3 Understanding Interest Rate

Chapter 4
Understanding
Interest Rates
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.

Definition and how to calculate
interest rate
• The percentage of money paid - interest for
use of others’ fund to principal in a period of
time (on a year or a month or a day basis…)
interest
i x100%
principal
4-2
• Let’s assume:
– i : interest rate
– C0: principal
– I1, I2, … In: interest payment
– C1, C2, ….Cn
4-3
• Simple interest rate calculation
• I1=I2=In= i x C0
4-4
• Compound interest rate
4-5
Let i = .10
In one year $100 X (1+ 0.10) = $110
In two years $110 X (1 + 0.10) = $121
2
or 100 X (1 + 0.10)
In three years $121 X (1 + 0.10) = $133
or 100 X (1 + 0.10)3
In n years
$100 X (1 + i) n
4-6
Which interest rate calculation
will be used?
• Example: How banks calculate interest on
saving account?
• You deposit 10 mil. VND into a bank account
@ 12%/year for 3-month period? Interest is
paid at the end of period.
– How much money do you get after 6 months,
assume that interest rate is constant.
– How much do you have if we use simple interest
calculation?
4-7
Future value of non-annual
compounding periods
• FVn: future value of
𝑚𝑛
𝑖
a deposit at the end
of n period
𝐹𝑉 𝑛=𝑃𝑉(1+ )
• PV: initial deposit
• Annual quote
interest
𝑚
• n: number of year
• m: number of time
compounding occurs
during the year
4-8
• What is the future
value of a 1,500
deposit after 20
years, with annual
interest rate of 8%?
• compounded
quarterly?
4-9
• FV1=1.500x(1+8%)^20
• FV2=1.500x(1+8%/4)^20x4
4-10
Computing the future value of
ordinary annuity
What will be your retirement account after 35

years if you make $2,000 annual deposits that
earn (a)10%, (b) 5%
4-11
How will you retire billionaire after 30
years?
• i=6%/year-> 0,5%/month
• n=360
4-12
Time value of money and
Present value
• Value of money is different at different point
in time. A dollar paid to you one year from
now is less valuable than a dollar paid to
you today
• Why?
– A dollar deposited today can earn interest and
become $1 x (1+i) one year from today.
– Change (increase) in price level (inflation) make
your money less valuable.
4-13
Simple Present Value
i discount rate
PV = today's (present) value
CF = future cash flow (payment)
i = the interest rate
CF
PV = n
(1 + i )
4-14
Time Line
Cannot directly compare payments scheduled in different points in the

time line
$100 $100 $100 $100
Year 0 1 2 n
PV 100 100/(1+i) 100/(1+i)2 100/(1+i)n
4-15
Simple Loan
PV = amount borrowed = $100

CF = cash flow in one year = $110
n = number of years = 1
$110
$100 =
(1 + i )1
(1 + i ) $100 = $110
$110
(1 + i ) =
$100
i = 0.10 = 10%
For simple loans, the simple interest rate equals the
yield to maturity
4-16
Fixed Payment Loan
The same cash flow payment every period throughout

the life of the loan
LV = loan value
FP = fixed yearly payment
n = number of years until maturity
FP FP FP FP
LV =  2
 3
 ...+
1 + i (1 + i ) (1 + i ) (1 + i) n
4-17
Present value of an annuity: loan
payments
• Suppose that you buy a new car with a loan
of $15,000 and would like to make monthly
payments for 2 year. The dealership has
offered a 12% interest rate on the loan.
What will be your monthly payment?
=PMT
4-18
Yield to Maturity
• The interest rate that equates the

present value of cash flow payments
received from a debt instrument with
its value today
4-19
Price of a Coupon Bond - YTM
Using the same strategy used for the fixed-payment loan:

P = price of coupon bond
C = yearly coupon payment
F = face value of the bond
n = years to maturity date
C C C C F
P=  2
 3
. . . + n
 n
1+i (1+i ) (1+i) (1+i) (1+i )
4-20
Table 1 Yields to Maturity on a 10%-
Coupon-Rate Bond Maturing in Ten Years
(Face Value = $1,000)
• The price of a coupon bond and the yield to maturity are

negatively related
• When the coupon bond is priced at its face value, the
yield to maturity equals the coupon rate
• The yield to maturity is greater than the coupon rate
when the bond price is below its face value
4-21
4-22
Consol or Perpetuity
• A bond with no maturity date that does not repay

principal but pays fixed coupon payments forever
P  C / ic
Pc  price of the consol
C  yearly interest payment
ic  yield to maturity of the consol
can rewrite above equation as this : ic  C / Pc

For coupon bonds, this equation gives the current yield, an
easy to calculate approximation to the yield to maturity
4-23
(Holding period)
Rate of Return
The payments to the owner plus the change in value
expressed as a fraction of the purchase price
C Pt1 - Pt
RET = +
Pt Pt
RET = return from holding the bond from time t to time t + 1
Pt = price of bond at time t
Pt1 = price of the bond at time t + 1
C = coupon payment
C
= current yield = ic
Pt
Pt1 - Pt
= rate of capital gain = g
Pt
4-24
Table 2 One-Year Returns on Different-Maturity
10%-Coupon-Rate Bonds When Interest Rates
Rise from 10% to 20% (p.123)
4-25
Rate of Return and Interest
Rates
• 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
4-26
Rate of Return and Interest
Rates (cont’d)
• The more distant a bond’s maturity, the lower the
rate of return the 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
4-27
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 (before the event) real interest rate is
adjusted for expected changes in the price level
• Ex post (after the fact) real interest rate is adjusted
for actual changes in the price level
4-28
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 (before the event) real interest rate is
adjusted for expected changes in the price level
• Ex post (after the fact) real interest rate is adjusted
for actual changes in the price level
4-29
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.
4-30
4-31
FIGURE 1 Real and Nominal Interest Rates
(Three-Month Treasury Bill), 1953–2008
Sources: Nominal rates from www.federalreserve.gov/releases/H15. The real rate is constructed using the
procedure outlined in Frederic S. Mishkin, “The Real Interest Rate: An Empirical Investigation,” Carnegie-
Rochester Conference Series on Public Policy 15 (1981): 151–200. This procedure involves estimating
expected inflation as a function of past interest rates, inflation, and time trends and then subtracting the
expected inflation measure from the nominal interest rate.
4-32
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
• Bond duration and interest rate risk (Bond
valuation)
4-33
Bond duration and price
• Duration: a measure of the sensitivity of the
price of a fixed-income investment to a
change in interest rates.
• Duration is expressed as a number of years.
• The bigger the duration number, the greater
the interest-rate risk or reward for bond
prices.
4-34
DUR : duration
t : years until cash payment is made
CPt cash payment at time t
i interest rate
n years to maturity of the security
4-35
Computing A Bond’s
duration
A 2-year bond has a par value of $1,000 and a
coupon rate of 5 percent. The prevailing
annualized yield on other bonds with similar
characteristics is 7 percent. (P=963.84)
?What is this bond’s duration
4-36
Computing the Duration
of A Bond
Excel file
Dur= 1.9515
4-37
Modified duration
𝑫𝑼𝑹
𝑫𝑼𝑹 ∗ ≈
𝟏+ 𝒊
4-38
Bond duration and price
x
where
• %ΔP = (Pt+1 - Pt)/Pt: percent change in the
price of the security from t to t +1 (rate of
capital gain)
• DUR : duration
• i : interest rate
• Δi : change in interest rate
4-39
Computing the Price Change of A Bond
in Response to A Change in Yield
In the previous example, assume that bond yields

rise by 0.30%. What is an estimate of the
?percentage drop in the bond’s price

40 4-40
Example
• Calculate the duration of a 5 year bond, face
value $1000, coupon rate 2%, YTM 3%.
– DUR=
• If YTM increases by 0,5%, what happens to
bond price? Use 2 ways to calculate
(P=)
4-41
Review of Major concepts
• Interest rate and bond price
• Time value of money: annuity
• Yield to maturity
• Rate of Return
• Interest rate risk
• Real and Nominal Interest rate: Fisher
equation
• Duration
4-42

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3 Understanding Interest Rate

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Chapter 4

Copyright © 2010 Pearson Addison-Wesley. All rights reserved.

What will be your retirement account after 35

Cannot directly compare payments scheduled in different points in the

$100 $100 $100 $100

PV 100 100/(1+i) 100/(1+i)2 100/(1+i)n

PV = amount borrowed = $100

The same cash flow payment every period throughout

• The interest rate that equates the

Using the same strategy used for the fixed-payment loan:

• The price of a coupon bond and the yield to maturity are

• A bond with no maturity date that does not repay

can rewrite above equation as this : ic  C / Pc

• Prices and returns for long-term bonds are

In the previous example, assume that bond yields

Copyright © 2010 Pearson Addison-Wesley. All rights reserved.

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