Lecture 3: Understanding Interest Rates

Interest Rate

Interest is the price or cost of earlier availability of resources.

For example, it is the price paid for the use of money such as by a borrower to a lender of money. It
is usually expressed at an annual rate. The rate is derived by dividing the amount of interest by the
amount of principal borrowed.
Annual cost of credit or debt-capital computed as the percentage ratio of interest to the principal.
Measuring Interest Rates

Present Value (Present Discounted Value)

A dollar paid in the future is less valuable to you than a dollar to you today. Present value is today’s
value of an amount to be received in the future when the interest rate is i. Present value of a
multiple sum or a stream of future income refers to the process of converting many future sums of
incomes into an equivalent amount of present income.

Simple Loan

The interest payment divided by the amount of loan is a natural way to measure the cost of
borrowing funds. The measure of the cost is simple interest rate.

Loan = $100; Interest Payment = $10; Interest Rate = i = $10 / $100 = 0.10 (10%)

1 year from now: $100 (1 + 0.1) = $110

2 years from now: $100 (1 + 0.1) (1 + 0.1) = $100 (1 + 0.1) 2 = $121
3 years from now: $100 (1 + 0.1) (1 + 0.1) (1 + 0.1) = $100 (1 + 0.1) 3 = $133.1

N years from now: $100 (1 + 0.1) N

For example, in the case of the $133.1 received 3 years from now, when i = 0.1,

i.e., Current Future

$100 $100 (1 + 0.1) 3 = $133.10

$133.1
then $100 =
( 1  i )3

Today’s value of a $1 payment received N years from now = $1 × (1 + 0.1) N.

$1 FVN
Present Value (PV) of future $1 = , or PV =
(1  i ) N
( 1  i )N

The process of calculating what dollars received in the future are worth today is called discounting
the future. Compounding refers to the process of converting present income into an equivalent
amount of future income.

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Yield to Maturity (孳息率)

The interest rate that equates the present value of payments received from a debt instrument with its
value today.

Recall the Simple-loan case, Loan = $100, Interest payment = $10. One year from now, you will
receive $110.

Yield to maturity: $100 = $110 / ( 1 + i )

$110  $100
i= = 0.1 = 10%
$100

In simple loan, the simple interest rate = the yield to maturity

Fixed-Payment Loan

Some debt instruments involve a series of equal, fixed investments throughout the term of the debt
so that the principal and the interest are both repaid by the end of the contract. Examples are
student loan, home mortgage, etc.

FP FP FP
Loan =  2
 ... 
(1+i) (1+i) ( 1 + i )N

where Loan = amount of the loan

FP = fixed payment
N = number of periods (years) until maturity

In practice, the computation of the fixed-payment loan often proceeds by assuming a value for the
size of the loan, the prevailing interest rate, and the desired term for the loan to arrive at a value for
FP.

e.g. Given that Loan = $1,000, i = 0.12 (12%) and N = 20

FP FP FP
$1,000 =  2
 ... 
( 1 + 0.12 ) ( 1 + 0.12 ) ( 1 + 0.12 ) 20

Solving for FP yields $133.88.

However, in our case, we want to find the yield to maturity. Given Loan = $1,000, FP
= $127.5 and N = 25,
$127.5 $127.5 $127.5
$1,000 =   ...  ,
(1  i ) (1  i ) 2
(1  i ) 25

then we solve i = 12% (Yield to maturity)

Yield to maturity is not a known quantity in fixed-payment loan.

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Bond (債券)

A bond is a debt instrument or security issued for a predetermined period of time with the purpose
of raising capital by borrowing. The authorised issuer owes the holders of this formal contract a
debt and repay borrowed money with interest at fixed intervals. A bond generally involves a
promise to pay interest (coupon) on specified dates and or repay the principal at a later day, termed
maturity.
In the debt market, the expression “bonds” generally refers to longer dated debt instruments while
“bills” or “notes” are usually short dated ones.

Bond’s Features

 Issuer is the party that borrows the money. Bonds are commonly classified by the nature of
their issuer. Listed companies or their subsidiaries issue corporate bonds. Government
issues government bonds. Hong Kong Monetary Authority (HKMA) issues Hong Kong
dollar debt securities, Exchange Fund Bills and Notes.
 Term is the life of the bond, i.e. the period (usually a number of years) over which the issuer
has promised to meet its obligations under the bond.
 Principal is also called the par value or face value. It is the amount repaid to the bondholder
when the bond matures.
 Coupon rate is the rate at which the issuer pays interest on the principal to the bondholder
each year. Interest payments are normally made at regular intervals, e.g. annually, semi-
annually, quarterly. The coupon rate can be fixed if it does not change over the term of the
bond. It can be floating if it is reset periodically according to a predetermined benchmark,
such as HIBOR/LIBOR plus a spread. The coupon rate can even be zero.
 Guarantor: Some bonds are guaranteed by a third party called a guarantor. If the issuer
defaults, the guarantor agrees to repay the principal and/or interest to the bondholder.

Coupon Bond

A credit market instrument pays the owners a fixed interest payment periodically (every year) until
the maturity date when a specified final amount is repaid.

C C C F
Pb =   ...  
(1  i ) (1  i ) 2
(1  i ) N
( 1  i )N

where C = Yearly coupon payment

F = Face value of the bond
N = Years to maturity date
Pb = Price of coupon bond
C/F = Coupon rate

e.g.: Given that F = $1,000, C = $100, C/F= $100/$1,000 = 10%, i = 0.10 and N = 10.

Pb = $100 
$100
 ... 
$100

$1,000 = $1,000,
(1  i ) (1  i ) 2
(1  i ) 10
( 1  i )10

then Pb = F.
If Pb < F, a bond is trading at a discount.
If Pb > F, a bond is trading at a premium.
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Yield to maturity is not a known quantity in fixed-payment loan. If C, F, N, and Pb are known, we
can find the yield to maturity, i.

e.g.: Given that Pb = $900, F = $1,000, C = $100 and N = 10.

$100 $100 $100 $1,000

$900 =   ...  
(1  i ) (1  i ) 2
(1  i )10
( 1  i )10

i = 0.11752 (11.75%)

e.g.: Given that Pb = $1,100, F = $1000, C = $100 and N = 10.

$100 $100 $100 $1,000

$1,100 =   ...  
(1  i ) (1  i ) 2
(1  i )10
( 1  i )10

i = 0.084775 (8.48%)

Remarks: 1. Pb = F, when the yield to maturity = the coupon rate

2. Pb < F, when the yield to maturity > the coupon rate
3. Pb > F, when the yield to maturity < the coupon rate
4. Pb and the yield to maturity are negatively related.

Consol / Perpetuity / Perpetual Bond

A bond without a maturity date, is a special case of coupon bond. Consols (originally short for
consolidated annuities) are a form of British government bond. There is no date of maturity or a
fixed maturity date and no repayment of principal but fixed coupon payments of C is paid forever.
Then
C C C
Pb =    ...
(1  i ) (1  i ) 2
(1  i ) 3
1 1 1
Pb = C [    ...]
(1  i ) (1  i ) 2
(1  i ) 3
1
Pb = C [ x  x 2  x 3  ...] where x =
(1  i )
1
Since 1  x  x 2  x 3  ... = ,
1 x
 
1  1  1  i i 
we have Pb = C [  1] = C   1 = C   
1 x 1  1   i i
 1  i 
C
Hence, Pb =
i

We observe that bond price is negatively related to yield to maturity.

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Discount Bond (Zero-Coupon Bond)

It is a financial instrument that is sold at a price below its face value.

e.g. A one-year discount bond (T-bills)

F = Face value of the discount bond

Pd = Current price of the discount bond

i.e., Current One year later

Pd = $900 F = $1,000

$1,000
then $900 =
(1  i )
$1, 000  $900
i = = 0.111 = 11.1%
$900
F - Pd
Hence, i = .
Pd

Again, the yield to maturity is negatively related to the current bond price.

Summary

 Simple loan and discount bonds make payment only at their maturity dates. Fixed-payment
loans and coupon bonds have payments periodically until maturity.
 Since payments are made at different times, concept of present value provide us to compare
their values with each other. And it also provides us with a procedure for measuring interest
rates on different types of instruments.

Other Measures of Interest Rates

Because the yield to maturity is sometimes difficult to calculate, less accurate measures of interest
rates have come into common use in bond markets.

Current Yield

It is an approximation of the yield to maturity on coupon bonds that is often reported because of
easy calculation.

ic = C / Pb

Recall, in the case of the perpetual bond, ic = C / Pc, therefore, ic = i.

C C C F F
Pb =   ...   and  0 as N is large.
(1  i ) (1  i ) 2
(1  i ) N
( 1  i )N  1+i  N

When a coupon bond has a longer term to maturity, i.e., N is very large, the current yield is a close
approximation of the yield to maturity for a long-term coupon bond.
On the other hand, the approximation does not hold when N is very small. ( ic  i ), i = C / Pc
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We have to note that the current yield and the yield to maturity always move together; a fall in the
current yield always signals that the yield to maturity has also decreased.

The current yield is negatively related to the price of the bond. i.e. Pb   ic 

e.g.: A 10-year bond with C = $100; Pb = $1000 increases to Pb = $1100; then ic = 10% decreases
to ic = 9.09%. But, i decreases from 10% to 8.48%

C C C F
Since Pb =   ...   ,
(1  i ) (1  i ) 2
(1  i ) N
( 1  i )N

$100 $100 $100 $1000

if $1,000 = + +....+ + , then i = 10%,
1+i  1+i 2 1+ i
10
    1+ i
10

$100 $100 $100 $1000

if $1,100 = + +....+ + , then i = 8.48%.
1+i  1+i 2 1+ i
10
    1+ i
10

The current yield and the yield to maturity always move together; a fall in the current yield always
signals that the yield to maturity has also decreased.

Discount Yield

The measure of interest rates by which dealers in bill or money markets quote the interest rate on
the US Treasury bills.

F - Pd 360
idb =  , where idb = discount yield.
F days to maturity

The discount yield understates the interest rate on T-bills as measured by the yield to maturity.

F - Pd
Recall the T-bills case, i = ,
Pd

F - Pd F - Pd 365 360
Since > and > ,
Pd F days to maturity days to maturity

then the greater the difference between the purchase price and the face value of the discount bond,
the more the discount yield understates the yield to maturity. In addition, longer the maturity,
greater is understatement.

Change in discount yield always signals change in same direction as yield to maturity.

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Interest-rate Risk

It is the riskiness of an asset’s return or value that results from interest rate changes. Interest rate
risk affects the value of bonds more directly than stocks, and it is a major risk to all bondholders.

Probability of changes in interest

rates for short-term debt instruments < Probability of changes in interest rates
for long-term debt instruments

The Distinction between Real and Nominal Interest Rates

Savings = $100 & Interest Rate ( i ) = 20%

Next year, you will have $120. But if prices also increase by 20%, you will not be better off because
there will be no change in the purchasing power of money.

U.S. Interest Rates https://www.longtermtrends.net/real-interest-rate/

Real Interest Rate

The interest rate adjusted for (expected) changes in the price level (inflation) so that it is more
accurately reflects the true cost of borrowing. It is defined by Fisher’s Equation:

Nominal Interest rate  Real Interest Rate + Inflation Rate

(i) ( ir ) ( πe )

i = ir + πe  ir = i - πe
Note that the rate of inflation during the year generally cannot be determined until the year is over.
So we use expected inflation rate πe instead of actual inflation rate ( π ). Moreover, the above
equation is valid only for small ir and πe.

Tax

We may have to consider the tax rate t, then we have ir = i ( 1 – t ) - πe

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The Distinction between Interest Rates and Returns

How well a person does holding a security (e.g. bond) over a particular time period is accurately
measured by the return, precisely terminology, the rate of return, not the interest rate stated on the
paper.
C  Pt 1 - Pt C P -P
We have, RET  , rewrite it, we get, RET   t 1 t ,
Pt Pt Pt

where RET = return from holding the bond from time t to t+1
Pt = price of the bond at time t
Pt+1 = price of the bond at time t+1
C = coupon payment
the first term and the second term of R.H.S. of above equation are the current yield ( ic )and the rate
of capital gain ( g ) respectively.

Bond price decreases as interest rate increases, it induces capital loss. If the capital loss is greater
than the initial yield to maturity, then there is negative return.