FIN2001 - FINANCIAL MARKETS

AND INSTITUTIONS

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 Chapter 2
INTEREST RATES

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 Content
▪ Interest rates
▪ Yield to maturity
▪ Types of interest rate
▪ Risk Structure of Interest Rates
▪ Default
▪ Liquidity
▪ Taxes.
▪ Term Structure of Interest Rates
▪ Pure Expectation Theory
▪ Segmented Markets Theory
▪ Liquidity Premium Theory
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 Readings
① Chapter 3,4,5 Financial Markets and Institutions; Federic S.
Mishkin, Stanley G. Eakins; Pearson (2012).
② Chapter 2,3, Financial Markets and Institutions; Jeff Madura;
South-Western Cengage Learning (2010).
③ Giáo trình Tài chính – tiền tệ; TS. Nguyễn Hòa Nhân,
PGS.TS.Lâm Chí Dũng, TS.Hồ Hữu Tiến, ThS.Võ Văn Vang,
ThS. Trịnh Thị Trinh, ThS. Đặng Tùng Lâm. Nhà xuất bản
Tài chính (2012).

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 2.1. Interest rates
◼ Interest rates are among the most closely watched
variables in the economy.
◼ It is imperative that you understand exactly what is
meant by the phrase interest rate.
◼ Interest rate is essentially a charge to the borrower for
the use of an asset. Assets borrowed can include cash,
consumer goods, vehicles, and property.

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 2.1. Interest rates
◼ Interest rates apply to most lending or borrowing
transactions.
◼ The interest rate is the amount a lender charges a
borrower and is a percentage of the principal (the
amount of the loan)
◼ The interest rate is the cost of debt for the borrower
and the rate of return for the lender.

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 2.2. Types of Interest rates
2.2.1. Real interest rate & Nominal interest rate

◼ Nominal interest rate refers to the stated interest rate

before adjustment for inflation.
◼ Real interest rate is interest rate adjusted for expected
changes in the price level.
◼ Fisher Effect equation: (1+i) = (1+ir)(1+πe)
FE equation can be rewritten as:
ir = i – πe
𝑖𝑟 : Real interest rate
i : Nominal interest rate
𝜋 𝑒 : Expected inflation rate 7
2.2. Types of Interest rates
2.2.1. Real interest rate & Nominal interest rate

◼ If i = 5% and 𝜋 𝑒 = 0% then 𝑖𝑟 = ?

◼ If i = 10% and 𝜋 𝑒 = 20% then 𝑖𝑟 = ?

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2.2. Types of Interest rates
2.2.1. Real interest rate & Nominal interest rate

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 2.2. Types of Interest rates
2.2.2. Simple interest rates & Compound interest rates

◼ Simple interest: is calculated only on the principal amount of

a loan
𝐅 = 𝐏 × (𝟏 + 𝐧 × 𝐢)
𝐒𝐢𝐦𝐩𝐥𝐞 𝐢𝐧𝐭𝐞𝐫𝐞𝐬𝐭 = 𝐏 × 𝐧 × 𝐢

F = Future value (including principal and interest)

P = Principal
i = annual simple interest rate in percentage terms
n = number of periods

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 2.2. Types of Interest rates
2.2.2. Simple interest rates & Compound interest rates

◼ Compound interest: is calculated on the principal amount and

also on the accumulated interest of previous periods, and can
thus be regarded as “interest on interest.”

𝐅 = 𝐏 × (𝟏 + 𝐢)𝐧
𝐂𝐨𝐦𝐩𝐨𝐮𝐧𝐝 𝐢𝐧𝐭𝐞𝐫𝐞𝐬𝐭 = 𝐏 × (𝟏 + 𝐢)𝐧 −𝐏

F = Future value (including principal and interest)

P = Principal
i = annual compound interest rate in percentage term
n = number of periods 11
 2.3. Interest rates Measurement
2.3.1 Present Value Introduction

◼ Different debt instruments have very different streams of cash

payments to the holder known as cash flows (CF).
◼ 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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 2.3. Interest rates Measurement
2.3.1 Present Value Introduction

◼ Present discounted value is based on the common-sense notion

that a dollar of cash flow paid to you one year from now is worth
less than a dollar paid to you today.
◼ WHY?
◼ 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.

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 2.3. Interest rates Measurement
2.3.1 Present Value Concept

◼ Simple loan
• For example, if you made your friend Jane a simple
loan of $100 for one year, you would require her to
repay the principal of $100 in one year’s time along
with an additional payment for interest; say, $10.

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 2.3. Interest rates Measurement
2.3.1 Present Value Concept

◼ Loan Principal: the amount of funds the lender provides to the

borrower. (100$)
◼ Maturity Date: the date the loan must be repaid; the Loan Term
is from initiation to maturity date. (1 year)
◼ Interest Payment: the cash amount that the borrower must pay
the lender for the use of the loan principal. (10$)
◼ 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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 2.3. Interest rates Measurement
2.3.1 Present Value Concept

◼ If you make this $100 loan, at the end of year 1 you would
have $110, which can be rewritten as:
◼ 100 + 100 × 0,10 = 100 × 1 + 0,10 = $110
◼ If you then lent out the $110, at the end of the second year
you would have: …
◼ At the end of the third year: …
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 2.3. Interest rates Measurement
2.3.1 Present Value Concept

◼ Simple Present Value:

𝐂𝐅
𝐏𝐕 =
(𝟏 + 𝐢)𝐧

PV : Present value
CF : Future cash flow
i : Interest rate
n : number of periods

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 2.3. Interest rates Measurement
2.3.2 Yield to Maturity

◼ The concept known as yield to maturity (YTM) is

the most accurate measure of interest rates.
◼ Yield to maturity = interest rate that equates today's
value with present value of all future payments
𝐂𝐅𝐧
𝐏𝐕 = ෍
(𝟏 + 𝐢𝐘𝐌 )𝐧

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 2.3. Interest rates Measurement
2.3.2 Yield to Maturity

a. Simple Loans
𝐂𝐅
𝐏𝐕 =
(𝟏 + 𝐢𝐘𝐌 )𝐧

PV = amount borrowed; CF = future cash flow

n = number of years

Ex: If Peter borrows $200 from his sister and next year she wants
$210 back from him, what is the yield to maturity on this loan?
210 210
200 = → 𝑖𝑌𝑀 = − 1 = 0.05 (5%)
(1+𝑖𝑌𝑀 )1 200
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 2.3. Interest rates Measurement
2.3.2 Yield to Maturity

b. Fixed payment Loans: are loans where the loan principal

and interest are repaid in several payments over the loan term.
𝐅𝐏 𝐅𝐏 𝐅𝐏 𝐅𝐏
𝐋𝐕 = + 𝟐
+ 𝟑
+ ⋯+ 𝐧
𝟏 + 𝐢𝐘𝐌 𝟏 + 𝐢𝐘𝐌 𝟏 + 𝐢𝐘𝐌 𝟏 + 𝐢𝐘𝐌

LV = loan value
FP = fixed yearly cash flow payment
n = number of years until maturity

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 2.3. Interest rates Measurement
2.3.2 Yield to Maturity

c. Coupon Bonds:
A coupon bond pays the owner of the bond a fixed interest payment
(coupon payment) every year until the maturity date, when a
specified final amount (face value or par value) is repaid.
𝐂 𝐂 𝐂 𝐂 𝐅
𝐏𝐕 = 𝟏
+ 𝟐
+ 𝟑
+ ⋯+ 𝐧
+ 𝐧
𝟏 + 𝐢𝐘𝐌 𝟏 + 𝐢𝐘𝐌 𝟏 + 𝐢𝐘𝐌 𝟏 + 𝐢𝐘𝐌 𝟏 + 𝐢𝐘𝐌

PV = price of coupon bond

C = yearly coupon payment
F = face value of the bond
n = years to maturity date
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 2.3. Interest rates Measurement
2.3.2 Yield to Maturity

d. Discount Bonds: A discount bond is a bond that is issued or

currently trading for less than its face value.
▪ The yield-to-maturity calculation for a discount bond is similar to
that for the simple loan.
More general, for one-year discount bond:
𝐅
𝐏=
𝟏 + 𝐢𝐘𝐌
F = face value of the discount bond
P = current price of the discount bond

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2.4. Risk Structure of Interest rates

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 2.4. Risk Structure of Interest rates

Factors Affecting Risk Structure of Interest Rates

▪ Default Risk

▪ Liquidity

▪ Income Tax Considerations

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 2.4. Risk Structure of Interest rates
2.4.1. Default risk

◼ Default risk occurs when the issuer of the bond is unable or

unwilling to make interest payments when promised.
◼ Default-free bonds?
◼ The spread between the interest rates on bonds with default
risk and default-free bonds, called the risk premium,
indicates how much additional interest people must earn in
order to be willing to hold that risky bond.

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2.4. Risk Structure of Interest rates
2.4.1. Default risk

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Bond Ratings

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 2.4. Risk Structure of Interest rates
2.4.2. Liquidity

◼ A liquid asset is one that can be quickly and cheaply converted

into cash.
◼ The more liquid an asset is, the more desirable it is (higher
demand), holding everything else constant.
◼ Treasury bonds are the most liquid of all long-term bonds
because they are so widely traded that they are easy to sell
quickly and the cost of selling them is low.
◼ Corporate Bonds?

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2.4. Risk Structure of Interest rates
2.4.2. Liquidity

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 2.4. Risk Structure of Interest rates
2.4.3. Income Tax Consideration

◼ Interest payments on municipal bonds are exempt from federal

income taxes.

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 2.5. Term Structure of Interest Rates
2.5.1. Yield curve

Yield curve: a plot of the yield on bonds with differing

terms to maturity
◼ Upward-sloping: long-term rates are above short-term rates
◼ Flat: short-term rates and long-term rates are the same
◼ Inverted: long-term rates are below short-term rates

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2.5. Term Structure of Interest Rates
2.5.1. Yield curve

US Treasury Yield Curve

Source: Financial Markets and Institutions, 9th Edition, Jeff Madura, p.52 32
 2.5. Term Structure of Interest Rates
2.5.1. Yield curve

Facts theory of the term structure of interest rates:

1. Interest rates on bonds of different maturities move together
over time
2. When short-term interest rates are low, yield curves are more
likely to have an upward slope; when short-term rates are
high, yield curves are more likely to slope downward and be
inverted
3. Yield curves almost always slope upward

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 2.5. Term Structure of Interest Rates
2.5.1. Expectations Theory

▪ The interest rate on a long-term bond will equal an average of the

short-term interest rates that people expect to occur over the life
of the long-term bond
▪ Key Assumption: Bonds of different maturities are perfect
substitutes
▪ Implication: Expected return on bonds of different maturities are
equal

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 2.5. Term Structure of Interest Rates
2.5.1. Expectations Theory

Investment strategies for two-period horizon:

▪ Buy $1 of one-year bond and when matures buy another one-
year bond
▪ Buy $1 of two-year bond and hold it

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 2.5. Term Structure of Interest Rates
2.5.1. Expectations Theory

▪ Expected return from strategy 1:

(1 + i1,t)(1+ ie1,t+1) – 1 = 1+ i1,t + ie1,t+1 + i1,t * ie1,t+1 -1
𝑒
▪ Since 𝑖1,𝑡 × 𝑖1,𝑡+1 is also extremely small, expected return is
approximately: 𝒊𝟏,𝒕 + 𝒊𝒆𝟏,𝒕+𝟏

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 2.5. Term Structure of Interest Rates
2.5.1. Expectations Theory

▪ Expected return from strategy 2:

(1 + i2,t)2 – 1 = 1+ 2*i2,t + i22,t -1
2
▪ Since 𝑖2,𝑡 is also extremely small, expected return is
approximately: 𝟐𝒊𝟐,𝒕

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 2.5. Term Structure of Interest Rates
2.5.1. Expectations Theory

◼ From implication above expected returns of two strategies are

equal. Therefore

𝐢𝟏,𝐭 + 𝐢𝐞𝟏,𝐭+𝟏
𝐢𝟐,𝐭 =
𝟐
The two-period rate must equal the average of the two one-period
rates

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 2.5. Term Structure of Interest Rates
2.5.1. Expectations Theory

For bonds with longer maturities

𝐢𝟏,𝐭 + 𝐢𝐞𝟏,𝐭+𝟏 + 𝐢𝐞𝟏,𝐭+𝟐 + ⋯ + 𝐢𝐞𝟏,𝐭+𝐧−𝟏

𝐢𝐧,𝐭 =
𝐧
The n-period interest rate equal the average of the one-period interest
rates expected to occur over the n-period of the bond

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 2.5. Term Structure of Interest Rates
2.5.1. Expectations Theory

Example: If the expected path of 1-year interest rates over the next
four years is 5 percent, 4 percent, 2 percent, and 1 percent. Then the
expectations theory predicts that today's interest rate on the four-year
bond is……

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 2.5. Term Structure of Interest Rates
2.5.1. Expectations Theory

◼ Explains why the term structure of interest rates changes at

different times
◼ Explains why interest rates on bonds with different maturities
move together over time (fact 1)
◼ Explains why yield curves tend to slope up when short-term rates
are low and slope down when short-term rates are high (fact 2)
◼ Cannot explain why yield curves usually slope upward (fact 3)

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 2.5. Term Structure of Interest Rates
2.5.2. Segmented Markets Theory

◼ Key Assumption: Bonds of different maturities are not substitute

at all
◼ Implication: Markets are completely segmented; interest rate at
each maturity determined separately

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 2.5. Term Structure of Interest Rates
2.5.2. Segmented Markets Theory

◼ Investors have preferences for bonds of one maturity over another

◼ If investors generally prefer bonds with shorter maturities that
have less interest-rate risk, then this explains why yield curves
usually slope upward (fact 3)
◼ Does not explain fact 1 or fact 2

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 2.5. Term Structure of Interest Rates
2.5.3. Liquidity Premium Theory

◼ Key Assumption: Bonds of different maturities are substitutes,

but are not perfect substitutes
◼ Implication: Modifies Pure Expectations Theory with features
of Market Segmentation Theory

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 2.5. Term Structure of Interest Rates
2.5.3. Liquidity Premium Theory

◼ Investors prefer short rather than long bonds, must be paid

positive liquidity premium to hold long term bonds
◼ Results in following modification of Pure Expectations Theory:
𝐢𝟏,𝐭 + 𝐢𝐞𝟏,𝐭+𝟏 + 𝐢𝐞𝟏,𝐭+𝟐 + ⋯ + 𝐢𝐞𝟏,𝐭+𝐧−𝟏
𝐢𝐧,𝐭 = + 𝐋𝐏𝟐
𝐧

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 2.5. Term Structure of Interest Rates
2.5.3. Liquidity Premium Theory

◼ Explains All 3 Facts

◼ Explains fact 3—that usual upward sloped yield curve by
liquidity premium for long-term bonds
◼ Explains fact 1 and fact 2 using same explanations as pure
expectations theory because it has average of future short rates as
determinant of long rate

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2.5. Term Structure of Interest Rates
2.5.3. Liquidity Premium Theory

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FIGURE 6 Yield Curves and the Market’s Expectations of Future Short-
Term Interest Rates According to the Liquidity Premium (Preferred
Habitat) Theory

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FIGURE 6 Yield Curves and the Market’s Expectations of Future Short-
Term Interest Rates According to the Liquidity Premium (Preferred
Habitat) Theory

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