Chapter 4: Understanding Interest Rates Importance of interest rates. Measuring Interest Rates Types of credit instruments (loans and bonds):
Periodic Payment at payments maturity Simple loan No Principal+interest Fixed payment loan Yes Periodic payment Coupon bond Yes Periodic payment +face value Discount bond No Face value Type Examples Commercial loan Car loan, mortgage Treasury bonds, Corporate bonds U.S. T-bills
The simple interest rate: no periodic payments. How to calculate interest rates with periodic payments? Present value.
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Yield to maturity: Interest rate that equates today's value with sum of present values of all future payments.
Consol: Fixed coupon payments forever. Current Yield:
A better approximation to yield to maturity the longer is the maturity.
A negative relation between interest rate and price of a bond. The Distinction Between Interest Rates and Returns
Capital gain.
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Rate of capital gain. Return. Rate of return.
Rate of return on a coupon bond. Relationship Between Interest Rates and Returns: 1. Return = interest rate only if don’t sell. 2. An interest rate increase reduces price: Capital loss. 3. The longer is the maturity, the greater is
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the price change associated with interest rate change. 4. A bond with a high initial interest rate can still have a negative return if the interest rate increases.
Interest rate risk.
The Distinction Between Real and Nominal Interest Rates Ex-Post Real interest rate: Interest rate that is adjusted for actual changes in the price level. Ex-Ante Real interest rate: Interest rate that is adjusted for expected changes in the price level.
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Fisher Equation. The real interest rate reflects more accurately the cost of borrowing.
When the real interest rate is low, there are greater incentives to borrow and less to lend.
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