The Meaning of
Interest Rates
Preview
Before we can go on with the study of
money, banking, and financial markets, we
must understand exactly what the phrase
interest rates means. In this chapter, we
see that a concept known as the yield to
maturity is the most accurate measure of
interest rate.
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Amount
$10,000.00
Interest Rate
Payment
$443.21
6.00%
Months
24
Interest
Principal
Beginning Balance
$10,000.00
1
$50.00
$393.21
$9,606.79
$48.03
$395.18
$9,211.61
$46.06
$397.15
$8,814.46
$44.07
$399.14
$8,415.32
$42.08
$401.13
$8,014.19
$40.07
$403.14
$7,611.05
$38.06
$405.15
$7,205.90
$36.03
$407.18
$6,798.72
$33.99
$409.22
$6,389.50
10
$31.95
$411.26
$5,978.24
11
$29.89
$413.32
$5,564.92
12
$27.82
$415.39
$5,149.53
13
$25.75
$417.46
$4,732.07
14
$23.66
$419.55
$4,312.52
15
$21.56
$421.65
$3,890.87
16
$19.45
$423.76
$3,467.12
17
$17.34
$425.87
$3,041.24
18
$15.21
$428.00
$2,613.24
19
$13.07
$430.14
$2,183.10
20
$10.92
$432.29
$1,750.80
21
$8.75
$434.46
$1,316.35
22
$6.58
$436.63
$879.72
23
$4.40
$438.81
$440.91
24
$2.20
$440.91
$-
$636.94
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Some definitions
Maturity Date the date a bond matures, or
in other words, redeemed.
Face Value the stated amount of a bond,
or what the issuer will pay the holder at the
bonds maturity. E.g., a bond with a FV of
$20,000.00 will pay the holder $20,000.00
at its maturity.
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Some definitions
Coupon rate (CPN) - the interest rate paid
on the FV of a bond, expressed on an annual
basis. E.g., a bond with a FV of $10,000.00
and coupon rate of 4% will pay the bond
holder $400.00 annually in interest.
Price the current market price of a bond,
expressed in $ per hundred.
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Some Definitions
Market Value (MV) (or Total Value) of a bond
its Face Value multiplied by its Price.
Discount if the MV of a bond purchased, or
trading at, is below its Face Value, it is
selling at a discount.
Premium - if the MV of a bond purchased, or
trading at, is above its Face Value, it is
selling at a premium.
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Some definitions
Par the bond is selling for its Face Value
CUSIP number Committee on Uniform
Security Identification Procedures.
All securities have a CUSIP number, but a
stock is typically identified by its ticker
symbol (E.g., Trustmarks is TRMK)
Everything other than stocks are identified
by their CUSIP number.
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Yield to Maturity
Yield to maturity: the interest rate that
equates the present value of cash flow
payments received from a debt instrument
with its value today
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Coupon Bond
When the coupon bond is priced at its face value,
the yield to maturity equals the coupon rate.
The price of a coupon bond and the yield to
maturity are negatively related.
The yield to maturity is greater than the coupon
rate when the bond price is below its face value.
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Sources: Nominal rates from Federal Reserve Bank of St. Louis FRED database: http://research.stlouisfed.org/fred2/. The real rate is
constructed using the procedure outlined in Frederic S. Mishkin, The Real Interest Rate: An Empirical Investigation, CarnegieRochester Conference Series on Public Policy 15 (1981): 151200. This procedure involves estimating expected inflation as a function
of past interest rates, inflation, and time trends, and then subtracting the expected inflation measure from the nominal interest rate.
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