FIN2001 – FINANCIAL

MARKETS AND INSTITUTIONS

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

Faculty of Banking, UD-DUE
CHAPTER 2

INTEREST RATES

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 Content

▪ Interest rates
▪ Types of interest rate
▪ Yield to maturity
▪ 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 (2017).
② Chapter 2,3, Financial Markets and Institutions; Jeff Madura;
South-Western Cengage Learning (2015).

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 2.1. Interest rates

•Interest rates are among the most closely

watched variables in the economy.
•Interest rates also affect the economic decisions
of businesses and households
•It is imperative that you understand exactly what
is meant by the phrase interest rates.
•The concept known as yield to maturity (YTM)
is the most accurate measure of interest rates.
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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
𝜋𝑒 : Expected inflation rate
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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

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 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 Introduction

•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 Introduction

• 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: 100 × (1 + 0,10)2 = $121
◼ At the end of the third year: 100 × (1 + 0,10)3 = $133,1
◼ At the end of n year: 100 × (1 + 0,10)𝑛
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2.3. Interest rates Measurement
2.3.1 Present Value Introduction

• 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

•Yield to maturity is 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

1. Simple Loans: 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
𝐂𝐅
𝐏𝐕 =
(𝟏 + 𝐢𝐘𝐌 )𝐧

PV = amount borrowed; CF = future cash flow

n = number of period
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 2.3. Interest rates Measurement
2.3.2 Yield to Maturity

2. 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
+ ⋯+
𝟏 + 𝐢𝐘𝐌 𝟏 + 𝐢𝐘𝐌 𝟏 + 𝐢𝐘𝐌 𝟏 + 𝐢𝐘𝐌 𝐧

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

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 2.3. Interest rates Measurement
2.3.2 Yield to Maturity

2. Fixed payment Loans:

1. Suppose the loan is $1000 and the yearly cash flow payment is
$85.81 for next 25 years. What is the yield to maturity of this
loan?
2. 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?

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 2.3. Interest rates Measurement
2.3.2 Yield to Maturity

3. Coupon Bonds: 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 or par 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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 2.3. Interest rates Measurement
2.3.2 Yield to Maturity

4. 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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 2.3. Interest rates Measurement
2.3.2 Yield to Maturity

4. Discount Bonds:
Example: Let’s consider a discount bond with a
face value of $1,000 in one year’s time. If the
current purchase price of this bill is $900, what is
the yield to maturity of this 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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2.4. Risk Structure of Interest rates
2.4.1. Default risk

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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.
• Illustration: Suppose you have investment in 2 bonds:
1. Government bond: $1,000 face value, 10% annual
interest rate, sell for $1,000
2. Municipal bond: $1,000 face value, 8% annual
interest rate, sell for $1,000
Assume tax rate is 35%, and municipal bonds are tax-
exempt. Compare interest returns from 2 investments

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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

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2.5. Term Structure of Interest Rates
2.5.1. Yield curve

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 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
2.5.2. 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
2.5.2. 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
2.5.2. 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
2.5.2. 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
2.5.2. 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
2.5.2. 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
2.5.2. 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
2.5.3. Segmented Markets Theory

• The interest rate for each bond with a different maturity is then
determined by the supply of and demand for that bond, with no
effects from expected returns on other bonds with other maturities.
• 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
2.5.3. 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
2.5.4. Liquidity Premium Theory

• 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 (also referred to as a term
premium) that responds to supply-and-demand conditions for that
bond
• 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
2.5.4. 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
2.5.4. 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
2.5.4. Liquidity Premium Theory

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

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 END OF
CHAPTER