What Do Interest Rates Mean? Copyright © 2009 Pearson Prentice Hall. All rights reserved. 3-1 Debt markets, or bond markets, allow governments (government bonds) and businesses (corporate bonds) to borrow to finance activities. The interest rate (bonds/loans) is the cost of borrowing. For savers, is the interest rate the income provided by bonds?

What Do Interest Rates Mean? A financial adviser has just given you the following advice: “Long-term bonds are a great investment because their interest rate is over 10%”. Is the financial adviser necessarily right? Copyright © 2009 Pearson Prentice Hall. All rights reserved. 3-2

What Do Interest Rates Mean? Does coupon interest rate equal the yield to maturity of a financial instruments? Does the return on a bond equal the interest rate on that bond? Copyright © 2009 Pearson Prentice Hall. All rights reserved. 3-3

Bond Markets & Interest Rates There are many different types of interest rates, including mortgage rates, car loan rates, credit card rates, etc. The level of these rates are important. For example, mortgage rates in the early part of 1983 exceeded 13%. Financing a house was quite expensive at this time. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 3-4

Interest Rates Copyright © 2009 Pearson Prentice Hall. All rights reserved. 3-5

Interest Rates We examine the terminology and calculation of various rates, and we show the importance of these rates in our lives and the general economy. Topics include: – Measuring Interest Rates – The Distinction Between Real and Nominal Interest Rates – The Distinction Between Interest Rates and Returns Copyright © 2009 Pearson Prentice Hall. All rights reserved. 3-6

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 3-7 Different types of bonds/loans Different debt instruments have very different streams of cash payments to the holder (known as cash flows), with very different timing. Debt instruments are evaluated against one another based on the amount of each cash flow and the timing of each cash flow.

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 3-8 Different types of bonds/loans There are four basic types of credit instruments : 1.Simple Loan 2.Fixed Payment Loan 3.Coupon Bond 4.Discount Bond

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 3-9 Loan Terms Principal: the amount of funds the lender provides to the borrower. Maturity Date: the date the loan must be repaid; the Loan Term is from initiation to maturity date. Interest Payment: the cash amount that the borrower must pay the lender for the use of the loan principal. Simple Interest Rate: the interest payment divided by the loan principal; the percentage of principal that must be paid as interest to the lender. Convention is to express on an annual basis, irrespective of the loan term.

Simple loans Simple Loans require payment of one amount which equals the loan principal plus the interest. In this loan, the lender provides the borrower with the principal, that must be repaid to the lender at the maturity date, along with an additional payment for the interest. Many money market instruments are of this type Copyright © 2009 Pearson Prentice Hall. All rights reserved. 3-10

Fixed-payment loans Fixed-Payment Loans are loans where the loan principal and interest are repaid in several payments, often monthly, in equal amounts over the loan term. The loan must be repaid by making the same payment every period, consisting of part of the principal and interest Auto loans and mortgages are frequently of the fixed-payment type Copyright © 2009 Pearson Prentice Hall. All rights reserved. 3-11

Coupon bonds A coupon bond pays the owner of the bond a fixed interest payment (coupon payment) every year until the maturity date, when a specified final amount (face value or par value) is repaid Corporate bonds are examples of coupon bonds Copyright © 2009 Pearson Prentice Hall. All rights reserved. 3-12

Discount bonds A discount bond (or zero-coupon bond) is bought at a price below its face value (at a discount), and the face value is repaid at the maturity date. A discount bond does not make any interest payments. It just pays off the face value In Italy, money goverment bonds (BOT) Copyright © 2009 Pearson Prentice Hall. All rights reserved. 3-13

Different types of instruments Simple loans and discount bonds make payment only at their maturity dates Fixed-payment loans and coupon bonds have payments periodically until maturity. How would you decide which of these instruments provides you with more income? Copyright © 2009 Pearson Prentice Hall. All rights reserved. 3-14

Copyright © 2009 Pearson Prentice Hall. All rights reserved Yield to Maturity Yield to maturity = interest rate that equates today's value with present value of all future payments Debt instruments are evaluated against one another based on the amount of each cash flow and the timing of each cash flow.

Present value The concept of present value (or present discounted value) is based on the commonsense notion that a dollar of cash flow paid to you one year from now is less valuable to you than a dollar paid to you today. This notion is true because you could invest the dollar in a savings account that earns interest and have more than a dollar in one year. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 3-16

Yield to Maturity: Loans 1. Simple Loan If Pete borrows $ 100 from his sister and next year she wants $110 back from him, what is the yield to maturity on this loans? Copyright © 2009 Pearson Prentice Hall. All rights reserved. 3-17

Copyright © 2009 Pearson Prentice Hall. All rights reserved Yield to Maturity: Loans 2.Fixed Payment Loan (i = 12%)

Copyright © 2009 Pearson Prentice Hall. All rights reserved Yield to Maturity: Bonds 3.Coupon Bond (Coupon rate = 10%)

Yield to Maturity: Bonds There is one special case of a coupon bond: perpetuity or consol It is a perpetual bond with no maturity date and no repayment of principal that makes fixed coupon payments of $C forever The formula simplifies to the following: Copyright © 2009 Pearson Prentice Hall. All rights reserved. 3-20

Copyright © 2009 Pearson Prentice Hall. All rights reserved Yield to Maturity: Bonds 4.One-Year Discount Bond (P = $900, F = $1000)

Copyright © 2009 Pearson Prentice Hall. All rights reserved Relationship Between Price and Yield to Maturity 1.When bond is at par, yield equals coupon rate: If the bond is purchased at the par value of $ 1,000, its yield to maturity must equal the coupon rate 2.The yield is greater than the coupon rate when bond price is below its par value

Copyright © 2009 Pearson Prentice Hall. All rights reserved Relationship Between Price and Yield to Maturity It’s also straight-forward to show that the value of a bond (price) and yield to maturity (YTM) are negatively related. If i increases, the PV of any given cash flow is lower; hence, the price of the bond must be lower. If the YTM rises, the price of the bond falls If the YTM falls, the price of the bond rises

Copyright © 2009 Pearson Prentice Hall. All rights reserved Current Yield Current yield (CY) is just an approximation for YTM – easier to calculate. I f a bond’s price is near par and has a long maturity, then CY is a good approximation.