Chapter 4

INTEREST RATES AND RATES

OF RETURN
2
CHAPTER PREVIEW
Objective: To develop better understanding of interest
rate; its terminology and calculation. Topics include:
1. Measuring Interest Rates
2. Distinction Between Real and Nominal Interest Rates
3. Distinction Between Interest Rates and Returns
Interest rate one of most closely watched variables in
economy; it is imperative to know what it means exactly
In this chapter, we will see that yield to maturity (YTM)
is the most accurate measure of interest rates
3
PRESENT VALUE CONCEPT
Interest rate is important in valuation of various
investment instruments

Different debt instruments have very different
streams of cash payments to the holder (cash flows),
with very different timing

These instruments are evaluated against one another
based on amount of each cash flow and timing of each
cash flow

This evaluation is called present value analysis: the
analysis of the amount and timing of a debt
instruments cash flows, leads to its yield to maturity
or interest rate
4
PRESENT VALUE CONCEPT
Concept of present value (PV) (or present discounted
value) is based on notion
A dollar today is better than a dollar tomorrow
A dollar of cash flow paid one year from now is less valuable
than a dollar paid today.
That one dollar today could be invested in a savings account that earns
interest and have more than a dollar in one year

PV analysis involves
Finding the PV of all future payments that can be received
from a debt instrument
PV of a single cash flow or sum of a sequence or group of
future cash flows
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4-5
Present Value
Comparing returns across debt types is difficult
since timing of repayment differs.
Solution is the concept of present value: to find
a common measure for funds at different times,
present each in todays dollars.
The present value of $1 received n years in the
future is $1/(1 + i )
n

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4-6
Types of Bonds
Categories of bonds are used to identify
variations in the timing of payments
Simple loan
Involves the principal (P) and interest ( i )
Total payment = P + iP = P(1 + i )
Discount bond
Repays in a single payment
Repays the face value at maturity, but receives
less than the face value initially.
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4-7
Types of Bonds, contd.
Coupon bond
Borrowers make multiple payments of interest at regular
intervals and repay the face value at maturity
Specifies the maturity date, face value, issuer, and coupon
rate (equals the yearly payment divided by face value)
Fixed-payment loan
Borrower makes regular periodic payments to the lender.
Payments include both interest and principal and no lump-
sum payment at maturity.

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4-8
Figure 4.1 Time Lines for Credit
Market Instrument Repayment
9
PRESENT VALUE APPLICATIONS:
1. Simple Loan Terms
Loan Principal: amount of funds lender provides to
borrower
Maturity Date: date loan must be repaid; Loan Term
is from initiation to maturity date
Interest Payment: cash amount that borrower must
pay lender for use of loan principal
Simple Interest Rate: interest payment divided by
loan principal; percentage of principal that must be
paid as interest to the lender, conventionally
expressed on an annual basis, irrespective of the loan
term
What is the cost of borrowing?
Loan of RM100 today requires the borrower to repay the
RM100 a year from now and to make an additional
interest payment of RM10. Calculations of interest
rates:-
i- = 10 = 0.10 = 10%
100
First Year
If you make this loan, at the end of the year, you would
receive RM110, which can be rewritten as:
100 x (1 + 0.10) = RM110
Second Year
110 x (1 + 0.10) = RM121 or 100 x (1 + 0.10) x (1 + 0.10) = 100 x (1 +
0.10)
2
= RM121
Continuing the Loan
121 x (1 + 0.10) = RM100 x (1 + 0.10)
3
= RM133
Today
0
Year 1 Year 2 Year 3
100 110 121 133
Can be generalized as:
If the simple interest rate i is expressed as a decimal
(0.10), then after making these loans for n years, you
will receive a total payment of
RM100 x (l +i)
n

or
RM100 today = RM110 next year
= RM121 next 2 years
= RM133 next 3 years
Discounting the future
Today Future
RM100 100 (I + i)
3
= RM133
So that,
100= 133
(1 + i)
3

From here, we can solve for the Present Value (Present
Discounted Value) The value today of a future payment
(FV) received n years from now
PV = FV
(1 + i)
n

Q:- What is the present value of RM250 to be paid in two
years if the interest rate is 15%
PV = FV
(1 + i)
n

FV = 250
i = 0.15
n = number of years
PV = ?
PV = 250 = 250 = RM189.04
(1 + 0.15)
2
1.3225
0
Today
Yr 1
Yr 2
250
Answer = RM189.04
13
Yield to Maturity: Loans
Yield to maturity = interest rate that equates today's
value with present value of all future payments
1. Simple Loan Interest Rate (i = 10%)
$100 = $110 1+i ( )
i =
$110 $100
$100
=
$10
$100
= .10 = 10%
14
PRESENT VALUE APPLICATION:
2. Fixed-Payment Loan Terms
Fixed-Payment Loans are loans where the loan
principal and interest are repaid in several payments,
often monthly, in equal dollar amounts over the loan
term.
Installment Loans, such as auto loans and home
mortgages are frequently of the fixed-payment type.
Example:
The loan is RM1000, and the yearly payment is
RM85.81 for the next 25 years.
1
st
Year:
PV = FV
1 + i
PV = 85.81
1 + i
2
nd
Year:
PV = 85.81
(1 + i)
2

25
th
Year:
PV = 85.81
(1 + i)
25

- Making todays value of the loan RM1000
= Sum of the present value of all the yearly payments
gives us:-
1000 = 85.81 + 85.81 + . 85.81
(1 + i) (1 + i)
2
(1 + i)
25

More generally, for any fixed payment loan:-
LV = FP + FP + FP + FP
(1 + i) (1 + i)
2
(1 + i)
3
(1 + i)
25

LV = Loan value
FP = Fixed yearly payment
n = Number of Years until maturity
For a fixed-payment loan amount, the fixed
yearly payment and the number of years until
maturity are known quantities, we can then
solve for yield to maturity.
Fixed-Payment Loan
You want to purchase a house and need a $100,000 mortgage.
You take up a loan from a bank that has an interest of 7%.
What is the yearly payment to the bank to pay off the loan
in 20 years?
LV = FP + FP . + FP
(1 + i) (1 + i)
1
(1 + i)
n

LV = loan value amount = 100,000
i = annual interest rate = 0.07
n = number of years = 20
1000,000 = FP + FP + . FP
(1 + 0.07) (1 + 0.07)
2
(1 + 0.07)
20

Solving Using Finance Calculator:
n = number of years = 20
PV = amount of the loan (LV) = 100,000
FV = amount of the loan after 20 years = 0
i = annual interest rate = 0.07

Yearly payment to bank
is:- RM9,439.29
19
PRESENT VALUE APPLICATION:
3. Coupon Bond
Pays owner of the bond a fixed interest payment (coupon payment) every
year until maturity date, when face value/par value is repaid
Three information: Issuer; maturity date; coupon rate-the value of yearly
coupon payment expressed as a % of the face value
Example: Find the price of a 10% coupon bond with a face value of $1000, a
12.25% yield-to-maturity, and 8 years to maturity
Use formula



Or use calculator
P =
C
1+ i ( )
+
C
1 + i ( )
2
+
C
1+ i ( )
3
+ ... +
C
1+ i ( )
n
+
F
1 + i ( )
n
Find the price of a 10% coupon bond with a face value of
$1,000, a 12.25% yield to maturity and eight years to
maturity
Solution :
- The price of bond is RM889.20
n = years to maturity = 8
FV = face value of the bond = 1000
i = annual interest rate = 12.25%
PMT = Yearly coupon payments = 100
21
Yield to Maturity: Bonds
3. Coupon Bond (Coupon rate = 10% = C/F)
P =
$100
1+ i ( )
+
$100
1 + i ( )
2
+
$100
1+ i ( )
3
+ . .. +
$100
1+ i ( )
10
+
$1000
1 + i ( )
10
P =
C
1+ i ( )
+
C
1 + i ( )
2
+
C
1+ i ( )
3
+ ... +
C
1+ i ( )
n
+
F
1 + i ( )
n
Consol/perpetuity: A perpetual bond with no maturity date and
no repayment of principal. Fixed coupon payments of $C
forever
P =
C
i
i =
C
P
22
PRESENT VALUE APPLICATION:
4. Discount Bond
Zero-coupon bond: a bond that is bought at a price below its
face value (at a discount), and the face value is repaid at the
maturity date.
Makes no interest payments-just pays off the face value
Example: A one-year TBILL paying a face value of $1,000 in 1
years time. If current purchase price is $900, find the yield-to-
maturity
Use formula
YTM formula similar to simple loan: PV= FV/(1+i)
n

23
Yield to Maturity: Bonds
4. One-Year Discount Bond (P = $900, F = $1000)
$900 =
$1000
1 + i ( )

i =
$1000$900
$900
= .111=11.1%
i =
F P
P
24
Relationship Between Price and YTM
Three observations:
1. When bond is at par, yield equals coupon rate
2. Price and yield are negatively related
3. Yield greater than coupon rate when bond price
is below par value
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4-25
Current Price and Face Value
If current price = face value, then yield to maturity =
current yield = coupon rate.
If current price < face value, then yield to maturity >
current yield > coupon rate.
If current price > face value, then yield to maturity <
current yield < coupon rate.
26
OTHER MEASURES OF INTEREST RATE
1. Current Yield
Current yield: An approximation of YTM that equals
to yearly coupon payment divided by price of a
coupon bond
Two characteristics
1. Is better approximation to yield to maturity, nearer price is
to par and longer is maturity of bond
2. Change in current yield always signals change in same
direction as yield to maturity
i
c
=
C
P
27
i
db
=
(F - P)
F

360
(number of days to maturity)
i
db
=
$1000- $900
$1000

360
365
= .099 = 9.9%
Two characteristics:
1. Understates yield to maturity; longer the maturity, greater
is understatement
2. Change in discount yield always signals change in same
direction as yield to maturity
OTHER MEASURES OF INTEREST RATE
2. Yield on a Discount Basis
One-Year Bill (P = $900, F = $1000)
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4-28
Bond Yields
The interest rate that equates the present value
to price is the yield to maturity
Current yield = coupon/current price
Coupon rate = coupon/face value
Yield on discount basis
29
Distinction Between Real
and Nominal Interest Rates
Real interest rate
1. Interest rate that is adjusted for expected changes in the
price level
i
r
= i t
e
2. Real interest rate more accurately reflects true cost of
borrowing
3. When real rate is low, greater incentives to borrow and less
to lend
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4-30
Real and Nominal Interest
Rates
Expected real interest rate = nominal interest
rate - the expected rate of inflation.
Fisher hypothesis: change in expected inflation
= change in nominal interest rate.
The real rate of return equals the nominal rate
of return adjusted for expected inflation.
31
Distinction Between Real
and Nominal Interest Rates (cont.)
If i = 5% and
e
= 0% then
i
r
= 5%0%= 5%
i
r
=10%20%= 10%
If i = 10% and
e
= 20% then
32
U.S. Real and Nominal Interest Rates
Figure 3-1 Real and Nominal Interest Rates (Three-Month Treasury Bill), 19532004
Sample of current rates and indexes
http://www.martincapital.com/charts.htm
33
RET =
C+ P
t +1
P
t
P
t
= i
c
+ g
where i
c
=
C
P
t
= current yield
g =
p
t +1
P
t
P
t
= capital gain
Distinction Between
Interest Rates and Returns
How well a person does by holding a bond over time is accurately
measured by rate of return
RET is the payments to the owner plus the change in the value of
the security
Rate of Return
34
Distinction Between
Interest Rates and Returns
What would the rate of return be on a bond bought for $1000 and
sold one year later for $800? The bond has a face value of $1000
and a coupon rate of 8%.
35
Key Facts about Relationship
Between Rates and Returns
See what happens to rate of returns on bonds of different maturities
when interest rate increases
36
Maturity and Volatility of Bond Returns
Key findings from Table
1. Only bond whose return = yield is one with
maturity = holding period
2. For bonds with maturity > holding period, i | P +
implying capital loss
3. Longer is maturity, greater is price change associated
with interest rate change
4. Longer is maturity, more return changes with change in
interest rate
5. Bond with high initial interest rate can still have negative
return if i |
37
Maturity and Volatility of Bond Returns
Conclusions from Table
1. Prices and returns more volatile for long-term bonds because
have higher interest-rate risk
2. No interest-rate risk for any bond whose maturity equals
holding period
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4-38
Figure 4.2 Sensitivity of Bond Prices
to Changes in Interest Rates