Understanding interest rates EK3301 Lecture 2 EK 3301 monetary economics

Introduction Interest rate. Definition: the yield to maturity Measuring interest rates: Simple loan; provides the borrower with an AMOUNT of funds that must be rapid to lender at the MATURITY DATE along with an ADDITIONAL AMOUNT known as interest payment Fixed-payment loan; provides a borrower with an amount of funds that is to be repaid by making the SAME MONTHLY PAYMENT Coupon bond; pays the owner of the bond a YEARLY FIXED interest payment until the maturity date , when a specified final amount (FACE VALUE) is repaid Discount bond; is BOUGHT at a price BELOW its FACE VALUE and the face value is repaid at the maturity date EK 3301 monetary economics

Present Value A dollar paid to a person one year from now IS LESS VALUABLE to that person than a dollar today In the case of simple loan, cost of borrowing funds is the simple interest rate Simple interest rate: Proceeds from simple loan: EK 3301 monetary economics

Discounting the future Calculating what dollars received in the future are worth today Example to calculate the present discounted value of the future $1 : EK 3301 monetary economics

Yield to Maturity Most common way of calculating interest rates. YTM; the interest rate that equates the present value of payment received from a debt instrument with its value today Methods of calculating YTM on the four types of credit market instruments EK 3301 monetary economics

***For simple loans, the simple interest rate = YTM**** E.g: 1-year loan and loan amount of $100 and payment in 1 yr’s time would be $110 Hence ***For simple loans, the simple interest rate = YTM**** EK 3301 monetary economics

ii. Fixed-payment loan E ii. Fixed-payment loan E.g: Loan is $1000, Yearly pmt $126 for the next 25 years. Hence, ***In FPL, the YTM is not known*** EK 3301 monetary economics

Way of calculating its YTM is the same as FPL: iii. Coupon bond Way of calculating its YTM is the same as FPL: EK 3301 monetary economics

iv. Discount bond The YTM calculation for a discount bond is similar to that for the simple loan. E.g: 1-yr treasury bill which pays off a face value of $1000 in 1 yr’s time. Current purchase price is $900, the PV of $900 in one year is EK 3301 monetary economics

Real Vs. Nominal Interest Rates Real interest rate is the interest rate that is adjusted for expected changes in the price level so that it more accurately reflects the true cost of borrowing Defined by the Fisher Equation: **when the RIR is low, greater incentives to borrow and lower incentives to lend.** EK 3301 monetary economics