the quantity demanded of the asset.
Example: what is the expected return on the Exxon-Mobil bond if the return is 12% two-
thirds of the time and 8% one-third of the time?
Expected return E(R)=∑ Pi × R i

Where:
Pi = probability of occurrence of return 1
Ri = return in state 1
Expected return = (2/3 × 0.12) + (1/3 × 0.08) = 0.08 + 0.026 = 0.106 = 10.6%
- Risk/standard deviation: the degree of uncertainty associated with the return on one
asset relative to alternative assets. The expected return gives us risk amount. Holding
everything else constant, if an asset’s risk rises relative to that of an alternative asset,
its quantity demanded will fall.
2
σ= √∑ ( R −Expected return) × P
i i

2
σ =√[(0.12−0.106)¿¿ 2¿×0.667]+[ ( 0.08−0.106 ) × 0.333]¿ ¿

σ =√ 0.000131+ 0.000225
σ =√ 0.000356
= 0.0189 = 1.89%
Consider the following two companies and their forecasted returns for the upcoming year:
What is the standard deviation of the returns on the Fly-by-Night Airlines and Feet-on-the-
Ground Bus Company, with the return outcomes and probabilities described on the previous
slide? Of these two stocks, which is riskier?
Fly-by-Night:
Expected return E(R)=∑ Pi × R i

= (0.50 × 0.15) + (0.50 × 0.05) = 0.075 + 0.025 = 0.1 = 10%

2
σ= √∑ ( R −Expected return) × P
i i

σ =√∑ [( 0.15−0.1¿¿) ² ×0.50 ]+ ¿ ¿ ¿0.50]

σ =√ ∑ ¿ ¿ ¿]

= 0.05 = 5%
Feet-on-the-Ground:
Expected return E(R)=∑ Pi × R i

= 1 × 0.10 = 10%
2
σ= √∑ ( R −Expected return) × P
i i

σ =√∑ [( 0.10−0.1¿¿)² ×1]¿ ¿

=0
Clearly, Fly-by-Night Airlines is a riskier stock because its standard deviation of returns of
5% is higher than the zero standard deviation of returns for Feet-on-the-Ground Bus
Company, which has a certain return.
A risk-averse person prefers stock in the Feet-on-the-Ground (the sure thing) to Fly-by-Night
stock (the riskier asset), even though the stocks have the same expected return, 10%. By
contrast, a person who prefers risk is a risk lover.
- Liquidity: the ease and speed with which an asset can be turned into cash relative to
alternative assets. The more liquid an asset is relative to alternative assets, holding
everything else equal, the more desirable it is, and the greater the quantity demanded.

SUPPLY AND DEMAND IN THE BOND MARKET

How interest rates are determined from a demand and supply perspective.
As price goes down, interest rate goes up and as a result demand increases.
Interest rate and supply have a negative relationship while interest rate and demand have a
positive relationship.

CHANGES IN EQUILIBRIUM INTEREST RATES

Market equilibrium occurs when the amount that people are willing to buy (demand) equals
the amount that people are willing to sell (supply) at a given price
Excess supply occurs when the amount that people are willing to sell (supply) is greater than
the amount people are willing to buy (demand) at a given price
Excess demand occurs when the amount that people are willing to buy (demand) is greater
than the amount that people are willing to sell (supply) at a given price

TUTORIAL:
1. If you borrow RM10, 000 for 5 years as a simple loan, how much you should
return after 5 years if your required rate of return is 8%?

FV =C ×(1+r )t
FV =10,000 ×(1+ 0.08)5
FV =10,000 ×1.4693❑
FV = $14,693
2. A lottery claims its grand prize is $10 million, payable over 20 years at $500,000
per year. If the first payment is made immediately, what is this grand prize
really worth? Use a discount rate of 6%.
1

PV =C ×
1−
[ ]
(1+r )t
r
1

PV =500,000 ×
1−
[ ( 1+0.06 )19 ]
0.06
1−[ 0.3305 1301 ]
PV =500,000 ×
0.06
PV =500,000 ×11.158 1165
PV =$ 5,579 , 058. 25 + First payment (500,000) = $6,079,058.25
3. For liquidity purposes, a client keeps $100,000 in a bank account. The bank
quotes a stated annual interest rate of 7 percent. The bank's service
representative explains that the stated rate is the rate one would earn if one were
to cash out rather than invest the interest payments. How much will your client
have in his account at the end of one year, assuming no additions or withdrawals,
using the following types of compounding?
A. Quarterly
PV = 100,000
R = 0.07/4 = 0.0175

FV =100,000 ×(1+ 0.0175) 4

= $107,185.9031
B. Monthly
R = 0.07/12 = 0.005833

FV =100,000 ×(1+ 0.005833)12

= $107,228.58
4. You found an investment project that will pay you and your heirs $1,000 per
year forever. If the required return on this investment is 8 percent, how much
will you pay for the policy?
 C
PV =
r
1000
PV = =$ 12,500
0.08
5. You are considering investing in two different instruments. The first instrument
will pay nothing for three years, but then it will pay $20,000 per year for four
years. The second instrument will pay $20,000 for three years and $30,000 in the
fourth year. All payments are made at year-end. If your required rate of return
on these investments is 8 percent annually, what should you be willing to pay
for?
A. The first instrument
1 2 3 4 5 6 7
- - - 20,000 20,000 20,000 20,000

PV =C ×
1−
[ ](1+r )t
r
1

PV =20,000 ×
1−
[ ( 1+0.08 )4 ]
0.08
1−[ 0.735029852 ]
PV =20,000 ×
0.08
PV =20,000 ×3.31212685

= $66,242.537
B. The second instrument (use the formula for a four-year annuity)
1 2 3 4
20,000 20,000 20,000 30,000
(30,000 - 20,000 =
10,000)
The time line shows that this instrument can be analysed as an ordinary annuity of
$20,000 with four payments
1

PV =C ×
1−
[ ](1+r )t
r
1

PV =20,000 ×
1−
[ ( 1+0.08 )4 ]
0.08
 1−[ 0.735029852 ]
PV =20,000 ×
0.08
PV =20,000 ×3.31212685
= $66,242.537
And a $10,000 payment to be received at t = 4
FV
PV =
( 1+ r )t
10,000
PV =
( 1+ 0.08 )4
10,000
PV =
1.36048896
PV =$ 7,350.299
Total = $66,242.537 + $ 7,350.299
= $ 73,592.836
6. What factors can shift the demand for and/or supply of bonds?
DEMAND
- Wealth: the total resources owned by the individual, including all assets. Holding
everything else constant, an increase in wealth raises the quantity demanded of an
asset.
- The expected return: the return expected over the next period on one asset relative to
alternative assets. An increase in an asset’s E (R) relative to an alternate asset, holding
everything else equal, raises the quantity demanded of the asset.
- Risk/standard deviation: the degree of uncertainty associated with the return on one
asset relative to alternative assets. The expected return gives us risk amount. Holding
everything else constant, if an asset’s risk rises relative to that of an alternative asset,
its quantity demanded will fall.
- Liquidity: the ease and speed with which an asset can be turned into cash relative to
alternative assets. The more liquid an asset is relative to alternative assets, holding
everything else equal, the more desirable it is, and the greater the quantity demanded.
SUPPLY:
- Government deficits: when governments run budget deficits, they frequently borrow
by selling bonds, which causes the supply curve to shift right and bond prices to fall
(yields to rise), everything else being equal. When governments run surpluses, they
redeem and/or buy back their bonds on net, shifting the supply curve to the left and
bond prices higher (yields down), everything else being equal.
- Expected inflation: If all other things remain constant, the anticipation of rising
inflation will drive borrowers to issue more bonds, pushing the supply curve
rightward and bond prices down (and yields up).
- Profitability of investments: When economic prospects are favorable, taxes are low,
and regulations are not prohibitively expensive, firms are willing to borrow, typically
by selling bonds, causing the supply curve to move to the right and bond prices to fall.