Economics of Money and Banking Dr, Rasha Qutb Understanding Interest.Rates This lecture focuses on the meaning and measurement of interest rates for key types of debt instruments (or "credit market instruments") > Basic Types of Debt Instruments Debt instruments (equivalently, Credit market instruments) are types of contractual agreements that require the borrower to pay the lender certain fixed dollar amounts at regular intervals until a specified time is reached. Simple loan contracts (Coupon bonds Consols ‘perpetuities" > Asimple loan Under the terms of a simple loan contract, the borrower (contract issuer) receives from the lender (contract buyer) a specificd amount of funds (the lean walue LV or principal) for a specifies period of time (the maturity). The borrower agrees that, at the end of this period of time -referred to as the maturity date -the borrower will repay the loan value to the lender together with an additional payment referred to as the interest payment. Borrower Receives: Loan Value LV 1 START | MATURITY DATE ' 1 Lender oan Value Lv Receives: + Interest Payment T N.B. for simple loans, the simple interest rate equals the yield to maturity is only true if N=1 is assumed for the simple loans and the yield to maturity is calculated as an annual rate. Example of a Simple Loan Contract ‘A borrower receives a loan on January 1, 2021, in amount $500.00, and agrees to pay the lender $550.00 on January 1, 2023. Thus, the loan value is $500.00, the maturity is two years, the maturity date is January 1, 2023, and the interest payment is $50.00. The simple (annual) interest rate for this loan is then $50/[$500*2] = 05, or 5 percent. Real-World Examples of Simple Loan Contrac form. Also, various money market instruments (¢.g., commé Standard bank deposit accounts take this, al loans to businesses)Economics of Money and Banking Dr. Rasha Qutb > A fixed- payment loan Contracts Uncer the terms of a fixed-payment loan contract, the borrower (contract issuer) receives from the lender (contract buyez) a specified amount of funds — the Joan vaiue — and, in return, makes periodic fixed payments to the lender until a specified manurity date. These periodic fixed payments include both principal (loan value) and interest, so at maturity there 1s no lump sum repayment of principal. Borrower Receives: Loan Value LV t ‘MATURITY START | DATE T T 1 1 I 1 Fixed Fixed Fixed Payment FP Payment FP Payment EP Example of a Fixed-Payment Loan Contract: ‘Mr. A arranges a 15-year installment loan with a finance company to help pay for a new car. Under the terms of this loan, Mr.A receives $20,000 now to finance the purchase of a new car but must make payments of $2000 every year for the next 15 years to the finance company. Real-World Examples of Fixed Payment Loan Contracts: Installment loans (¢.g., auto loans) and home mortgages typically take this form. » Acoupon bond Under the terms of a coupon bond, the borrower (bond issuer) agrees to pay the lender (bond buyer) a fixed amount of funds (the coupon payment) on a periodic basis until a specified maturity date, at which time the borrower must also pay the lender the face value (or par value) of the bond. ‘The coupon rate of a coupon bond is, by definition, the amount of the coupon payment divided by the face value of the bond. As will be clarified in the next section, below. the purchase price of a coupon bond depends on the “present value" of the stream of anticipated coupon payments plus the final face vahte payment ‘promised by the bond. Coupon bonds that sell above their face value are said to sell at a premium, and those that sell below their face value are said to sell at a discount. Borrower Purchase Receives: Price Pb | MATURITY START | ININ\/\ DATE I 1 ' I 1 I Coupon Coupen Conpen Payment C Payment © Payment C + Pace Value FEconomics of Money and Banking Dr. Rasha Qutb Example of a Coupon Bond: Suppose a coupon bond has a face value of $1000, a maturity of five years, and an annual coupon payment of $60. Then. at the end of each year for the next five years. the borrower (bond issuer) must pay the lender (bond buyer) a coupon payment of $60. In addition, at the end of five years (the maturity date), the borrower must pay the lender the face value of the bond, $1000. The coupon rate for this coupon bond is $60/$1000 = .06, of 6 percent Real-World Examples of Coupon Bonds: Capital market instruments such as U.S. Treasury notes and bonds take this form. Corporate bonds also typically take this form. > Discount Bond (or Zero-Coupon Bond) Under the terms of a discount bond, the borrower (bond issuer) immediately receives from the lender (bond buye:) the purchase price Pd of the bond, which is typically less than the face value F of the ‘bond. In rerum, the borrower promises that, at the bond's maturity date, he will pay the lender the face value F of the bond. Borrower Purchase Receives Price Pa 1 START | ‘MATURITY DATE 1 ' Lender Face Value F Receives: Discount Bond Example: On January 1, 1999, a borrower gives a lender a discount bond with a face value of $200 and a maturity of 2 years, and the lender gives $150 to the bomower. The borrower must then pay the lender $200 on January 1, 2001 Real-World Examples of Discount Bonds: U.S. Treasury bills and US. savings bonds take this form > The Concept of 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 ‘youtoday. We can calculate the present value of future cash flow using this formula: py= PV: present value CF future cash flow K:interest rate ‘NN: Numbers of years till maturityEconomics of Money and Banking Dr. Rasha Qutb Nominal 2 a value cf §1 aayesa, (asap 482 (asap +g Savings: a D> Measuring Interest Rates by Yield to Maturity * Wield to Maturity: the interest rate that equates the present value of cash flows received fiom a debt instrument with its value today. ‘THUS, the calculation of the yield to maturity is equating today’s value of the debt instrument with the present value of all of its future cash flow payments 1. A simple loan: EX: If Anas borrows $100 from hus sister and next year she wants $110 back from him. what is the ‘yield to matunty on this loan? NB for simple loans, the simple interest rate equals the yield to maturltyEconomics of Money and Banking Dr. Rasha Qutb ‘Yield to Maturity for Fixed-Payment Loan: rp (+2) Asay Where: LV=loan value, FP = fixed yearly cash flow payment, n= number of years until maturity EX: You decide to purchase a new home and need a $100,000 mortgage. You take out a loan from the bank that has an interest rate of 7%. What is the yearly payment to the bank to pay off the loan in 20 years? hon Yield to Maturity for Perpetuity (Consol) Itisa perpetual bond with no maturity date and no repayment of principal. Where: Pe= price of the perpetuity, C= yearly payment, ic = yield to maturity of the perpetity EX: What is the yield to maturity on a bond that has a price of $2,000 and pays $100 annually forever? =e > $100 = 005 = Yield to Maturity for A discount bond A 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) for any one-year discount bond, the yield to maturity can be written as ‘-F P ‘Where: F=face value of the discountbond P= current price of the discount bond. NB: current bond prices and interest rates are negatively related: When the interest rate rises, the price of the bond falls, and vice versa EX: Treasury bill, which pays a face value of $1,000 in one year’s time, and the current purchase price of this bill is $900 1 (1000-900)/1000= 0.111, THUS, yield to maturity= 11.1%Economics of Money and Banking Dr. Rasha Qutb Yield ta Maturity for Coupon Bonds Recall from previous discussion the basic contractual terms of a coupon bond: Borrower Purchase Receives: Brice ED 1 MaroRITy START | IN DATE T T T I 1 | Coupoa Coupon... Coupon Lender Payment © Payment C Payment Receives + Face Value F Where: P= price of coupon bond (C= yearly coupon payment F = face value of the bond n= years to maturity date ‘EX: Find the price of a 10% coupon bond with a face value of $1,000, a 12.25% yield to maturity, and eight years to maturity. ‘ é [ é F oe a met a aay” iat” Gey (+ayn" (1+) P= 100/(1+0.125)'*1001(1+0.125)"..........+100/(1+0.125)*+1000/(1+0.125)'=P =$889.20 N.B: For any coupon bond with a given coupon payment C, face value F, and maturity N: # the yield to maturity i of the bond is inversely related to the purchase price Pb of the bond. That is, the higher the yield to maturity i, the lower the purchase price Pb, and conversely. # the purchase price Pb of the bond = the face value F only if the yield to maturity i for the bond is equal to the coupon rate C/F (if the bond is kept until it matures) # the purchase price Pb of the bond is lower (higher) than F if and only if the yield to maturity i is higher (lowes) than the coupon rate C/F.Economics of Money and Banking Dr. Rasha Qutb (2)The Distinction between Interest Rates and Returns *The rate of return: the payments to the owner plus the change in its value, expressed as a fraction of its purchase price. NB: the return on a bond will not necessarily equal the interest rate on that bond. ‘The retum on a bond held from time 1 to time t+ 1 can be written as: O+P, Where, R=retum from holding the bond from time fto time +1 -Pt= price of the bond at time t Pt+1 = price of the bond at time t+ 1 (C=coupon payment ‘EX: What would the rate of retum be on a bond bought for $1.000 and sold one year later for $800? ‘The bond has a face value of $1,000 and a coupon rate of 8% coupon payment = $1,000 * 0.08 = $20 Pr“ 1 ~ price of the bond one year laier~ $800 ‘P= price of the bond today = $1,000 $80 + ($800 31,000, 000) N.B: The Return formula can be split into two separate terms: R c 5. Prvi — Pr P, P, First: The first term is the current vield (the coupon payment over the purchase price). or as a % of the current price ‘Second: The second term is the rate of capital gain, or the change in the bond’s price relative to the initial purchase price. Pig —P, P ‘THUS, retum equation can be written as: R=-i.+g Rate of return the current yield + the of capital gain NB: Retums will differ from the interest rate especially if there are sizable fluctuations in the price of the bond, which then produce substantial capital gains or losses.Economics of Money and Banking Dr. Rasha Qutb (8) The Distinction between Real and Nominal Interest Rates “Real interest rate: (The ex ante real interest rate): the interest rate that is adjusted by subtracting expected changes in the price level (expected inflation rates) so that it more accurately reflects the tmue cost of borrowing "The ex post real interest rate: The interest rate that is adjusted for aciual changes in the price level. “The Fisher equation: the nominal interest rate 1 equals the real interest rate 1+ plus the expected rate of inflation 7” iit “THUS, the seal interest rate equals the nominal interest rate minus the expected inflaton rate. i,-i-w EX: What is the real interest rate if the nominal interest rate is 8% and the expected inflation rate is 10% over the course of a year? Where ) = nominal interest rate = 0.08 ‘expected inflation rate = 0.10 i, = 0.08 — 0.10 = =0,02 = =2% NB: When the real interest rate is low, there are greater incentives to borrow and fewer incentives tolend.