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BSACC 2-3
CHAPTER 3
The interest rate is the amount a lender charges for the use of assets expressed as a
percentage of the principal. The interest rate is typically noted on an annual basis known as
the annual percentage rate (APR). The assets borrowed could include cash, consumer goods, or large
assets such as a vehicle or building.
For loans, the interest rate is applied to the principal, which is the amount of the loan. The
interest rate is the cost of debt for the borrower and the rate of return for the lender.
Interest rates apply to most lending or borrowing transactions. Individuals borrow money to
purchase homes, fund projects, launch or fund businesses, or pay for college tuition. Businesses take
loans to fund capital projects and expand their operations by purchasing fixed and long-term assets
such as land, buildings, and machinery. Borrowed money is repaid either in a lump sum by a pre-
determined date or in periodic installments.
The money to be repaid is usually more than the borrowed amount since lenders require
compensation for the loss of use of the money during the loan period. The lender could have
invested the funds during that period instead of providing a loan, which would have generated
income from the asset. The difference between the total repayment sum and the original loan is the
interest charged. The interest charged is applied to the principal amount.
A country's central bank sets interest rates. High interest rates make loans more expensive.
When interest rates are high, fewer people and businesses can afford to borrow. That lowers the
amount of credit available to fund purchases, slowing consumer demand. At the same time, it
encourages more people to save because they receive more on their savings rate. High-interest rates
also reduce the capital available to expand businesses, strangling supply. This reduction
in liquidity slows the economy.
Low interest rates have the opposite effect on the economy. Low mortgage rates have the
same effect as lower housing prices, stimulating demand for real estate. Savings rates fall. When
savers find they get less interest on their deposits, they might decide to spend more. Low-
interest rates make business loans more affordable. That encourages business expansion and new
jobs.
The Central Bank of the Philippines lowered its overnight reverse repurchase facility by
25bps to 4.25 percent during its August meeting, saying inflation expectations have moderated
further amid weakening global growth. Meanwhile, data showed the country's economic growth
slowed to an over four-year low in the second quarter of the year. Policymakers also noted that the
benign inflation outlook provides room for a further reduction in the policy rate.
Bangko Sentral ng Pilipinas policy statement:
At its meeting on monetary policy today, the Monetary Board decided to cut the interest
rate on the BSP’s overnight reverse repurchase (RRP) facility by 25 basis points (bps) to 4.25 percent.
Accordingly, the interest rates on the overnight deposit and lending facilities were reduced to 3.75
percent and 4.75 percent, respectively.
The Monetary Board noted that prospects for global economic activity are likely to remain
weak amid sustained trade tensions among major economies. Domestically, the outlook for growth
continues to be firm on the back of a projected recovery in household spending and the accelerated
implementation of the government’s infrastructure spending program, after the delay in
expenditures due to the legislative impasse in the approval of the budget in January to April 2019.
On balance, therefore, the Monetary Board believes that the benign inflation outlook
provides room for a further reduction in the policy rate as a pre-emptive move against the risks
associated with weakening global growth. Going forward, the BSP will continue to monitor price and
output conditions to ensure that monetary policy remains appropriately supportive of sustained
non-inflationary economic growth over the medium term.
An Introduction to Bonds
Bonds form a significant portion of the financial market and are a key source of capital for
the corporate world
a. Face Value
The face value (also known as the par value) of a bond is the price at which the bond is sold
to investors when first issued; it is also the price at which the bond is redeemed at maturity.
b. Coupon Rate
c. Maturity
A bond’s maturity is the length of time until the principal is scheduled to be repaid.
Occasionally a bond is issued with a much longer maturity; there have also been a few instances of
bonds with an infinite maturity; these bonds are known as consols. With a consol, interest is paid
forever, but the principal is never repaid.
d. Call Provisions
Many bonds contain a provision that enables the issuer to buy the bond back from the
bondholder at a pre-specified price prior to maturity. A bond containing a call provision is said to
be callable. This provision enables issuers to reduce their interest costs if rates fall after a bond is
issued, since existing bonds can then be replaced with lower yielding bonds. Since a call provision is
disadvantageous to the bond holder, the bond will offer a higher yield than an otherwise identical
bond with no call provision.
e. Put Provisions
Some bonds contain a provision that enables the buyer to sell the bond back to the issuer at
a pre-specified price prior to maturity. This price is known as the put price. A bond containing such a
provision is said to be putable. This provision enables bond holders to benefit from rising interest
rates since the bond can be sold and the proceeds reinvested at a higher yield than the original
bond. Since a put provision is advantageous to the bond holder, the bond will offer a lower yield
than an otherwise identical bond with no put provision.
Some bonds are issued with a provision that requires the issuer to repurchase a fixed
percentage of the outstanding bonds each year, regardless of the level of interest rates. A sinking
fund reduces the possibility of default; default occurs when a bond issuer is unable to make
promised payments in a timely manner. Since a sinking fund reduces credit risk to bond holders,
these bonds can be offered with a lower yield than an otherwise identical bond with no sinking fund.
The price of a bond and its yield-to-maturity are negatively correlated to each other. When
the yield-to-maturity is higher than the coupon rate, the price of a bond is less than the face value
and vice-versa. Usually bonds are issued at coupon rates close to the prevailing interest rate, so that
they can be sold close to their face values.
However as time passes, bonds frequently trade at prices that are different from their face
values. While two parties can agree on a price and execute a trade, a vast majority of bonds are sold
either through a public sale or through an exchange platform and the price of the bond is thus
determined by the market, and as a result, may vary every minute.
The price of a bond issued by a party is directly linked to the credit rating of that party, since
there is always a default risk associated with a bond, which means that the borrower might not be
able to pay the full or partial amount of the loan taken. So, bonds with low ratings, called junk
bonds, are sold at lower prices and those with higher ratings, called investment-grade bonds, are
sold at higher prices.
When interest rates rise, bond prices fall, which results in a rise in yields of the older bonds
and bring them into the same category as newer bonds being issued with higher coupons and vice-
versa.
Bonds are long-term fixed income securities. Debentures are also long-term fixed income
securities. Both of these are debt securities.
Government bonds
Corporate bonds.
Theorem 1
Theorem 2
Theorem 3
If the bond's yield does not change over its life then the size of its discount or premium will
decrease at an increasing rate as it life shortens
Theorem 4
The percentage change in a bond’s price owing to change in its yield will be smaller if the
coupon rate is higher
Theorem 5
A decrease in a bonds yield will rise the bonds price by an amount that is greater in size than
the corresponding fall in the bond’s price that would occur if there where an equal sized
increase in the bond’s yield
The price-yield relation is convex
NOTE:
A real interest rate is an interest rate that has been adjusted to remove the effects of
inflation to reflect the real cost of funds to the borrower and the real yield to the lender or to an
investor. The real interest rate reflects the rate of time-preference for current goods over future
goods. The real interest rate of an investment is calculated as the difference between the nominal
interest rate and the inflation rate.
Cost of Funds – The amount of money paid in interest on a loan. The cost of funds is an expense for
both personal and business loans. A reference to the interest rate paid by financial institutions for
the funds that they use in their business.
Time Preference – The time preference theory of interest explains interest rates in terms of people's
preference to spend in the present over the future.
Key Points:
o The real interest rate adjusts the observed market interest rate for the effects of inflation.
o The real interest rate reflects the purchasing power value of the interest paid on an
investment or loan and represents the rate of time-preference of the borrower and lender.
o Because inflation rates are not constant, prospective real interest rates must rely on
estimates of expected future inflation over the time to maturity of a loan or investment.
Interest Rates: Nominal vs. Real
It is also known as neo-classical theory of interest which was created by the Swedish
economist Knut Wicksell. Later on, economists like Ohlin, Myrdal, Lindahl, Robertson and J. Viner
have considerably contributed to this theory.
According to this theory, rate of interest is determined by the demand for and supply of
loanable funds. In this regard, this theory is more realistic and broader than the classical theory of
interest.
The market for loanable funds consists of arrangements and procedures to carry out
transactions between people who want to borrow money and people who want to lend money.
Demand
The demand for loanable funds originally from two basic units of the economy: consumers
and business firms.
Consumers demand loanable funds because they prefer current goods to the same amount
of future goods. This simply means that people subjectively value goods to be obtained in the
immediate or near future more highly than goods obtained in the distant future.
Business firms or investors demand loanable funds because they are a form of capital.
Capital is demanded because it is productive. Capital makes other factors more productive.
The Three Purposes of Demand for Loanable Funds
According to this theory demand for loanable funds arises for the following three purposes:
investment, hoarding and dissaving:
1) Investment
The main source of demand for loanable funds is the demand for investment. Investment
refers to the expenditure for the purchase of making of new capital goods including
inventories.
2) Hoarding
The demand for loanable funds is also made up by those people who want to hoard it as idle
cash balances to satisfy their desire for liquidity. The demand for loanable funds for hoarding
purpose is a decreasing function of the rate of interest. At low rate of interest demand for
loanable funds for hoarding will be more and vice-versa.
3) Dissaving
Dissaving’s is opposite to an act of savings. This demand comes from the people at that time
when they want to spend beyond their current income.
The supply of loanable funds is derived from the basic four sources as savings, dishoarding,
disinvestment and bank credit.
1) Savings
Savings constitute the most important source of the supply of loanable funds. Savings is
unchanged, so the amount of savings varies with the rate of interest. Individuals as well as
business firms will save more at a higher rate of interest and vice-versa.
2) Dishoarding
Dishoarding is another important source of the supply of loanable funds. Generally,
individuals may dishoard money from the past hoardings at a higher rate of interest.
3) Disinvestment
Disinvestment occurs when the existing stock of capital is allowed to wear out without being
replaced by new capital equipment.
4) Bank Money
The banks advance loans to the businessmen through the process of credit creation. The
money created by the banks adds to the supply of loanable funds.
Price Expectations - Analyzing how price expectations are formed is essential since the dynamics of
market prices are mainly driven by the agent’s belief concerning the future values of prices and by
the uncertainty characterizing these values. This is a difficult task as prices are highly volatile in most
markets and expectational behaviour is heterogeneous and unstable.
When setting the price for the products and services, there are many factors that may affect
this. The following are listed below.
Desire – price expectation is, to a significant extent, related to desire. When we want something
more, then we are prepared to pay more.
The needs and wants – the basic driver of any purchase is that your product or service satisfies
needs and wants that your customer has.
Promotional effects – one of the key goals of any marketing and other persuasion is to create desire
Reference – by using contrast, comparing it with a reference as a base point and making any
adjustments from there.
The reference price – When deciding what a price should be, or whether something is expensive or
cheap, the reference price may come from various sources, such as the general industry average,
market leader pricing and what they have been told.
Experience – Aside from other sources, one of the most notable references is experience. What a
customer paid last time has a great deal to do with how much they expect to pay this time.
Image – what a person expects to pay may well be related to how they view the product and how
they view themselves.
Availability – when we buy, the easy or difficult availability of products may have a significant effect
on what people expect to pay.
Scarcity – when a product is not easy to find, then scarcity has the effect of making it more desirable
as people fear not being able to buy it.
Your exclusivity – when you have a monopoly or otherwise offer something that they cannot easily
get elsewhere, then they will may have some difficulty in identifying a reference and be more
dependent on you for price as well as the product.
Communication – what is said can have a huge effect on expectation. Even casual estimates, for
example, can be perceived as promises as the reference point is established.
Research – as well as listening, customers will often do their own research, especially when buying
more expensive and important items.
Stage 2. Peak
The second stage is a peak when the economy hits a snag, having reached the maximum level of
growth. Prices hit their highest level, and economic indicators stop growing.
Stage 3. Recession
These are periods of contraction. During a recession, unemployment rises, production slows down,
and sales start to drop because of a decline in demand, and incomes become stagnant or decline.
Stage 4. Depression
Economic growth continues to drop while unemployment rises and production plummets.
Consumers and businesses find it hard to secure credit, trade is reduced, and bankruptcies start to
increase.
Stage 5. Trough
This period marks the end of the depression, leading an economy into the next step: recovery.
Stage 6. Recovery
In this stage, the economy starts to turn around. Low prices spur an increase in demand,
employment and production start to rise, and lenders start to open up their credit coffers.
o The interest rate cycle is closely related to the economic or trade cycle. In theory,
movements in interest rates should mirror the economic cycle.
o If the economy is growing strongly and inflationary pressures increasing – Central Banks will
increase interest rates to slow down the economy and prevent inflation.
o If the economy enters into recession with falling inflation and rising unemployment – Central
Banks will cut interest rates to provide an economic stimulus to try and increase the rate of
economic growth.
CHAPTER 4
The term structure of interest rates, also called the yield curve, is a graph that plots the
yields of similar-quality bonds against their maturity from shortest to longest. (Sa structure of
interest rates ay pinagsasama-sama ang may magkakahalintulad na maturity period at inaalam kung
magkano ang maaring asahan na balik sa atin. Dahil dito ay mas madaling nasusukat ng investors
kung magkano ang maasahan nilang ani at kung mas nababagay na sila ay mag-invest sa short-term
bonds, medium-term bonds, o ‘di kaya’y sa long-term bonds.)
If short term yields are lower than long-term yields, the curve slopes upwards and the curve
is called a positive (or normal) yield curve. Generally, it indicates that investors are requiring
a higher rate of return for taking the added risk of lending money for a long period of time.
Indicates inflation.
If short-term yields are higher than long-term yields, the curve slopes downwards and the
curve is called a negative (or inverted) yields curve. Generally, it indicates that investors are
requiring a higher rate of return for taking the added risk of lending money for a short
period of time. Indicates recession.
If there is little or no variation between short and long-term yield rates, it is a flat term
structure. It generally indicates that investors are unsure about future economic growth.
It Is important that only bonds of similar risk are plotted on the same yield curve. The shape
of the curve changes over time. Investors who are able to predict term structure of interest rates will
change the way they invest accordingly and take advantage of the corresponding changes in bond
prices.
Three central theories that attempt to explain why yield curves are shapes the way they are:
1. Expectation Theory
This theory states that expectations of increasing short-term interest rates are what create a
normal curve (and vice versa). This implies that a long-term bond rate equals the average short-term
rates covering the same investment period. This way, investors view assets of all maturities as
perfect substitute at the same level of default risk, liquidity, information cost and taxation. The
perfect substitutability assumption of the expectation theory implies that expected returns for a
holding period must be the same for bonds of different maturities. Otherwise, investors would
change their relative demand for instruments with different maturities to take advantage of
differences in yields. In addition, the perfect substitutability assumption also implies that the yield
on a long-term bond will equal an average of expected short-term yields over the life of the bond.
(Walang mas pinapaboran ang investors mapa-short-term man ‘yan o long-term bonds ‘yan dahil
inaasahan na parehas lamang ang ani o return na makukuha sa mga ito. Kung hindi ay
magdedemand ang mga investors ng ibang rates dahil na nga walang pagkakaparehas na batayan at
maari nila itong pansamantalahan.)
This theory has combined expectations and segmented markets theories, explain all 3 facts.
Default risk is the possibility than an entity or an individual will be unable to make the
required payments on their debt obligations.
Sovereign Risk
It is the type of default risk associated with the government not being able to meet loan
obligations. When sovereign countries default on their loans, they are not liable to court suits or
bankruptcy courts.
Strategic Default
It is an intended default of a loan. This happens when a borrower can pay a loan, but they
choose not to. This is mostly applied to nonrecourse loans whereby the debtor cannot get any
other claims from the debtor.
Consumer Default
This arises when an individual doesn’t make payments required such as utility payments,
mortgage payments, and consumer credits, etc. This could be the result when an individual
suddenlt failed to make payments due to losing a source of income, when income decreases,
unemployment or even personal issues that may arise at any time. Research also included
factors such as being young, illiteracy, or being too old to defaulting consumer loans. This type of
default often attracts legal litigation cases or even bankruptcy procedures.
Bond Ratings according to the top three rating agencies, Fitch, Standard and Poor’s, and Moody’s
The government has none to very low risk of defaulting its bonds as it could always meet its
nominal obligations by creating money. The Philippines currently has a Baa2 rating under
Moody’s, BBB under Fitch’s, and BBB+ on S&P as of 2019.
Municipalities have defaulted on their bonds in the past and could do so again in the future
because, although they have the power to tax, they do not have the power to create money
at will. Nevertheless, the risk of default on municipal bonds is often quite low.
Corporations are more likely to default on their bonds than governments are because they
must rely on business conditions and management acumen. They have no power to tax and
only a limited ability to create the less-liquid form of money. Some corporations are more
likely to default on their bonds than others.
The Bureau of Internal Revenue (BIR) has clarified the following provisions of Revenue
Regulations No. 14-2012 on the tax treatment of interest income on certain financial instruments:
1. On the tax treatment of interest income from government debt securities (Section 2, RR 14-2012)
Mere issuance of government debt instruments and securities is deemed falling within the coverage
of "deposit substitutes" (regardless of the number of lenders at the time of origination), hence
subject to the 20% final withholding tax (FWT) on interest income. In case of zero-coupon
government debt instruments and securities, the FWT is payable upon original issuance while in case
of interest-bearing government debt instruments and securities, the FWT shall be payable upon
payment of the interest.
2. On the imposition of 20% CWT on interest income from other debt instruments not classified as
"deposit substitutes" (Section 7, RR 14-2012)
Under the new subsection (Y) of Sec, 2.57.2 of RR 2-98, a 20% creditable withholding tax
(CWT) shall be imposed on Interest from all debt instruments, other than from deposit substitutes or
those subject to the 20% final withholding tax. The 20% CWT shall apply to each interest payment to
be made beginning on November 23, 2012 (date of effectivity of RR 14-2012), regardless of when
the instruments or securities were issued. The 20% CWT shall cover all interest income from current
outstanding instruments, securities, or accounts as of November 23, 2012.
3. On the tax treatment of interest income from long-term deposits of domestic and resident
foreign corporations (Section 3(6), RR 14-2012)
Interest income derived by domestic and resident foreign corporations from long-term
deposits not issued by banks or investment certificates that are not considered deposit substitutes
shall be subject to 20% CWT, and reported as part of taxable income of the domestic and resident
foreign corporations subject to 30% regular corporate income tax.
4.4 Marketability
Cost of trade
Physical transfer cost
Search cost
Information cost
The interest rate, or yield, on a security varies inversely with its degree of marketability.
The difference in interest rates or yields between a marketable security and a less
marketable security is known as the marketability risk premium (MRP).
1. Call option
2. Put option
3. Conversion option
Call Option
A call option permits the issuer (borrower) to call (buy back) the bond before maturity at a
predetermined price (call price).
When bonds are called, bondholders (investors) suffer from a financial loss because they are
forced to surrender their high-yielding bonds and reinvest their bonds at the lower prevailing market
rate of interest. Issuers call bond if the interest rates decline.
Callable bonds are sold at a higher market yield than comparable noncallable bonds because
they are to the benefit of the issuer. Bondholder demands a call interest premium (CIP).
CIP is the difference in interest rates between callable bond and a comparable noncallable
bond.
CIP = ic ― inc
wherein:
ic = yield on callable bonds
inc = yield on noncallable bonds
Bonds issued during periods when interest is high are likely to be called when interest rates
decline, and as a result, these bonds have high CIP.
Put Option
A put option permits the bondholder (investor) to sell the bond back to the issuer at a
predetermined price before maturity.
The yield on the putable bond (ip) will be lower than the yield on the non-putable bond (inp)
because they are advantageous to the part of the bondholder.
The difference in interest rates between putable and non-putable bonds is called the put
interest discount (PID).
PID = ip ― inp
wherein:
ip = yield on putable bonds
inp = yield on non-putable bonds
Bondholders are likely to put their bonds during periods of increasing rates
Conversion Option
A conversion option permits the bondholder to convert a bond into another security (usually
to a common stock).
Convertible bonds generally have lower yields (icon) than non-convertible bonds (incon)
because it is advantageous to the part of the bondholder.
The conversion yield discount (CYD) is the difference between the yields on convertible
relative to non-convertibles.
wherein:
icon = yield on convertible bonds
incon = yield on non-convertible bonds
Bondholders tend to use the conversion option when the stock market prices are rising and
bond prices are declining.
Interest rates are used everywhere in the finance and investment industries, from personal
loans and mortgages to bond rates and savings accounts. Almost every type of financial product has
an interest rate associated with it.
1. Nominal rates
2. Real rates
3. Effective rates
Nominal interest rate is the simplest rate to understand. It’s the stated interest rate of the
financial product or loan. The nominal interest is simply the expected amount of interest to be
earned or paid on a financial product. There is no formula to calculate a nominal interest rate; the
rate is chosen by the financial institution.
Real interest rate is more complex than a nominal interest rate. Purchasing power goes
down over time because prices for goods and services rise.
The real interest rate is the actual interest rate you earn or pay after taking the effects of
inflation into account. The simple way to calculate the real interest rate is to take the nominal
interest rate and subtract the inflation rate. The Fisher Effect will further explain about this.
For example, assume an investment offers to pay you 10% interest. This is the nominal rate.
Upon some research, you find that the inflation rate for the year is 2%. Therefore, real interest rate
is 8%.
The effective interest rate is a way to figure out the total amount of money earned or paid,
because it includes the effects of compound interest.
Compounding typically refers to the increasing value of an asset due to the interest earned
on both a principal and accumulated interest. It is the process of an investment’s profits generating
more profits themselves.
The more times per year an investment is compounded, the more money it will make.
For example, an investment that’s compounded annually ends up being worth less money
than an investment that’s compounded quarterly, even if both investments have the same interest
rate.
The Fisher Effect is an economic theory coined by American economist Irving Fisher that
describes the relationship between inflation and both real and nominal interest rates.
It states that:
Therefore, real interest rates fall as inflation increases, unless nominal rates increase at the
same rate as inflation.
Nominal interest rates reflect the financial return an individual gets when he deposits
money.
Unlike nominal interest rate, real interest rate considers purchasing power in the equation.
In the Fisher Effect, the nominal interest rate is the provided actual interest rate that reflects
the monetary growth padded over time to a particular amount of money or currency owed to a
financial lender. Real interest rate is the amount that mirrors the purchasing power of the borrowed
money as it grows over time.
The International Fisher Effect (IFE) states that the difference between the nominal interest
rates in two countries is directly proportional to the changes in their currencies at any given time.
The International Fisher Effect is based on current and future nominal interest rates, and it is
used to predict spot and future currency movements. The IFE is in contrast to other methods that
use pure inflation to predict and understand movements in the exchange rate.
It was designed on the basis that interest rates are independent of other monetary variables
and that it is a strong indicator of how the currency of a specific country is performing. According to
Fisher, changes in inflation do not impact real interest rates, since the real interest rate is simply the
nominal rate minus inflation.
This theory assumes that a country with lower interest rates will see lower levels of inflation,
which will translate to an increase in the real value of the country’s currency in comparison to
another country’s currency. However, when interest rates are high, there will be higher levels of
inflation, which will result the country’s currency to decline.
The Fisher effect describes the relationship between interest rates and the rate of inflation.
It proposes that the nominal interest rate in a country is equal to the real interest rate plus the
inflation rate, which means that the real interest rate is equal to the nominal rate of interest minus
the rate of inflation.
Therefore, any increase in the rate of inflation will result in a proportional increase in the
nominal interest rate, where the real interest rate is constant. The International Fisher expands on
the Fisher Effect theory by suggesting that the estimated appreciation or depreciation of two
countries’ currencies is proportional to the difference in their nominal interest rates. For example, if
the nominal interest rate in the United States is greater than that of the United Kingdom, the
former’s currency should fall by the interest rate differential.
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