What is

Interest?
• Interest is defined as the
cost of using money over time
• Interest represents the time
value of money
Time Value of Money involves two
major concepts:

1. Future Value
2. Present Value
Kinds of Interest
1. Simple Interest
2. Compound Interest
Simple Interest
It is the product of the
principal amount multiplied
by the period's Interest
rate.
Computation:

Principal (Beginning Balance) 10 000

Interest (10 000 x 0.10) 1 000
Future value at the end of year 11 000
Compound Interest
Interest paid on both the principal
and the amount of interest
accumulated in prior periods.
Computation:

Principal (beginning balance) 11 000

Interest for year 2 at 10%
(11,000 x 0.10) 1,100
Future value at the end of year 2 12,100
Simple Interest Compared with
Compound Interest

Simple Interest Compound Interest

• Interest paid or earned on • Interest paid on both the

the initial principal only. Principal and the amount of
interest accumulated in prior
periods.
 SIMPLE INTEREST COMPOUND INTEREST
Beginning simple Ending Beginning Compound Ending Amount
Amount Interest Amount Amount Interest

1 1000 100 1100 1000 100 1100

2 1000 100 1200 1100 110 1210

3 1000 100 1300 1210 121 1331

4 1000 100 1400 1331 133.10 1464

5 1000 100 1500 1464 146.41 1610.51

500 610.51
Time Value
of
Money
Future Value
and
Present Value
Future Value
FV=PV×(1+i)n
Example:
PV= 1000
i= 10%
n= 10
FV=1 000(1+.10)10
=1 000(2.59)
=2 590
Annuity

• Ordinary Annuity
• Annuity Due
Future Value of an ordinary annuity
Other way of solving

(1+i)n -1
FV= PV×
i
Future Value of annuity Due
Other way of solving

(1+i)n -1
FV= PV× 1+i
i
Present Value
FV
PV=
(1+i)n
Example:
FV= 1000
i= 10%
n= 1
PV = 1 000
1

(1+ 0.10)1
= 909.10
Present Value of an ordinary annuity
Present Value of annuity Due
Present Value of a Perpetuity

PV of a = Annuity(A)
perpetuity Discount rate (i)
Example:
Honey Dew Corporation wants to deposit an amount of
money in a bank that will allow it to withdraw 1000
indefinitely at the end of each year without reducing
the amount of the initial deposit. The bank
guarantees to pay the firm 10 percent interest in
each deposit.
A= 1 000
i= 0.10
PV of a 1000
perpetuity = = 10 000
0.10
The rate of interest
Interest rate is a rate of
return paid by a borrower of
funds to a lender of them, or
a price paid by a borrower for
a service, the right to make
use of funds for a specified
period. Thus it is one form of
yield on financial instruments
THEORIES OF DETERMINATION
OF INTEREST RATES

• LIQUIDITY PREFERENCE THEORY

(Keynesian Approach)

• LOANABLE FUND THEORY

(Neo-classical Theory)
LIQUIDITY PREFERENCE THEORY
(Keynesian approach)
Three Types of Demand for Money
• TRANSACTIONARY
(day-to-day transactions)

• PRECAUTIONARY
(unforeseen events)

• SPECULATIVE
LOANABLE FUND THEORY
(neo-classical theory)
• Loanable Funds are the sums of money supplied
and demanded at any time in the market.

Supply for the Loanable funds is constituted by

the savings (S) plus new money (M) resulting from
credit creation by commercial banks.

Demand for Loanable funds is constituted by the

demand for investible fund (I) plus net hoarding
(H).
Demand for Loanable Fund

• Household Demand
• Business Demand
• Government Demand
• Foreign Demand
EQUILIBRIUM INTEREST RATE
Equilibrium Interest Rate
Demand for Funds
DA=Dh+Db+Dg+Dm+Df
where:
Dh = Household demand for loanable fund
Db = Business demand for loanabale fund
Dg= Government demand for loanable fund
Dm= Municipal Demand for loanable fund
Df= Foreign demand for loanable fund
Equilibrium Interest Rate
Supply for Funds
SA=Sh+Sb+Sg+Sm+Sf
where:
Sh = Household supply for loanable fund
Sb = Business supply for loanabale fund
Sg= Government supply for loanable fund
Sm= Municipal supply for loanable fund
Sf= Foreign supply for loanable fund
 FACTORS THAT AFFECT
INTEREST RATE
• Economic Growth
• Inflation
• Monetary Policy
• Budget Dificit
• Foreign Flows of Fund
Forecasting Interest Rate
ND = DA - SA
=(Dh+Db+Dg+Dm+Df)-(Sh+Sb+Sg+Sm+Sf)
Interest Rate
Structure

Prepared by: Iris V. Calma

 Overview
 THE STRUCTURE OF INTEREST RATES
 Three Main Causes of Difference in Interest Rates
 Yield Curve
 Four Characteristics that affect Yields on Debt
Securities
 Yield Differentials
 Estimating the Appropriate Yield
 TERM STRUCTURE OF INTEREST RATES
 Pure Expectation Theory
 Liquidity Premium Theory
 Market Segmentation Theory
 Preferred Habitat Theory
 represents the cost of money. It is the
compensation that a supplier of funds
expects and a demander of funds must pay.
Time Period

Degree of Risk

Transactions Costs
Time Period

The longer the duration of

loans the higher will be the
interest rate and vice versa.
Degree of Risk

The greater the risk, the higher

the interest rate paid upon it as
compensation for the risk.
Transaction Costs

-in addition to the price of

the good
yield

maturity
 Why Debt
Security Yields
vary?
Characteristics that affects yield
on debt securities
CREDIT (default) RISK

LIQUIDITY

TAX STATUS

TERM TO MATURITY
Four Characteristics that affect
Yields on Debt Securities

1. CREDIT (default)
RISK
Four Characteristics that affect
Yields on Debt Securities

CREDIT (default) RISK

Four Characteristics that affect
Yields on Debt Securities

CREDIT (default) Risk

EXAMPLE:
Investors can purchase a Treasury bond with a 10-year maturity that presently offers an
annualized yield of 7 percent if they hold the bond until maturity. Alternatively, investors can
purchase bonds that are being issued by Zanstell Co. Although Zanstell is in good financial
condition, there is a small possibility that it could file for bankruptcy during the next 10 years, in
which case it would discontinue making payments to investors who purchased the bonds. Thus
there is a small possibility that investors could lose most of their investment in these bonds. The
only way in which investors would even consider purchasing bonds issued by Zanstell Co. is if the
annualized yield offered on these bonds is higher than the Treasury bond yield. Zanstell’s bonds
presently offer a yield of 8 percent, which is 1 percent higher than the yield offered on Treasury
bonds. At this yield, some investors are willing to purchase Zanstell’s bonds because they think
Zanstell Co. should have sufficient cash flows to repay its debt over the next 10 years.
Four Characteristics that affect
Yields on Debt Securities

CREDIT (default) RISK

How do Investors
measure the credit risk
of debt securities?
Four Characteristics that affect
Yields on Debt Securities

CREDIT (default) RISK

How do Investors
measure the credit risk
of debt securities?
Four Characteristics that affect
Yields on Debt Securities
CREDIT (default) Risk
RATINGS ASSIGNED BY:
DESCRIPTION OF MOODY’S INVESTOR STANDARD &POOR’S
Creditworthiness
SECURITY SERVICE CORPORATION
An obligor has EXTREMELY STRONG capacity to meet its
Highest Quality Aaa AAA
financial commitments.
An obligor has VERY STRONG capacity to meet its financial
High Quality Aa AA
commitments.
High-Medium An obligor has STRONG capacity to meet its financial
A A
Quality commitments
An obligor has ADEQUATE capacity to meet its financial
Medium Quality Baa BBB
commitments..
An obligor is LESS VULNERABLE in the near term than other
Medium-Low Quality Ba BB
lower-rated obligors.
An obligor is MORE VULNERABLE than the obligors rated 'BB',
Low Quality B B but the obligor currently has the capacity to meet its financial
commitments.
An obligor is CURRENTLY VULNERABLE, and is dependent
Poor Quality Caa CCC upon favorable business, financial, and economic conditions to
meet its financial commitments.
Very Poor Quality Ca CC An obligor is CURRENTLY HIGHLY-VULNERABLE.
Four Characteristics that affect
Yields on Debt Securities
CREDIT (default) Risk
RATINGS ASSIGNED BY:
DESCRIPTION OF MOODY’S INVESTOR STANDARD &POOR’S
Creditworthiness
SECURITY SERVICE CORPORATION
An obligor has EXTREMELY STRONG capacity to meet its
Highest Quality Aaa AAA
financial commitments.
An obligor has VERY STRONG capacity to meet its financial
High Quality Aa AA
commitments.
High-Medium An obligor has STRONG capacity to meet its financial
A A
Quality commitments
An obligor has ADEQUATE capacity to meet its financial
Medium Quality Baa BBB
commitments..
An obligor is LESS VULNERABLE in the near term than other
Medium-Low Quality Ba BB
lower-rated obligors.
An obligor is MORE VULNERABLE than the obligors rated 'BB',
Low Quality B B but the obligor currently has the capacity to meet its financial
commitments.
An obligor is CURRENTLY VULNERABLE, and is dependent
Poor Quality Caa CCC upon favorable business, financial, and economic conditions to
meet its financial commitments.
Very Poor Quality Ca CC An obligor is CURRENTLY HIGHLY-VULNERABLE.
S&P Moody’s Interpretation
AAA Aaa Highest quality (with minimal credit risk)
AA+ Aa1
AA Aa2 High quality (subject to very low credit risk)
AA- Aa3
A+ A1
Upper-medium grade (with low credit risk and
A A2
strong payment capacity)
A- A3
BBB+ Baa1
Investment grade (subject to moderate credit risk and
BBB Baa2
with adequate payment capacity)
BBB- Baa3
BB+ Ba1
Less vulnerable to non-payment (default) but with
BB Ba2
ongoing uncertainty (subject to substantial credit risk)
BB- Ba3
B+ B1
More vulnerable to non-payment
B B2
(with high credit risk)
B- B3
CCC+ Caa1
Currently vulnerable to default
CCC Caa2
(subject to very high credit risk)
CCC- Caa3
Highly speculative (likely in or very near default, with some
CCC Ca
prospect of recovery of principal or interest)
Four Characteristics that affect
Yields on Debt Securities

CREDIT (default) Risk

The ratings issued by the agencies

are OPINIONS, not GUARANTEES
Four Characteristics that affect
Yields on Debt Securities

LIQUIDITY

could easily be
converted to cash
without a loss in
value
Four Characteristics that affect
Yields on Debt Securities

LIQUIDITY

 Securities with less  Investor that need a high degree

liquidity will have to of liquidity prefer liquid securities
offer a higher yield
 Investors who will not need their
 Securities with short funds until the securities mature
term maturity have are more willing to invest with
greater liquidity less liquid
Four Characteristics that affect
Yields on Debt Securities

TAX STATUS
 After-tax income
 Before-tax income
Investor’s
After-tax Yield Marginal Tax Rate

Yat = Ybt (1-T)

Before-tax Yield
Four Characteristics that affect
Yields on Debt Securities

TAX STATUS
Example: Consider a taxable security
that offers a before- tax yield of 8
After-tax Investor’s
percent. When converted into after-tax
Yield Marginal Tax
terms, the yield will be reduced by the Rate
tax percentage. The precise after-tax
yield is dependent on the tax rate T. If Yat = Ybt (1-T)
the tax rate of the investor is 20
percent, then what is the after-tax Before-tax
yield? Yield
Four Characteristics that affect
Yields on Debt Securities

TAX STATUS

After-Tax Yield Based on Various Tax Rates and Before-Tax Yield

BEFORE- TAX YIELD

TAX RATE 6% 8% 10% 12% 14%
10% 5.40% 7.20% 9.00% 10.80% 12.60%
15% 5.10% 6.80% 8.50% 10.20% 11.90%
25% 4.50% 6.00% 7.50% 9.00% 10.50%
28% 4.32% 5.76% 7.20% 8.64% 10.08%
35% 3.90% 5.20% 6.50% 7.80% 9.10%
Four Characteristics that affect
Yields on Debt Securities

TAX STATUS
Computing the Equivalent
Before- Tax Yield

Yat After-tax
Ybt = Yield
1-T
Before-tax Investor’s Marginal
Yield Tax Rate
Four Characteristics that affect
Yields on Debt Securities

TAX STATUS
Example: After-tax
Suppose that a firm in the Yield
20 percent tax bracket is aware Yat
of a txt-exempt security that is Ybt =
1-T
paying a yield of 8 percent. To
match this after tax- yield, Before-tax
Yield
taxable securities must offer a Investor’s Marginal
before-tax yield of? Tax Rate
Four Characteristics that affect
Yields on Debt Securities

TERM TO MATURITY

a fixed or limited
period for which
something lasts or is
intended to last.
YIELD DIFFERENTIALS
Yield Differentials of
Money Market Securities
although these yields are quite valuable from year to
year, their differences to not change much over time. The
difference between yield on T-bills and commercial paper
is higher during recession periods because the credit risk
is higher then.
Yield Differentials of
Capital Market Securities
municipal bonds have the lowest before-tax yield. T-bills
are expected to offer the lower yield because they are
credit risk free and very liquid. Investors prefer municipal
or corporate bonds over T-bills only if the after-tax yield
is sufficiently higher as compensate for credit risk and a
low liquidity.
ESTIMATING THE APPROPRIATE
YIELD
 FORWARD RATE

= RLP TA

Y = yield of an n-day debt security

R = yield (return) of an n-day Treasury (risk-free) security
DP = default premium to compensate for credit risk
LP = liquidity premium to compensate for less liquidity
TA = adjustment due to the differences in tax status
 EXAMPLES

Suppose that the three-month t-bills annualized rate is 8%,

and that Elizabeth Company plans to issue 90-day
commercial paper. Assume Elizabeth Company believes that
an 0.7% default risk premium, 0.2% liquidity premium, and
an 0.3% tax adjustment are necessary to sell its commercial
paper to investor. The appropriate yield to be offered on the
commercial paper is?
 ANSWER

COMMERCIAL PAPER YIELD

= RLP TA
=8%0.2% 0.3%
=9.2%
 EXAMPLES

If the default risk premium decreases from 0.7% to 0.5% but

R increases from 8% to 8.7%, the appropriate yield to be
offered on commercial paper (assuming no change in the
previously assumed liquidity and tax adjustment premium)
would be?
 ANSWER:

= RLP TA
=8.7%0.2% 0.3%
=9.7%
A CLOSER LOOK AT THE
TERM STRUCTURE

S
1. PURE EXPECTATION THEORY
2. LIQUIDITY PREMIUM THEORY
3. SEGMENTED MARKETS THEORY
4. PREFERRED HABITAT THEORY
 PURE EXPECTATION THEORY

 Also known as EXPECTATION THEORY

 According to this theory, the term structure of interest

rates is determined solely by expectations of interest
rate.
 Unbiased expectation theory
 FORWARD INTEREST RATE

 Interest rate that will take place in

the future.
 Make investment and financing
decisions
 RELATIONSHIP OF FORWARD
INTEREST RATE AND YIELD CURVE

STRUCTURE OF YIELD EXPECTATION ABOUT THE

SCENARIO CURVE FUTURE INTEREST RATE

t+1r1 > ti1 Upward slope Higher than today’s rate

t+1r1 = ti1 Flat Same as today’s rate

t+1r1 < ti1 Downward slope Lower than today’s rate

 (1 +ti2)2 = (1 +ti1) (1 +t+1r1)
Where:

ti2 = known annualized rate of a two-year security as of time t

ti1 = known annualized interest rate of a one-year as of time t

t+1r1 = one-year interest rate that is anticipated as of time t+1 (one-year ahead)
 r
t+1 1 = (1+ i
t 2) 2 / (1+ i ) - 1
t 1

Assume that, as of today (time t), the annualized two-year interest

rate is 10% and the one-year interest rate is 8%. The forward rate is
then estimated as?

t+1r1 = (1+0.10)2 / (1+0.08) -1

t+1r1 = 0.1203704

t+1r1 = 12.04%
 (1+ti3)3 = (1+ti1) (1+t+1r1) (1+t+2r1)

Where:

ti3 = annualized interest rate on a three-year security as of time

t+2r1 = one-year interest that it anticipate as of time + 2 (two years)

 r
t+2 1 = (1+ i
t 3 )3 / (1+ i )(1+ r ) - 1
t 1 t+1 1

Assume that a three-year security has an annualized interest rate of 11%.

Given the previous calculation, the one-year forward rate two years from
now can be?

r
t+2 1 = (1+0.11)3 / (1+0.08)(1+0.12037) -1

t+2r1 = 1.367631 / 1.21 -1

t+2r1 = 13.02736%
 (1 + t+1i3)3 = (1+ti1)(1+t+1r2)2

(1+t+1r2)2 = (1+ti3)3 / 1+ti1

Recall that today’s annualized yields for one-year and three year securities are 8%
and 11% respectively. With this information (1 +t+1r2)2 is estimated as?

(1+t+1r2)2 = (1+0.11)3 / 1+0.08

(1+t+1r2)2 = 1.266325
(1+t+1r2)2 = √1.266325
(1+t+1r2)2 = 1.1253

t+1r2 = 0.1253 or 12.53%

 LIQUIDITY PREMIUM THEORY

 Alsoknown as LIQUIDITY PREFERENCE

THEORY.
 Some investors may prefer to own shorter rather than
longer term securities because a shorter maturity
represents greater liquidity.
 Liquidity premium is a premium demanded by investors when any given
security cannot be easily converted into cash for its fair market value.
ESTIMATION OF FR BASED ON A
LIQUIDITY PREMIUM
(1 +ti2)2 = (1 +ti1) (1 +t+1r1) + LP2
Reconsider the example where i1 = 8% and i2 = 10%, and assume that the
liquidity premium on a two-year security is 0.5%. The one-year forward
rate can be?
 SEGMENTED MARKET THEORY

S This theory states that the market for different-

maturity bonds is completely separate and
segmented.

S Two sectors – government bonds and corporate bonds

S Two maturities – short-term and long-term
 MARKET SEGMENTED

DEMAND SUPPLY
S The demand for short-term(LT) S The supply of Treasury
bonds in one sector is inversely
related to the demand in another Bonds depends only on
sector (Corp vs. Gov’t)but is not government actions
related to demand for the long-
term(ST) bonds in either sector.
 PREFERRED HABITAT THEORY

 Flexible variant of segmented market theory

 Although investors and borrowers may normally

concentrate on a particular maturity market, certain
events may cause them to wander from their natural
market.
 INTEGRATING THE THEORIES OF
TERM STRUCTURE

1. Investors and borrowers who select security maturities based on

anticipated interest rate movements currently expect interest rates
to rise. (E)
2. Most borrowers are in need of long-term funds, while most
investors have only short-term funds to invest (E+S)
3. Investors prefer more liquidity to less. (E+S+L)
USE OF TERM STRUCTURE

1. FORECASTING INTEREST RATE

2. FORECASTING RECESSIONS

3. MAKING INVESTMENT DECISION

4. MAKING DECISION ABOUT FINANCING

WHY THE SLOPE OF YIELD CURVE
CHANGES?
RISK AND
RETURN
OVERVIEW

 RISK AND RETURN FUNDAMENTALS

 RISK DEFINED
 RETURN DEFINED
 RISK PREFERENCES
 RISK OF A SINGLE ASSET
 RISK ASSESSMENT
 RISK MEASUREMENT
 RISK OF A PORTFOLIO
 PORTFOLIO RETURN
 CORRELATION
 DIVERSIFICATION
 THE CAPITAL ASSET PRICING MODEL (CAPM)
 INTEREST RATE FUNDAMENTALS
 NOMINAL RATE
 REAL RATE
 RISK PREMIUMS 102
• IS THE CHANCE OF FINANCIAL LOSS

103
 RETURN

◉ IS THE TOTAL GAIN OR LOSS

EXPERIENCED ON AN INVESTMENT OVER
A GIVEN PERIOD OF TIME

104
 The expression for calculating the rate of return
earned on any asset over period
is commonly defined as:

105
 Robin’s Gameroom, a high-traffic video arcade, wishes to
determine the return on two of its video machines, Conqueror and
Demolition.
 Conqueror was purchased 1 year ago for P20,000 and currently has
a market value of P21,500. During the year, it generated P800 of
after-tax cash receipts.
 Demolition was purchased 4 years ago; its value in the year just
completed declined from P12,000 to P11,800. During the year, it
generated P1,700 of after-tax cash receipts.

106
Risk Preferences

107
1. Risk-indifferent - the attitude toward risk
in which no change in return would be
required for an increase in risk

 this attitude is nonsensical in almost any

business context.

108
2. Risk-averse - the attitude toward risk in which
an increased return would be required for an
increase in risk

109
3. Risk-seeking - the attitude toward risk in
which a decreased would be accepted for
an increase in risk

 such behavior would not be likely to

benefit the firm.

110
 Risk Assessment

Sensitivity analysis and Probability

distributions can be used to assess the
general level of risk embodied in a given
asset.

111
 Sensitivity analysis
◉ An approach for assessing risk that uses several
possible-return estimates to obtain a sense of
the variability among outcomes.

112
◉ Sensitivity analysis uses several possible-return
estimates to obtain a sense of the variability
among outcomes. One common method
involves making pessimistic (worst), most likely
(expected), and optimistic (best) estimates of
the returns associated with a given asset.

113
◉ In this case, the asset’s risk can be
measured by the range of returns.

◉ Range is found by subtracting the

pessimistic outcome from the optimistic
outcome. The greater the range, the
more variability, or risk, the asset is said
to have.

114
 Norman Company, a custom golf equipment manufacturer, wants to
choose the better of two investments, A and B.

 Each requires an initial outlay of P10,000, and each has a

. Asset A has a Pessimistic of 13% and
Optimistic of 17%, while Asset B has a Pessimistic of 7% and Optimistic of
23%

 Management has made pessimistic and optimistic estimates of the returns

associated with each

115
 Probability Distributions

◉ A model that relates probabilities to the

associated outcomes.
◉ The simplest type of probability
distribution is the bar chart, which shows
only a limited number of outcome–
probability coordinates

116
 Norman Company’s past estimates indicate that the probabilities
of the pessimistic, most likely, and optimistic outcomes are 25%,
50%, and 25%, respectively.

117
Continuous probability distribution - A probability
distribution showing all the possible outcomes and
associated probabilities for a given event.

118
Bar charts for asset A’s and asset B’s returns

119
 Risk Measurement
• the risk of an asset can be measured
quantitatively by using statistics.

• Two statistics: the standard deviation and

coefficient of variation

120
 Standard Deviation
◉ The most common statistical indicator of an asset’s risk

◉ which measures the dispersion around the expected value.

The expected value of a return, ,is the most likely return on
______

an asset. k

121
122
123
124
125
126
127
 Coefficient of Variation
◉ The coefficient of variation, CV, is
a measure of relative dispersion
that is useful in comparing the
risks of assets with differing
expected returns.

128
 A firm wants to select the less risky of two alternative assets—X
and Y. The expected return, standard deviation, and coefficient of
variation for each of these assets’ returns are

129
1. RISK OF A PORTFOLIO
 Portfolio return
 Correlation
 Diversification
2. CAPITAL ASSET PRICING MODEL (CAPM)
3. INTEREST RATE FUNDAMENTALS
 Nominal Rate
 Real Rate
4. RISK PREMIUMS
PORTFOLIO RISK

Portfolio risk is a chance that the combination of assets, within the investments
that you own, fail to meet financial objectives.

Risk can only be minimized and not eliminated.

You must monitor your portfolio risk to make sure you have a variety of
investments whose high and low risks offset each other.
CORRELATION

Correlation is a statistical measure of the relationship between any two series

of numbers.

If two series move in the same direction, they are positively correlated. If the
series move in opposite directions, they are negatively correlated.

We can measure correlation with correlation coefficient.

DIVERSIFICATION

“Not putting all your eggs in one basket”

To reduce overall risk, it is best to combine, or add to the

portfolio, assets that have a negative (or a low positive)
correlation.
1. RISK OF A PORTFOLIO
 Portfolio return
 Correlation
 Diversification
2. CAPITAL ASSET PRICING MODEL (CAPM)

3. INTEREST RATE FUNDAMENTALS

 Nominal Rate
 Real Rate
4. RISK PREMIUMS
CAPITAL ASSET PRICING MODEL (CAPM)

Model that deals with how asset is priced.

Helps investors measure the risk and the expected return of an

investment to appropriately price the asset.
 FORMULA:
If the stock's beta is 2.0, the risk-free rate
Ra=Rrf+βa∗(Rm−Rrf)
is 3%, and the market rate of return is 7%,
the market's excess return is 4% (7% -
where:
3%). Accordingly, the stock's excess return
Ra=Expected return on a security
is 8% (2 x 4%, multiplying market return by
Rrf=Risk free rate
the beta), and the stock's total required
Rm=Expected return of the market
return is 11% (8% + 3%, the stock's excess
βa=The beta of the security
return plus the risk-free rate).
(Rm−Rrf)=Equity market premium
1. RISK OF A PORTFOLIO
 Portfolio return
 Correlation
 Diversification
 2. CAPITAL ASSET PRICING MODEL (CAPM)

3. INTEREST RATE FUNDAMENTALS

 Nominal Rate
 Real Rate
4. RISK PREMIUMS
139
REAL RATE

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.

NOMINAL RATE

The actual rate of interest charged by the supplier of funds and paid by
the demander.
1. RISK OF A PORTFOLIO
 Portfolio return
 Correlation
 Diversification
 2. CAPITAL ASSET PRICING MODEL (CAPM)

3. INTEREST RATE FUNDAMENTALS

 Nominal Rate
 Real Rate
4. RISK PREMIUMS
141
RISK PREMIUM
Minimum amount of money by which the expected return on a risky
asset must exceed the known return on a risk free asset in order to
induce an individual to hold the risky asset rather than the risk-free
asset.
MONEY
MARKET
 MONEY MARKETS

◉ Used to facilitate the transfer of short-term funds from individuals, corporations,

or governments with excess funds to those with deficient funds.
◉ Money market securities – are debt securities with a maturity of one year or less.
◉ Money market securities are issued in the primary market through
telecommunications network by the treasury, corporations and financial
intermediaries that wish to obtain short-term financing.
 MOST POPULAR MONEY MARKET
SECURITIES

1. Treasury Bills (T-bills)

2. Commercial Paper
3. Negotiable Certificates of Deposit
4. Repurchase Agreements
5. Federal Funds
6. Banker’s acceptances
 TREASURY BILLS

◉ Are short-term money market instruments issued by government and backed by

it.
◉ Typical life to maturity of the securities is from 4 weeks to 12 months.
◉ They are sold at a discount from par value, and the gain to the investor holding a
T-bill until maturity is the difference between par value and the price paid.
◉ T-bills are attractive to investors because they are backed by the federal
government and are therefore virtually free of credit (default) risk.
 PRICING TREASURY BILLS
◉ If investors require a 7 percent annualized
return on a one-year T-bill with a $10,000 par
value, the price that they are willing to pay is
P = $10,000/1.07
P = $9,345.79
◉ If investor require a 6 percent annualized return
on a six-month T-bill, the price that they are
willing to pay for a T-bill with a par value of
$10,000 is therefore
P = $10,000/ 1.03
P = $9,708.74
 Treasury Bill Auction
◉ Primary T-bill market is an auction.

◉ NONCOMPETITIVE BIDDERS – specifies only

the amount of the security that the bidder wants to
buy, without providing the price, and automatically
pay the defined price.

◉ COMPETITIVE BIDDERS – specifies both the

amount of the security that the bidder wants to
buy as well as the price the bidder wants to pay.
 ESTIMATING THE YIELD

SP = Selling price
PP = Purchasing Price
n = number of days of the investment (holding period)
◉ An investor purchases a T-bill with a six-month
(182-day) maturity and $10,000 par value for
$9,600. If this T-bill is held to maturity, its yield
is

◉ Suppose the investor plans to sell the T-bill after

120 days and forecasts a selling price of
$9,820 at that time. The expected annualized
yield based on this forecast is
ESTIMATING THE TREASURY BILL DISCOUNT

Using the information from the previous example,

the T-bill discount is
 COMMERCIAL PAPER
◉ Is a short-term debt instrument issued only by
well-known, credit worthy firms and is typically
unsecured.
◉ It is normally issued to provide liquidity or to
finance a firm’s investment. (inventory and accounts
receivable)
◉ Maturities are normally between 20 and 45 days
but can be as short as 1 day or as long as 270
days.
◉ Money market fund can invest only in commercial
paper that has top-tier and second-tier rating.
◉ Junk Commercial Paper
◉ Some COMMERCIAL PAPER is backed by assets
ESTIMATING THE YIELD of
COMMERCIAL PAPER
◉ If an investor purchases 30-day commercial
paper with a par value of $1,000,000 for a price
of $990,000 the yield is?

◉ Consider the case of a firm that plans to issue

90-day commercial paper with par value of
$5,000,000. It expect to sell the commercial
paper for $4,850,000. The yield it expects to
pay investors is therefore estimated to be
Certificates of
Deposit

Prepared by: Iris V. Calma

 kinds of certificate of depositS

•TRADITIONAL
•CALLABLE

•ZERO-COUPON

•LIQUID
Negotiable Certificates of
deposit
◉ -are certificates issued by large commercial
banks and other depository institutions as a
short-term source of funds.

• PLACEMENT
• PREMIUM
• YIELD
 Annual yield

◉ 𝒀𝒏𝒄𝒅 =
𝑺𝑷−𝑷𝑷+𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕
𝑷𝑷
Where in:

SP- Selling Price

PP- Purchase Price
Annual yield
𝑺𝑷−𝑷𝑷+𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕
◉ 𝒀𝒏𝒄𝒅 = 𝑷𝑷

EXAMPLE
An investor purchased an NCD a year ago in
the secondary market for P970,000. He redeems it
today upon maturity and receives P1,000,000. He
also receives interest of P40,000.
EXAMPLE
An investor purchased an NCD a year ago in
the secondary market for P970,000. He redeems it
today upon maturity and receives P1,000,000. He
also receives interest of P40,000.

𝑺𝑷−𝑷𝑷+𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕
◉ 𝒀𝒏𝒄𝒅 = 𝑷𝑷

𝟏,𝟎𝟎𝟎,𝟎𝟎𝟎−𝟗𝟕𝟎,𝟎𝟎𝟎+𝟒𝟎,𝟎𝟎𝟎
𝒀𝒏𝒄𝒅 = 𝟗𝟕𝟎,𝟎𝟎𝟎

𝒀𝒏𝒄𝒅 = 7.22%
 Repurchase
Agreement (REPO)

Prepared by: Iris V. Calma

 Repurchase agreement

◉ -is an agreement to buy any securities from a

seller with the agreement that they will be
repurchased at some specified date and price in
the future.
REVERSE REPO
-a reverse REPO transaction is a purchase of
securities by one party from another with the
agreement to sell them.
 Repurchase agreement
◉ -is an agreement to buy any securities from a
seller with the agreement that they will be
repurchased at some specified date and price in
the future.

• PLACEMENT
• IMPACT OF THE CREDIT
CRISIS
• ESTIMATING THE YIELD
 Repo rate

𝑺𝑷−𝑷𝑷 𝟑𝟔𝟎
◉ X
𝑷𝑷 𝒏

Where in:

SP- Selling price

PP- Purchase price
n- term
 Repo rate

𝑺𝑷−𝑷𝑷 𝟑𝟔𝟎
◉ X
𝑷𝑷 𝒏

Example:
An investor initially purchased securities at a
price of P9,852,271 while agreeing to sell them
back at a price of P10,000,000 at the end of a
60-day period.
Example:
An investor initially purchased securities
at a price of P9,852,217 while agreeing to sell them
back at a price of P10,000,000 at the end of a 60-
day period.
𝑺𝑷−𝑷𝑷
◉ REPO RATE= X
𝑷𝑷
𝟑𝟔𝟎 𝟏𝟎,𝟎𝟎𝟎,𝟎𝟎𝟎−𝟗,𝟖𝟓𝟐,𝟐𝟏𝟕
REPO𝒏RATE= X
𝟗,𝟖𝟓𝟐,𝟐𝟏𝟕
𝟑𝟔𝟎
REPO
𝟔𝟎
RATE= 9
%
1. International use of money market
2. Interest rate risk
COMMONLY ISSUED MONEY MARKET
SECURITIES
SECURITIES ISSUED BY COMMON INVESTORS COMMON MATURITIES SECONDARY MARKET
ACTIVITY
Treasury bills Federal government Households, firms and 13 weeks, 26 weeks, 1 High
financial institutions year
Negotiable COD Large banks and Firms 2 weeks to 1 year Moderate
financial institutions
Commercial paper Bank holding Firms 1 day to 270 days Low
companies, finance
companies and other
companies
Banker’s acceptances Banks Firms 30 days to 270 days High
Federal funds Depository institutions Depository institutions 1 day to 7 days Nonexistent
Repurchase Firms and financial Firms and financial 1 day to 15 days Nonexistent
agreements institutions institutions
MONEY MARKET SECURITIES USED TO ENHANCE LIQUIDITY in two
ways:

1. Newly issued securities generate cash.

2. Institutions that previously purchased money market
securities will generate cash upon liquidation of securities.
INTEREST RATE RISK cccccc

FORMULA: (Original price – New Price) / New Price