FIN2001 – FINANCIAL

MARKETS AND INSTITUTIONS

Lecturer: Nguyen, T.T. Quang (PhD)

Faculty of Banking, UD-DUE
 CHAPTER 2

INTEREST RATES

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3
 Interest rates

Yield to maturity

Risk Structure of Interest Rates

• Default
• Liquidity
Content • Taxes

Term Structure of Interest Rates

• Pure Expectation Theory

• Segmented Markets Theory
• Liquidity Premium Theory

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 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
Readings (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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 • 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
2.1. Interest interest rates.
rates - • Interest rate is the price of
Measurement borrowing money for the use of
its purchasing power
• The concept known as yield to
maturity (YTM) is the most
accurate measure of interest
rates.

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2.1. Interest rates Measurement
2.1.1 Present Value

• 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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2.1. Interest rates Measurement
2.1.1 Present Value

• 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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2.1. Interest rates
Measurement
2.1.1 Present Value
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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 2.1. Interest rates
Measurement
2.1.1 Present Value
• 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. (?) 10
2.1. Interest rates Measurement
2.1.1 Present Value

• 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 đ
• 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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2.1. Interest rates
Measurement
2.1.1 Present Value
Simple Present Value

𝐶𝐹
𝑃𝑉 =
(1 + 𝑖)𝑛

PV : Today’s (present) value

CF : Future cash flow
i : Interest rate
n : number of periods
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2.1. Interest rates
Measurement
2.1.2 Yield to Maturity
• 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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 Four Types of Credit Market Instruments
1. Simple loan: the lender provides the
borrower with an amount of funds, which
must be repaid to the lender at the
maturity date along with an additional
payment for the interest (e.g. business
loans)
2.1. Interest 2. Fixed-payment loan (fully amortized loan):
rates are loans where the loan principal and
Measurement interest are repaid in several payments over
the loan term (e.g. Installment loans,
2.1.2 Yield to mortgages)
Maturity 3. 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 (e.g. Treasury bonds and
notes)
4. Discount bond (zero-coupon bond) is
bought at a price below its face value (at a
discount), and the face value is repaid at
the maturity date (e.g. Treasury bills)
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2.1. Interest rates Measurement
2.1.2 Yield to Maturity

1. Simple Loans
𝐶𝐹
𝑃𝑉 =
(1 + 𝑖𝑌𝑀 )𝑛

PV = amount borrowed;
CF = future cash flow
n = number of years

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 If Peter borrows $100 from his
sister and next year she wants
Example $110 back from him, what is the
yield to maturity on this loan?

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2.1. Interest rates Measurement
2.1.2 Yield to Maturity

2. Fixed payment Loans:

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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 2.1. Interest rates Measurement
2.1.2 Yield to Maturity

3. Coupon Bonds:
𝐶 𝐶 𝐶 𝐶 𝐹
𝑃= 1+ 1+𝑖 2+ 1+𝑖 3 + ⋯+ 1 + 𝑖 𝑛+ 1+𝑖 𝑛
1 + 𝑖𝑌𝑀 𝑌𝑀 𝑌𝑀 𝑌𝑀 𝑌𝑀

PV = price of coupon bond

C = yearly coupon payment
F = face value of the bond
n = years to maturity date

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2.1. Interest rates Measurement
2.1.2 Yield to Maturity

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2.1. Interest rates Measurement
2.1.2 Yield to Maturity
3. Coupon bond (Cont’)
➢When the coupon bond is priced at its face value, the yield
to maturity equals the coupon rate.
➢The price of a coupon bond and the yield to maturity are
negatively related
➢The yield to maturity is greater than the coupon rate when
the bond price is below its face value.

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2.1. Interest rates Measurement
2.1.2 Yield to Maturity

4. Discount Bonds: 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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 Summary

• Present value: a dollar in the future

2.1. Interest is not as valuable to you as a
rates dollar today
• The present value of a set of
Measurement future cash flows on a debt
2.1.2 Yield to instrument equals the sum of the
present values of each of the
Maturity future cash flows.
• The yield to maturity for an
instrument is the interest rate that
equates the present value of the
future cash flows on that
instrument to its value today.
• Current bond prices and interest
rates are negatively related 29
2.2. Types of Interest rates
Real interest rate & Nominal interest rate

• Real interest rate is interest rate adjusted for expected

changes in the price level.
• Fisher Effect equation:
1 + 𝑖 = 1 + 𝑖𝑟 1 + 𝜋 𝑒
FE equation can be rewritten as:
𝑖 ≈ 𝑖𝑟 + 𝜋 𝑒
𝑖𝑟 : Real interest rate
i : Nominal interest rate
𝜋𝑒 : Expected inflation rate

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2.2. Types of Interest rates
Real
• If i = interest
5% and 𝜋 𝑒rate
= 0%&then
Nominal
𝑖𝑟 = ?
interest rate
• If i = 10% and 𝜋 𝑒 = 20% then 𝑖𝑟 = ?

• When the real interest rate is low,

there are greater incentives to
borrow and fewer incentives to lend

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

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2.2. Types of Interest rates
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
P = Principal
i = annual simple interest rate in percentage terms
n = number of periods

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

• Compound interest: 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
P = Principal
i = annual compound interest rate in percentage term
n = number of periods

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2.3. Risk Structure of Interest rates

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 2.3. Risk
Structure of
Interest rates
- Factors
Affecting Risk ▪ Default Risk
Structure of ▪ Liquidity
Interest Rates ▪ Income Tax
Considerations

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2.3. Risk Structure of Interest rates
- Default risk

• Default Risk occurs when the issuer of the bond is

unable or unwilling to make interest payments when
promised or to pay off the face value when the bond
matures
• 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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2.3. Risk Structure of Interest rates- Default
risk

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Bond Ratings

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2.3. Risk Structure of Interest rates - Liquidity
Factor

• 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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2.3. Risk Structure of Interest rates -
Liquidity Factor

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 43

2.3. Risk Structure of Interest

rates -
Income Tax Consideration

• Interest payments on municipal

bonds are exempt from federal
income taxes.
2.3. Risk Structure of Interest rates -
Income Tax Consideration

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2.4. Term Structure of Interest Rates

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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2.4. Term Structure of Interest Rates
US Treasury Yield Curve

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2.4. Term Structure of Interest Rates

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2.4. Term Structure of Interest Rates -
Empirical Facts

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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2.4. Term Structure of Interest Rates
2.4.1. 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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 2.4. Term
Investment strategies for
Structure of two-period horizon:
Interest Rates ▪ Buy $1 of one-year
2.4.1. bond and when
matures buy another
Expectations one-year bond
Theory
▪ Buy $1 of two-year
bond and hold it

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2.4. Term Structure of Interest Rates
2.4.1. Expectations Theory

▪ Expected return from strategy 1:

𝑒 𝑒 𝑒
1 + 𝑖1,𝑡 1 + 𝑖1,𝑡+1 − 1 = 1 + 𝑖1,𝑡 + 𝑖1,𝑡+1 + 𝑖1,𝑡 × 𝑖1,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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2.4. Term Structure of Interest Rates
2.4.1. Expectations Theory

▪ Expected return from strategy 2:

2
(1 + 𝑖2,𝑡 )2 −1 = 1 + 2𝑖2,𝑡 + 𝑖2,𝑡 −1
2
Since 𝑖2,𝑡 is also extremely small, expected return is
approximately: 𝟐𝒊𝟐,𝒕

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2.4. Term Structure of Interest Rates
2.4.1. Expectations Theory

• From implication above expected returns of two

strategies are equal. Therefore,
𝑒
𝑖1,𝑡 + 𝑖1,𝑡+1
𝑖2,𝑡 =
2

The two-period rate must equal the average of the two

one-period rates

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2.4. Term Structure of Interest Rates
2.4.1. Expectations Theory

For bonds with longer maturities

𝑒 𝑒 𝑒
𝑖1,𝑡 + 𝑖1,𝑡+1 + 𝑖1,𝑡+2 + ⋯ + 𝑖1,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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2.4. Term Structure of Interest Rates
2.4.1. 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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2.4. Term Structure of Interest Rates
2.4.1. Segmented Markets Theory

• Key Assumption: Bonds of different maturities are not

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

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2.4. Term Structure of Interest Rates
2.4.1. 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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2.4. Term Structure of Interest Rates
Liquidity Premium Theory

• Key Assumption: Bonds of different maturities are

substitutes, but are not perfect substitutes
• Implication: The interest rate on a long-term bond will
equal an average of short-term interest rates expected
to occur over the life of the long-term bond plus a
liquidity premium

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2.4. Term Structure of Interest Rates
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:
𝑒 𝑒 𝑒
𝑖𝑡 + 𝑖𝑡+1 + 𝑖𝑡+2 + ⋯ + 𝑖𝑡+𝑛−1
𝑖𝑛𝑡 = + 𝐿𝑃𝑛𝑡
𝑛
➢𝑖𝑡 is the short-term interest rate for year t
➢𝑖𝑛𝑡 is the interest rate for for the n-period bond at time
t
➢𝐿𝑃𝑛𝑡 is the liquidity (term) premium for the n-period
bond at time t.

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2.4. Term Structure of Interest Rates
Liquidity Premium Theory

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2.4. Term Structure of Interest Rates
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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2.4. Term Structure of Interest Rates
Liquidity Premium Theory

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END OF CHAPTER