Chapter 4

Understanding
InterestRates

Present Value
FourTypesofCreditInstruments
1. Simpleloan
2. Fixedpaymentloan
3. Couponbond
4. Discount(zerocoupon)bond
ConceptofPresentValue
Simpleloanof$1at10%interest
Year
1
2
3
$1.10
$1.21
$1.33
$1
PVoffuture$1=
(1+i)n
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n
$1x(1+i)n

4-2

Yield to Maturity: Loans

Yieldtomaturity=interestratethatequatestodaysvaluewith
presentvalueofallfuturepayments
1. SimpleLoan(i=10%)
$100=$110/(1+i)
i=

$110$100
$100

$10
$100

=0.10=10%

2. Fixed Payment Loan (i = 12%)

$1000 =
LV =

$126
(1+i)
FP
(1+i)

+
+

$126
(1+i)

FP
(1+i)

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+
+

$126
(1+i)

FP
(1+i)

+ ... +
+ ... +

$126
(1+i)25
FP
(1+i)n

4-3

Yield to Maturity: Bonds

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

$100
$100
+
+
(1+i)
(1+i)2

$100
$100
$1000
+
...
+
+
(1+i)3
(1+i)10
(1+i)10

P=

C
(1+i)

C
C
+
...
+
(1+i)3
(1+i)n

C
+
(1+i)2

F
(1+i)n

Consol: Fixed coupon payments of $C forever

C
C
P=
i =
i
P
4. Discount Bond (P = $900, F = $1000), one year
$900 =

$1000
(1+i)

i=

$1000 $900
$900

i=

FP
P

= 0.111 = 11.1%

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4-4

Consol (or Perpetuity)

Aperpetualbondwithnomaturitydateandnorepaymentof
principalthatmakesfixedcouponpaymentsof$Cforever.
FirstsoldduringtheNapoleonicWars(17991815)bythe
BritishTreasury.
P=C/i
Theformulaofinfinitesum

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4-5

Relationship Between Price

and Yield to Maturity

ThreeInterestingFactsinTable1
1. Whenbondisatpar,yieldequalscouponrate
2. Priceandyieldarenegativelyrelated
3. Yieldgreaterthancouponratewhenbondpriceisbelowparvalue

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4-6

Current bond prices and interest rates are

negatively related

Whentheinterestraterises,
thepriceofbondfalls

Whentheinterestratefalls,
thepriceofbondrises.
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4-7

Distinction Between Interest Rates

and Returns
RateofReturn
RET=

C+Pt+1Pt

=ic+g

Pt

where: ic =

g=

C
Pt
Pt+1 Pt
Pt

= current yield

= capital gain

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4-8

Key Facts about Relationship

Between Interest Rates and Returns

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4-9

Maturity and the Volatility

of Bond Returns
KeyFindingsfromTable2
1. Onlybondwhosereturn=yieldisonewithmaturity=holdingperiod
2. Forbondswithmaturity>holdingperiod,iPimplyingcapitalloss
3. Longerismaturity,greateris%pricechangeassociatedwithinterest
ratechange
4. Longerismaturity,morereturnchangeswithchangeininterestrate
5. Bondwithhighinitialinterestratecanstillhavenegativereturnifi

ConclusionfromTable2Analysis
1. Pricesandreturnsmorevolatileforlongtermbondsbecausehave
higherinterestraterisk
2. Nointerestrateriskforanybondwhosematurityequalsholdingperiod

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4-10

Distinction Between Real

and Nominal Interest Rates
RealInterestRate
Interestratethatisadjustedforexpectedchangesinthepricelevel
ir=ie

(1+i)=(1+ )(1+ e)

1. Realinterestratemoreaccuratelyreflectstruecostofborrowing
2. Whenrealrateislow,greaterincentivestoborrowandlesstolend
ifi=5%and e=3%then:
ir=5%3%=2%
ifi=8%and e=10%then
ir=8%10%=2%

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4-11

U.S. Real and Nominal Interest Rates

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4-12