Monetary Economics

UNDERSTANDING INTEREST RATES CONT

Yield to Maturity
 Yield to Maturity interest rate that equates the

present value of payments received from a debt instrument with its value today - most accurate measure of interest rates Ex. Simple Loan P100 today will yield a value of P133 after 3 years What is the interest rate?

Yield to Maturity
 Solve for i

The Distinction Between Interest Rates and Returns

 Rate of Return Payments to the owner plus the

change in its value expressed as a fraction of its purchase price  Ex. P1000 coupon bond, 10% interest rate  Held for one year then sold for P1200  How much is the payments to the owner? Interest: P100 Change in value: P1200-1000 = 200 Total Earnings: 100+200 = 300 Rate of Return: 300/1000 = 30% * The return on bond will not necessarily equal the interest rate on that bond

The Distinction Between Interest Rates and Returns

 The return on a bond from time t to t+1 can be

expressed as

Where: RET = rate of return from holding the bond from time t to time t+1 Pt = price of bond at time t Pt+1 = price of bond at Pt+1 C= coupon payment

The Distinction Between Interest Rates and Returns

Rewriting it:

*The first term is the *The second term is the current yield, ic is the rate of capital gain, g

The Distinction Between Interest Rates and Returns

 Then:

RET = ic + g
*returns will differ form the interest rate especially if there are sizeable fluctuations in the price of the bond that produce substantial capital gains or losses

The Distinction Between Interest Rates and Returns

 Example: One year Returns on Different maturity 10% Coupon Rate Bonds when Interest Rates rise from 10% to 20%
Years to maturity when bond is purchased (1) 30 20 10 5 2 1 1nitial Current yield (%) Initial Price (Php) Price Next year (Php) Rate of Capital gain Rate of return (%) (2+5)

(2) 10 10 10 10 10 10

(3) 1000 1000 1000 1000 1000 1000

(4) 503 516 597 741 917 1000

(5) -49.7 -48.4 -40.3 -25.9 -8.3 0.0

(6) -39.7 -38.4 -30.3 -15.9 +1.7 +10.0

The Distinction Between Interest Rates and Returns

 Observations  The only bond whose return equals the yield to

maturity is the one whose time to maturity is the same as the holding period  A rise in interest rates is associated with a fall in bond prices, resulting in capital losses on bonds whose terms to maturity are longer than the holding period  The more distant a bond s maturity, the greater the size of the percentage price associated with an interest rate change

The Distinction Between Interest Rates and Returns

 Observations cont .  The more distant a bond s maturity, the lower

the rate of return that occurs as a result of the increase in the interest rate  Even though a bond has a substantial interest rate, its return can turn out to be negative if interest rates rise **Note: A rise in the interest rate means that the price of the bond has fallen (capital loss). If this loss is large enough the bond is a poor investment

Maturity and the Volatility of bond returns

 Prices and returns for long term bonds are

more volatile than those for shorter term bonds  Interest rate risk the riskiness of an asset s return resulting from interest rate changes

The Distinction Between Real and Nominal Interest Rates

 Nominal Interest rate unadjusted for inflation

i = ir + 2  Real Interest rate adjusted for inflation ir = i - 2 Ex1. Made a simple loan for 1 year with 5% interest rate, you expect the price level to increase by 3% i = 5% ir = 2% Ex2. Interest rate rises to 8%, but the price level rises to 10% i = 8% ir = -2% **When the real interest rate is low, there are greater incentives to borrow and fewer incentives to lend