Money and

Understanding
Interest Rates
Chapter 4 (second part) and
Web Appendix

1
 The Distinction Between Interest
Rates and Returns
• The return equals the yield to maturity only if the
holding period equals the time to maturity
• A rise in interest rates is associated with a fall in
bond prices, resulting in a capital loss if time to
maturity is longer than the holding period
• The more distant a bond’s maturity, the greater
the size of the percentage price change
associated with an interest-rate change
 The Distinction Between
Interest Rates and Returns
(cont’d)
• The more distant a bond’s maturity, the
lower the rate of return that occurs as a
result of an increase in the interest rate
• Even if a bond has a substantial initial interest
rate, its return can be negative if interest
rates rise
 Interest-Rate Risk
• Prices and returns for long-term bonds are
more volatile than those for shorter-term
bonds
• There is no interest-rate risk for any bond
whose time to maturity matches the holding
period
 Duration
• Longer-term bonds are more exposed to
interest rate risk than shorter-term bonds.
• However bonds really have different
durations due to the timing of the payments.
• Duration is a way to measure the effective
term of a bond.
• It is the average maturity of a bond
(weighted average).
• Many in finance call this Macaulay duration
named after its originator.
 Duration (cont’d)
• Suppose German Eurobond (in $) has a face
value of $1000, 5% yield to maturity, 3 year
term, and 10% coupon payment.

$100 $100 $1100

P  
(1.05) (1.05) 2 (1.05)3

P  $95.24  $90.70  $950.22

P  $1136.16
 Duration (cont’d)
P  $95.24  $90.70  $950.22
P  $1136.16

Duration 
95.24
1  90.70
2  950.22
3
1136.16 1136.16 1136.16

Duration  0.0841  0.0802  0.8363

Duration  0.084  0.160  2.508  2.752

 Duration (cont’d)
• You can also calculate the duration of a
portfolio.
• Suppose you invest 80% in one bond with a
duration of 2.75 years and 20% in a bond with
a duration of 9.00 years. Then the duration of
your portfolio is (0.8)*2.75 + (0.20)*9.00 = 4.00
years.
• Recall again that longer duration implies
greater interest rate risk.
 Duration (cont’d)
• To get a sense of interest rate risk and
duration we can use a simple approximation.

%P Duration

i 1 i
• Suppose the duration of a bond is 8 and the
current interest (yield to maturity) is 3%.
%P 8.0
  7.77
i 1  .03
• So a 1 percentage point increase (0.03 to
0.04) in the interest rate would lower the bond
price by about 7.77%
 The Distinction Between Real and
Nominal Interest Rates
• Nominal interest rate makes no allowance for
inflation
• Real interest rate is adjusted for changes in
price level so it more accurately reflects the
cost of borrowing
• Ex ante real interest rate is adjusted for
expected changes in the price level
• Ex post real interest rate is adjusted for actual
changes in the price level
 Fisher Equation
i  ir   e
i = nominal interest rate
ir = real interest rate
 e = expected inflation rate
When the real interest rate is low,
there are greater incentives to borrow and fewer incentives to lend.
The real interest rate is a better indicator of the incentives to
borrow and lend.
Real and Nominal Interest Rates (Three-
Month Treasury Bill), 1953–2011

Sources: Nominal rates from www.federalreserve.gov/releases/H15 and inflation from

ftp://ftp.bis.gov/special.requests/cpi/cpia.txt.