CUCEA

Departamento de Economa

INTEREST RATES

Mishkin Cap. 4

Mercado
de
Capitales
D R . I SAI G UIZAR

1. Different debt instruments have very different streams of cash

payments to the holder (known as cash flows), with very different
timing.
2. In order to compare the value of one kind of instrument with
another we use the concept of present value
3. Present value analysis (analysis of the amount and timing of a debt
instruments cash flows) leads to the yield to maturity or interest
rate of debt instruments

There are four basic types of credit instruments which

incorporate present value concepts:

1. Simple Loan
2. Fixed Payment Loan
3. Coupon Bond
4. Discount Bond

1. Simple Loan
The loan must be paid at maturity along with an additional payment
for the interest
2. Fixed Payment Loan
The loan is repaid by making the same payment every period,
consisting of part of the principal and the interest and interest for a set
number of years
3. Coupon Bond
Pays the owner of the bond a fixed interest payment (at coupon rate)
every year until maturity date, when an specified final amount (face
value or par value) is repaid
4. Discount Bond (zero-coupon bond)
It is bought at a price its face value (at a discount) and the face value is
paid at maturity date
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Yield to Maturity:
Interest rate that equates todays value with present value of all future
payments

Simple Loan:
The simple interest rate equals the yield to maturity.
Example:

Yield to Maturity:
Interest rate that equates todays value with present value of all future
payments

Fixed Payment Loan:

Example:

Yield to Maturity:
Interest rate that equates todays value with present value of all future
payments

Coupon Bond:

Example:

The perpetuity bond is a special case of a coupon bond, with no

maturity date and no repayment of principal

Coupon Bond:

Yields to Maturity on a 10% Coupon Rate Bond Maturing in

10 Years (Face Value = $1,000)

Note:
When bond is at par, yield equals coupon rate
Price and yield are negatively related
Yield greater than coupon rate when bond price
is below par value

Yield to Maturity:
Interest rate that equates todays value with present value of all future
payments

Discount bond
Similar to a simple bond
Example:

A treasury bill pays a face value of $1,00 in one years time.

If the current purchase price is $900, the yield to maturity is:

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Annual Percentage Rate:

The APR is the annual percentage rate of return (annualized) that
equates expected total payments with the amount of the loan.
Example:

A bank offers a $4,000 loan, which must be paid off in twelve

equal monthly installments of $370. The APR, 12*r, is such that

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Annual Percentage Rate:

In order to purchase a new car Juan can take a loan from Banamex for
$800,000, which should be repaid in 5 years at fixed monthly
installments. The bank charges him an opening fee of $50,000. Find
the annual percentage rate on this loan?

Banorte offers the same loan to him with no opening fee, instead, the
loan policy includes a fixed monthly payment of $1000. If Juan will
make a decision only based on APRs, should it borrow from banamex
or banorte?

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Nominal vs Real Interest Rates:

Interest rate that is adjusted for expected changes in the price level
i=r+
Real interest rate more accurately reflects true cost of borrowing
When the real rate is low, there are greater incentives to borrow and
less to lend

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Interest vs Returns
The rate of return is defined as the payments to the
owner plus the change in its value

Example:

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