03_INTERESTE RATES

PartTwoFundamentalsofFinancialMarketsChapter3UnderstandingInterestRatesOutlines•MeasuringInterestRates–PresentValue–YieldtoMaturity•OtherMeasuresofInterestRates•TheDistinctionBetweenRealandNominalInterestRates•TheDistinctionBetweenInterestRatesandReturns–MaturityandtheVolatilityofBondReturns:Interest-RateRisk•ThePracticingFinancialInstitutionManager:CalculatingDurationtoMeasureInterest-RateRisk–CalculatingDuration–DurationandInterest-RateRiskChapterPreview•Interestratesareamongthemostcloselywatchedvariablesintheeconomy.•yieldtomaturity(YTM)isthemostaccuratemeasureofinterestrates.Copyright©2009PearsonPrenticeHall.Allrightsreserved.3-4ChapterPreview•So,inthischapter,wewilldevelopabetterunderstandingofinterestrates.Weexaminetheterminologyandcalculationofvariousrates,andweshowtheimportanceoftheseratesinourlivesandthegeneraleconomy.Topicsinclude:–MeasuringInterestRates–TheDistinctionBetweenRealandNominalInterestRates–TheDistinctionBetweenInterestRatesandReturnsCopyright©2009PearsonPrenticeHall.Allrightsreserved.3-5FourTypesofCreditInstruments1.SimpleLoan•principal+interest,maturity•Commercialloan2.FixedPaymentLoan•Samepaymenteverymonth•Mortgages,installmentloans3.CouponBond•Couponpayment•Facevalueorparvalue•Issuer,maturity,couponrate•Treasurybonds,corporatebonds4.DiscountBond•Pricebelowfacevalue•Repaidfacevalue•NointerestpaymentOnlyatmaturitydatesperiodicallyPresentValueConcept:SimpleLoanTerms•LoanPrincipal:theamountoffundsthelenderprovidestotheborrower.•MaturityDate:thedatetheloanmustberepaid;theLoanTermisfrominitiationtomaturitydate.•InterestPayment:thecashamountthattheborrowermustpaythelenderfortheuseoftheloanprincipal.•SimpleInterestRate:theinterestpaymentdividedbytheloanprincipal;thepercentageofprincipalthatmustbepaidasinteresttothelender.Conventionistoexpressonanannualbasis,irrespectiveoftheloanterm.Copyright©2009PearsonPrenticeHall.Allrightsreserved.3-7PresentValueIntroduction•Differentdebtinstrumentshaveverydifferentstreamsofcashpaymentstotheholder(knownascashflows),withverydifferenttiming.•Allelsebeingequal,debtinstrumentsareevaluatedagainstoneanotherbasedontheamountofeachcashflowandthetimingofeachcashflow.•Thisevaluation,wheretheanalysisoftheamountandtimingofadebtinstrument’scashflowsleadtoitsyieldtomaturityorinterestrate,iscalledpresentvalueanalysis.Copyright©2009PearsonPrenticeHall.Allrightsreserved.3-8PresentValue•Theconceptofpresentvalue(orpresentdiscountedvalue)isbasedonthecommonsensenotionthatadollarofcashflowpaidtoyouoneyearfromnowislessvaluabletoyouthanadollarpaidtoyoutoday.Thisnotionistruebecauseyoucouldinvestthedollarinasavingsaccountthatearnsinterestandhavemorethanadollarinoneyear.•Thetermpresentvalue(PV)canbeextendedtomeanthePVofasinglecashfloworthesumofasequenceorgroupofcashflows.Copyright©2009PearsonPrenticeHall.Allrightsreserved.3-9PresentValueConcept:SimpleLoanCopyright©2009PearsonPrenticeHall.Allrightsreserved.3-10Simpleloanof$100Year:0123n$100$110$121$133100(1+i)nPVoffuture$1=$11+inPresentValueofCashFlows:ExampleYieldtoMaturity:Loans•Yieldtomaturity=interestratethatequatestoday'svaluewithpresentvalueofallfuturepayments1.SimpleLoanCopyright©2009PearsonPrenticeHall.Allrightsreserved.3-12$100$1101ii$110$100$100$10$100.1010%YieldtoMaturity:Loans2.FixedPaymentLoan(i=12%)Copyright©2009PearsonPrenticeHall.Allrightsreserved.3-13$1000$1261i$1261i2$1261i3...$1261i25LVFP1iFP1i2FP1i3...FP1inYieldtoMaturity:Bonds3.CouponBond(Couponrate=10%=C/F)Copyright©2009PearsonPrenticeHall.Allrightsreserved.3-14P$1001i$1001i2$1001i3...$1001i10$10001i10PC1iC1i2C1i3...C1inF1inFixedcouponpaymentsof$Cforever，perpetuitybondPCiiCPRelationshipBetweenPriceandYieldtoMaturity•ThreeinterestingfactsinTable3-11.Whenbondisatpar,yieldequalscouponrate2.Priceandyieldarenegativelyrelated3.YieldgreaterthancouponratewhenbondpriceisbelowparvalueCopyright©2009PearsonPrenticeHall.Allrightsreserved.3-15YieldtoMaturity:Bonds4.One-YearDiscountBond(P=$900,F=$1000)Copyright©2009PearsonPrenticeHall.Allrightsreserved.3-16$900$10001ii$1000$900$900.11111.1%iFPPGlobalperspective•InNovember1998,ratesonJapanese6-monthgovernmentbondswerenegative!Investorswerewillingtopaymorethantheywouldreceiveinthefuture.•Bestexplanationisthatinvestorsfoundtheconvenienceofthebillsworthsomething–moreconvenientthancash.Butthatcanonlygosofar–theratewasonlyslightlynegative.Copyright©2009PearsonPrenticeHall.Allrightsreserved.3-17Calculation1•WhatistheYTMonabondthathasapriceof$2000andpays$100annuallyfor10years?PC1iC1i2C1i3...C1inF1inOtherMeasuresofInterestRatesCurrentYield•Currentyield(CY)isjustanapproximationforYTM–easiertocalculate.However,weshouldbeawareofitsproperties:1.Ifabond’spriceisnearparandhasalongmaturity,thenCYisagoodapproximation.2.AchangeinthecurrentyieldalwayssignalschangeinsamedirectionasyieldtomaturityCopyright©2009PearsonPrenticeHall.Allrightsreserved.3-19icCPBondPageoftheNewspaperCalculation2•WhatistheYTMonadiscountbondthathas