1. Interest Rate Measurement and Behavior
Chapter 4
Interest Rate Measurement and Behavior

2. Key Words and Concepts Interest - Simple interest - Compound interest
Principal (Face value)
Future Value
Present Value
Coupon rate
Yield to Maturity, Maturity
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3. Key Words and Concepts Inversely related or opposite Capital gain
Opportunity Cost
Nominal Interest Rate
Real Interest Rate
Rate of return
Supply and Demand
Equilibrium Interest Rate
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4. Introduction P. 51
INTEREST RATES SERVE AS A YARDSTICK, OR MEASURING TOOL FOR COMPARING DIFFERENT TYPES OF SECURITIES AND MATURITIES (date for final payment)
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5. Calculating Interest Rates P. 51, 52
Simple Interest
Interest earned on the principal in one year’s time.
Time is worth money
A dollar today is worth more than a dollar in the future
A dollar due in the future is worth less than a dollar today
Interest earned = principal  rate  time (in years)
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6. Calculating Interest Rates (Cont.) p. 52,53
Compound Interest
Interest added to the principal at year’s end, earning more interest in the following year
Banks add interest earned to the principal at certain time intervals
Future Value [FV]—amount today’s principal will be worth in “n” years after adding compounded interest of rate “r”.
FV = principal (PV)  (1 + r)n
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7. Calculating Interest Rates (Cont.) p. 53
Compound Interest (Cont.)
Present Value [PV]—amount a future sum of money in “n” years will be worth today after discounting back to the present at rate “r”
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8. Measuring Interest Rates
What is Present Value?
A dollar paid to you one year from now is less valuable than a dollar paid to you today.
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9. Calculating Interest Rates (Cont.) p. 53,54
Coupon Rate on Bonds
Amount printed on the face of the bond
Annual interest payment (coupon payment)
Return based on face value of the bond, not amount paid for the bond
Current Yield
Yield on annual interest received based on purchase price of bond
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10. US GOVERNMENT BOND FACE VALUE
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11. 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 (inversely) 逆 (Nì) related
The yield to maturity is greater than the coupon rate when the bond price is below its face value
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12. Calculating Interest Rates (Cont.) p. 54, 55
Yield to Maturity
Most accurate and widely used measure of interest rates
Assume the bond is held to maturity (when it comes due, for example 1, 5 or 10 years
Interest rate (rate of discount) which makes sum of present values of all future payments (annual interest plus face value) equal to purchase price
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13. Calculating Interest Rates (Cont.) p. 55
Yield to Maturity (Cont.)
Where: P = Purchase price of bond
C = Annual coupon payment
Fn = Face value at maturity
r = rate of discount
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14. Calculating Interest Rates (Cont.) p. 57
Zero-Coupon Bonds
Bond holder received no coupon interest payments, only the face value of the bond when it matures
Rate of discount (return on the bond) equates discounted face value (n—number of years to maturity) with purchase price
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15. Calculating Interest Rates (Cont.) p. 59,60
Inverse 逆 (Nì) or Opposite 相反 (Xiāngfǎn)
Relationship Between Yields and Bond Prices
Higher interest rates mean lower bond prices. High prices, lower interest rates.
If the interest rate or price is known, the other can be calculated
If either the rate of interest or purchase price changes, the other will automatically change in the opposite direction
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16. Calculating Interest Rates (Cont.) p. 60, 61
Why Long-Term Bonds are Riskier than Short-Term
For long-term securities, a small change in interest rates involves a large change in price
For short-term securities, even a big change in yield involves only a small change in price
Longer a bond’s maturity, the more its price will be affected by a change in the general level of interest rates
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17. Calculating Interest Rates (Cont.) p. 60, 61
Why Long-Term Bonds are Riskier than Short-Term (Cont.)
Long-term bonds are riskier because threat of potential loss is greater provided the bonds must be sold prior to maturity. Opportunity Cost.
Greater likelihood with long-term bonds of needing to sell before maturity.
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18. Calculating Interest Rates (Cont.) p. 61
Nominal Versus Real Interest Rates
Nominal Interest Rates—Money amount of interest received
Real Interest Rates—Purchasing power of interest received
Real interest rate is the nominal interest adjusted for inflation
Real interest rate = Nominal rate – Inflation rate
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19. Calculating Interest Rates (Cont.) p. 62, 63
Return Versus Yield to Maturity
Rate of return measures the cash flows received during a period relative to the amount invested at the beginning
For a bond held for one year, the return is computed as follows:
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20. What Determines the Level of Interest Rates p. 63
Supply/Demand Determine Interest Rate (Figure 4.1)
Interest rate is price of credit or borrowing money
Market for Credit or Loanable Funds ([Interest rate vs. Quantity of funds)
Supply of Funds—Upward sloping, lenders are willing to extend more credit at higher interest rates
Demand for Funds—Downward sloping, borrowers are willing to borrow less at higher interest rates
Equilibrium—Intersection of supply and demand, no tendency to change
Financial Markets—Competitive so supply and demand pressures will result in interest rate changes
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21. Figure 4.1 Supply and demand determine the interest rate p. 64
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22. What Determines the Level of Interest Rates (Cont.) p. 66-68
Why Does the Interest Rate Change (go up and down)
U.S. Treasury bond yields change day to day (Figure 4.2)
Movement along a single curve—Changes in the interest rate results in a movement along a single demand or supply curve (Figure 4.3)
Shifts of a Curve—Change in determinants of supply or demand (other than interest rate) causes the respective curve to shift (Figure 4.4)
Changes in Equilibrium—Shift of either the supply or demand curve will reflect a change in the equilibrium interest rate
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23. Figure 4.2 U.S. Treasury bond yields fluctuate from day to day (2003)
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24. Figure 4.3 Movement along a demand curve versus a shift in demand
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25. Figure 4.4 Shifts in demand (1) or supply (2) curves can change the equilibrium interest rate
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26. What Determines the Level of Interest Rates (Cont.)
Behind Supply and Demand
Borrowing (demand)
Business firms—finance inventory or buy capital equipment
Households—buy cars, consumer goods, or homes
State and local government—provide infrastructure or public services
Federal government—finance Federal Budget Deficit
INCREASES IN BORROWING—SHIFT DEMAND TO RIGHT AND RAISE INTEREST
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27. What Determines the Level of Interest Rates (Cont.)
Behind Supply and Demand (Cont.)
Lending or Credit (supply)
Financial institutions or individuals lend to market
Government authorities may restrict lending by banks
Ability of individuals to lend depends on their savings—less savings results in lower amount of lending
DECREASES IN LENDING—SHIFT SUPPLY TO LEFT AND RAISE INTEREST
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28. What Determines the Level of Interest Rates (Cont.)
The Importance of Expectations 期望 (Qīwàng)
Effect of a change in expectations of increasing inflation
Demand—Borrowers increase demand since they will be repaying in depreciated dollars (dollars that are worth less money) and desire to purchase before the prices increase
Supply—Lenders decrease supply since they will be repaid with money of diminished purchasing power
SHIFTS OF THE DEMAND AND SUPPLY CURVE WILL CAUSE THE INTEREST RATE TO INCREASE
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29. What Determines the Level of Interest Rates (Cont.)
The Importance of Expectations (Cont.)
Self-fulfilling expectations—If individuals and institutions expect inflation and interest rates to increase, they will alter behavior that causes the higher rates that were anticipated
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30. What Determines the Level of Interest Rates (Cont.)
Cyclical and Long-term Trends in Interest Rates (Figure 4.5)
Level of interest rates tends to rise during cyclical expansion and fall during recessions. During economic expansion:
Firms and households increase borrowing—demand curve right
FED usually tightens credit during expansion—supply curve left
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31. What Determines the Level of Interest Rates (Cont.)
Cyclical and Long-term Trends in Interest Rates (Figure 4.5) (Cont.)
Level of interest rates on upward long-term trend between 1950 and 1981
Large federal budget deficit forced US Treasury to increase borrowing—pushing up interest rates
Expectations of increasing inflation
Since 1981 rates have trended downward
Federal deficits continued to increase in 1980’s
Expectations of lower inflation has been major reason for fall of interest rates.
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32. Figure 4.5 Trends in interest rates since 1950
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33. Questions for discussion
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34. Question 3
3. Which $1,000 bond has the higher yield to maturity, a 20 year bond selling for $800 with a current yield of 15% or a 1 year bond selling for $800 with a current yield of 5%?
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35. Chapter Summary
Time is money. A dollar (or rmb) today is worth more than a dollar a year from now, by earning interest. Compound interest earns more than simple interest as the payment includes interest on interest.
Yield to maturity is the most widely used measure of interest rate.
Present value or discounting the future means a dollar paid to you one year from now is less valuable than a dollar paid to you today.
The present value formula shows why there is a inverse (opposite) relationship between bond yield (interest rate) and bond price.
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36. Chapter Summary
5. There is a difference between real and nominal interest rates. The real rate is the normal rate minus the rate of inflation.
6. The interest rate is the price of credit and is determined by supply of and demand for funds. The rate changes because of shifts in supply and/or demand.
7. Interest rates rise when demand curve shifts to the right or when supply curve shifts to the left. Rates fall when demand curve shifts to left or supply curve shifts to the right. This effects the borrowing of businesses, households and governments and the monetary policies of the FED.
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37. Chapter Summary
8. Interest rates tend to rise during business cycle expansion (growth) because of increased demand and fall during recessions cause of decreased demand.
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