Welcome to the Session

on
Interest Rate Determination, YTM
and Yield Curve

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 Interest Rate and YTM

• Since interest rates are among the most

closely watched variables in the economy,
it is imperative that we understand exactly
what interest rate means.

• In this session, we will see that a concept

known as yield to maturity (YTM) is the
most accurate measure of interest rates.
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 Present Value Introduction

• Different debt instruments have very

different cash flows with very different
timing.
• To value a debt instrument’s cash flows,
we use present value analysis.
• Present value analysis also allows us to
measure the instrument’s yield to maturity
or interest rate.
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 Present Value

• Present discounted value is based on the

commonsense notion that one taka
tomorrow is worth less to you than a taka
today.
• WHY?
Because one could put the taka in a
savings account that earns interest and
have more than a taka in one year.
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 Present Value

To determine the future value of a single

amount

FV = PV(1+i)n
Here, FV = Future Value
PV = Present Value
i = Interest Rate
n = Number of Period

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 Present Value

Sample problem:
One invest Tk. 10,000 for four years at 10% interest.
What is the value at the end of the fourth period?

FV = Tk. 10,000 (1 + 0.10)4

= Tk. 10,000 (1.10)4
= Tk. 10,000 X 1.464
= Tk. 14,640.
So, the value at the end of the fourth year is Tk. 14,640.

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 Present Value Applications

• Four different types of debt instruments:

1. Simple Loan
2. Fixed Payment Loan
3. Coupon Bond
4. Discount Bond

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 Present Value Concept:
Simple Loan Terms
• Loan Principal: the amount of funds the lender provides to
the borrower.
• Maturity Date: the date the loan must be repaid; the Loan
Term is from initiation to maturity date.
• Interest Payment: the cash amount that the borrower
must pay the lender for the use of the loan principal.
• Simple 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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 Present Value Concept:
Fixed-Payment Loan Terms

• Simple Loans require payment of one

amount which equals the loan principal plus
the interest.
• Fixed-Payment Loans are loans where the
loan principal and interest are repaid in
several payments in equal taka amounts
over the loan term.

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 Yield to Maturity: Loans

• Yield to maturity = interest rate that equates today's

value with present value of all
future payments
1. Simple Loan Interest Rate

$100  $110 1  i  

$110  $100 $10

i   .10  10%
$100 $100
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 Yield to Maturity: Loans

2. Fixed Payment Loan (i = 12%)

$126 $126 $126 $126

$1000   2  3  ... 
1 i  1  i 1 i  1 i 25

FP FP FP FP
LV   2  3  ... 
1  i  1  i  1 i  1 i n

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 Yield to Maturity: Bonds

3. Coupon Bond (Coupon rate = 10% = C/F)

$100 $100 $100 $100 $1000
P  2  3  ...  10 
1 i  1  i 1 i  1 i  1  i 10
C C C C F
P  2  3  ...  n 
1 i  1  i 1 i  1 i  1  i n

Consol: Fixed coupon payments of $C forever

C C
P i
i P
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 Yield to Maturity: Bonds

4. One-Year Discount Bond (P = $900, F = $1000)

$1000
$900  
1  i
$1000  $900
i  .111  11.1%
$900
FP
i
P
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 Relationship Between Price
and Yield to Maturity

• Three interesting facts in Table 1

1. When bond is at par, yield equals coupon rate
2. Price and yield are negatively related
3. Yield greater than coupon rate when bond price
is below par value
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 Other Measures of Interest Rate

• Current Yield
• Yield on a discount basis

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 Distinction Between Real
and Nominal Interest Rates

• Real interest rate

1. Interest rate that is adjusted for expected
changes in the price level
ir  i   e

2. Real interest rate more accurately reflects

true cost of borrowing
3. When real rate is low, greater incentives to
borrow and less to lend

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 Distinction Between Real
and Nominal Interest Rates (cont.)

• If i = 5% and πe = 0% then

ir  5%  0%  5%
• If i = 10% and πe = 20% then

ir  10%  20%  10%

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 Distinction Between Interest Rates
and Returns

• Rate of Return
C  Pt 1  Pt
RET   ic  g
Pt
C
where ic   current yield
Pt
pt 1  Pt
g  capital gain
Pt
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 Behavior of Interest Rates
Loanable Funds Framework
Changes in Equilibrium Interest Rates
Shifts in the Demand for Bonds
 Wealth
 ER
 Risk
 Liquidity
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 Shifts in the Supply of Bonds

 Expected Profitability
 Expected Inflation
 Government Activities

Liquidity Preference Framework

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 Shifts in the Demand for Money

 Income Effect
 Price Level Effect

Shifts in the Supply of Money

Money and Interest Rate

 Income Effect
 Price-level Effect
 Expected-Inflation Effect

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 Risk Structure of Interest Rates

 Default Risk
 Liquidity Risk
 Income Tax Consideration

Term Structure of Interest Rates

 The Expectation Hypothesis
 The Segmented Market Theory
 The Liquidity Premium Theory

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 The Yield Curve

• Yield Curve (Term Structure of

Interest Rates): A plot of the
interest rates of Treasury Bills and
Treasury Bonds versus their
maturities at a point in time.
 Yield Curve: An Example

Term (years) Interest Rate (%)

0.25 3.62
2.00 4.34
5.00 5.07
10.00 5.54
30.00 5.86
 Yield Curve

– A graph of yields to maturity by time to maturity

is called a yield curve.

7.00%

6.50%

6.00%

5.50%

5.00%

4.50%

4.00%
3mo 6mo 1yr 2yr 3yr 5yr 10yr 30yr
 Yield Curve

– Typically, the yield curve is upward sloping

• Yield to maturity rises with term to maturity
• The excess of the long yield over the short yield is called a
“term premium”

7.00%

6.50%

6.00%

5.50%

5.00%

4.50%

4.00%
3mo 6mo 1yr 2yr 3yr 5yr 10yr 30yr
 Yield Curve

– Other shapes are also possible, however

• Inverted: Commonly associated with recessions
• Flat

15.00%

13.00%

11.00%

9.00%

7.00%

5.00%

3.00%

1.00%

-1.00% 3mo 6mo 1yr 2yr 3yr 5yr 10yr 30yr

 The Slope of the Yield Curve

• Upward Sloping (term  i) -- usual

case.
• Downward Sloping or Inverted Yield
Curve (term  i) -- occurs periodically

• What information can we get from the

yield curve?
Observed Phenomena -- Yield
Curve
• The downward sloping (inverted) yield
curve is unusual but not rare.
• Interest rates of bonds of all maturities
move together (are positively
correlated)
• The downward sloping (inverted) yield
curve tends to occur when interest
rates in general are high.
 Theories (Hypotheses)
Which Explain
Yield Curve Behavior
• Key difference in assumptions: How close of
substitutes are bonds of different maturities?
• We will assess each hypothesis – how well
does it predict the three observed
phenomena?
(1) Expectations Hypothesis

• The Expectations Hypothesis -- The

interest rate on a long-term bond
will be equal to the average of short-
term rates expected to occur over
the lifetime of the long-term bond.
• Key assumption: Bonds of different
maturities are perfect substitutes.
 Assessment: Expectations
Hypothesis
• The downward sloping (inverted)
yield curve is unusual but not rare.

Fails to predict this occurrence.

(predicts 50-50 probability of

upward versus downward slope)
 Expectations Hypothesis

• Interest rates of bonds of all

maturities move together (are
positively correlated)

Accurately predicts this

occurrence.

(bonds are substitutes)

 Expectations Hypothesis

• The downward sloping (inverted) yield

curve tends to occur when interest rates
in general are high.

Accurately predicts this occurrence

(When are interest rates expected to

decrease?)
 (2) The Market Segmentation
Hypothesis
• The Market Segmentation
Hypothesis -- Each investor has
his/her preferred maturity sector and
stays within it. Consequently,
interest rates on bonds are
determined by independent demand
and supply conditions within that
sector.
 Market Segmentation
Hypothesis: Assumption

• Key Assumption: Bonds of

different maturities are not
substitutes at all.
 Market Segmentation
Hypothesis: Predictions
•Upward sloping yield
curve is the usual case --
more demand for short-
term bonds than long-term
bonds.
 Assessment: Market
Segmentation Hypothesis
• The downward sloping (inverted) yield
curve is unusual but not rare.

Accurately predicts this occurrence.

(Highly contractionary monetary policy)

 Market Segmentation
Hypothesis
• Interest rates of bonds of all maturities
move together (are positively
correlated)

Fails to predict this occurrence.

(Independently determined interest

rates should not move together)
 Market Segmentation
Hypothesis
• The downward sloping (inverted) yield
curve tends to occur when interest rates
in general are high.

Accurately predicts occurrence.

(High expected inflation,

contractionary monetary policy)
 (3) The Preferred Habitat
Hypothesis
• The Preferred Habitat Hypothesis
The interest rate on a long-term
bond equals the average of short-
term rates expected to occur over
the lifetime of the long-term bond
plus a risk premium due to higher
market risk in the long-term bond.
Preferred Habitat Hypothesis:
Assumption
• Key assumption -- Bonds of
different maturities are close
substitutes but not perfect
substitutes.
• Major non-price difference -- longer
term bonds have higher market
risk.
Assessment: Preferred Habitat
Hypothesis
• The downward sloping (inverted) yield
curve is unusual but not rare.

Accurately predicts occurrence.

(Investors must expect interest

rates to decrease a lot in the
future.)
Preferred Habitat Hypothesis

• Interest rates of bonds of all

maturities move together (are
positively correlated)

Accurately predicts this

occurrence.

(Close substitutes)
Preferred Habitat Hypothesis

• The downward sloping (inverted) yield

curve tends to occur when interest rates
in general are high.

Accurately predicts occurrence

(When are interest rates expected

to decrease a lot?)