© 2013 Pearson Education, Inc. All rights reserved.4-1 Money & Banking Video 03—Interest Rates Understanding interest rates ( Chapter 4) Hal W. Snarr 8/20/2015.

Chapter 4 Understanding Interest Rates

© 2013 Pearson Education, Inc. All rights reserved.4-3 Measuring Interest Rates Discount rate – the rate used to weigh a stream of future payments Most choices require decision-makers to trade-off costs and benefits at different points in time (e.g., savings, work effort, education, projects…) As the payment gets further and further into the future, people tend to place less and less weight on it People who are more worried about Right Now, discount the future more than those who are concerned more with the futureRight Now In economics, the discount rate is determined by o market rate of interest i o one’s time preference

© 2013 Pearson Education, Inc. All rights reserved.4-4 If discount rate i represents a time preference, the present value of a stream of future payments is Present Value P=present value of a discounted stream of payments F i =dollar value of a future payment received at the END of period i n=years to maturity date

© 2013 Pearson Education, Inc. All rights reserved.4-5 If discount rate i represents a time preference, the present value of a stream of future payments is P=present value of a discounted stream of payments F i =dollar value of a future payment received at the START of period i n=years to maturity date Present Value

© 2013 Pearson Education, Inc. All rights reserved.4-6 If discount rate i represents a time preference, the present value of a stream of future payments is Example: Suppose a person with a monthly discount rate of 0.4% wins a lottery. When the winner is announced, the winner can choose one check in the amount of $1,000,000, or checks in the amount of $10,000 each month for the next 10 years. Either way, the person leaves the building with a huge check in hand. Which option will the winner choose? Present Value

© 2013 Pearson Education, Inc. All rights reserved.4-9 If discount rate i represents a time preference, the present value of a stream of future payments is Example: Suppose a person with a monthly discount rate of 0.4% wins a lottery. When the winner is announced, the winner can choose one check in the amount of $1,000,000, or checks in the amount of $10,000 each month for the next 10 years. Either way, the person leaves the building with a huge check in hand. Which option will the winner choose? M&B_lottery.xlsx Present Value

© 2013 Pearson Education, Inc. All rights reserved.4-10 If discount rate i represents a time preference, the present value of a stream of future payments is Example: Suppose a person with a monthly discount rate of 0.4% wins a lottery. When the winner is announced, the winner can choose one check in the amount of $1,000,000, or checks in the amount of $10,000 each month for the next 10 years. Either way, the person leaves the building with a huge check in hand. Which option will the winner choose? M&B_lottery.xlsx Present Value

© 2013 Pearson Education, Inc. All rights reserved.4-11 If discount rate i represents a time preference, the present value of a stream of future payments is Example: Suppose a person with a monthly discount rate of 0.4% wins a lottery. When the winner is announced, the winner can choose one check in the amount of $1,000,000, or checks in the amount of $10,000 each month for the next 10 years. Either way, the person leaves the building with a huge check in hand. Which option will the winner choose? The winner chooses the $1,000,000 check M&B_lottery.xlsx Present Value

© 2013 Pearson Education, Inc. All rights reserved.4-12 18 65 22 Age 40,000 16,000 -5,000 Dollars/year Goes to College Only High School 0 A person who gets a HS diploma earns $16,000 a year from age 18 until he/she retires. If the person goes to college, he/she pays $20,000 in tuition foregoes earning $64,000 but earns $1,032,000 more by graduating from college from age 22 to age 64. (24,000/year)(43 years) = $1,032,000 $20,000$64,000+ = $84,000 Why do people invest in HUMAN capital?

© 2013 Pearson Education, Inc. All rights reserved.4-13 The previous model ignores the discount rate Swann (2003) estimates the annual discount rate of women at 20% Keane and Wolpin (1997) estimate the discount rate of young men at 28% Why do people invest in HUMAN capital? NPV = -15130 NPV = 3484 M&B_pv_college.xlsx

© 2013 Pearson Education, Inc. All rights reserved.4-14 In Money & Banking, the discount rate is market rate of interest i on a loan: called the Yield to Maturity Interest Rates P=price of bond when auctioned/issued F=face value of bond c=annual coupon rate (in percent) C=dollar value of annual coupon payment = cF n=years to maturity date coupon bond

© 2013 Pearson Education, Inc. All rights reserved.4-15 c = 10%, n = 10, F = $1,000 Interest Rates coupon bond 100 1000 In Money & Banking, the discount rate is market rate of interest i on a loan: called the Yield to Maturity

© 2013 Pearson Education, Inc. All rights reserved.4-19 c = 10%, n = 10, F = $1,000 M&B_bond_prices.xlsx Interest Rates coupon bond 100 1000 In Money & Banking, the discount rate is market rate of interest i on a loan: called the Yield to Maturity

© 2013 Pearson Education, Inc. All rights reserved.4-20 c = 10%, n = 10, F = $1,000 Interest Rates 100 1000 In Money & Banking, the discount rate is market rate of interest i on a loan: called the Yield to Maturity coupon bond 1200

© 2013 Pearson Education, Inc. All rights reserved.4-24 c = 10%, n = 10, F = $1,000 Interest Rates M&B_yields.xlsx 100 1000 In Money & Banking, the discount rate is market rate of interest i on a loan: called the Yield to Maturity coupon bond 800

© 2013 Pearson Education, Inc. All rights reserved.4-25 Interest Rates fixed payment loan 0 In Money & Banking, the discount rate is market rate of interest i on a loan: called the Yield to Maturity P=payment to borrower after loan is signed F=0F=0 C=annual cash payment n=years to maturity date

© 2013 Pearson Education, Inc. All rights reserved.4-26 Interest Rates fixed payment loan M&B_loan.xlsx 0 In Money & Banking, the discount rate is market rate of interest i on a loan: called the Yield to Maturity Example: You borrow $10,000 to buy a pickup. If you have to pay 60 monthly payments of $200, what is the interest rate? What is the annual rate of interest?

© 2013 Pearson Education, Inc. All rights reserved.4-29 Interest Rates P=price of bond when auctioned/issued F=0 C=dollar value of annual coupon payment n=infinity perpetuity (or consol) bond In Money & Banking, the discount rate is market rate of interest i on a loan: called the Yield to Maturity

© 2013 Pearson Education, Inc. All rights reserved.4-30 Interest Rates perpetuity (or consol) bond In Money & Banking, the discount rate is market rate of interest i on a loan: called the Yield to Maturity P=price of bond when auctioned/issued F=0 C=dollar value of annual coupon payment n=infinity

© 2013 Pearson Education, Inc. All rights reserved.4-33 Interest Rates In Money & Banking, the discount rate is market rate of interest i on a loan: called the Yield to Maturity perpetuity (or consol) bond P=price of bond when auctioned/issued F=0 C=dollar value of annual coupon payment n=infinity

© 2013 Pearson Education, Inc. All rights reserved.4-38 Interest Rates c In Money & Banking, the discount rate is market rate of interest i on a loan: called the Yield to Maturity perpetuity (or consol) bond P=price of bond when auctioned/issued F=0 C=dollar value of annual coupon payment n=infinity

© 2013 Pearson Education, Inc. All rights reserved.4-40 Interest Rates In Money & Banking, the discount rate is market rate of interest i on a loan: called the Yield to Maturity perpetuity (or consol) bond Example: A consol pays out $20 annually, and interest rates are 5%. Compute the price of the consol.

© 2013 Pearson Education, Inc. All rights reserved.4-44 Interest Rates In Money & Banking, the discount rate is market rate of interest i on a loan: called the Yield to Maturity perpetuity (or consol) bond Example: A perpetuity that pays $150 annually is currently has a price of $2500. Compute the current yield of the perpetuity.

© 2013 Pearson Education, Inc. All rights reserved.4-48 In Money & Banking, the discount rate is market rate of interest i on a loan: called the Yield to Maturity Interest Rates perpetuity (or consol) bond Example: A perpetuity that pays $150 annually is currently has a price of $2500. Compute the current yield of the perpetuity using the above equation. To do this, assume the perpetuity ends in 5000 years and assume the future value is any value, say $1400. (Is 5000 years close to infinity? To the average human, yes.)

© 2013 Pearson Education, Inc. All rights reserved.4-49 In Money & Banking, the discount rate is market rate of interest i on a loan: called the Yield to Maturity Interest Rates perpetuity (or consol) bond Example: A perpetuity that pays $150 annually is currently has a price of $2500. Compute the current yield of the perpetuity using the above equation. To do this, assume the perpetuity ends in 3500 years and assume the future value is any value, say $1400. (Is 3500 years close to infinity? To the average human, yes.)

© 2013 Pearson Education, Inc. All rights reserved.4-50 In Money & Banking, the discount rate is market rate of interest i on a loan: called the Yield to Maturity Interest Rates perpetuity (or consol) bond Example: A perpetuity that pays $150 annually is currently has a price of $2500. Compute the current yield of the perpetuity using the above equation. To do this, assume the perpetuity ends in 3500 years and assume the future value is any value, say $1400. (Is 3500 years close to infinity? To the average human, yes.) M&B_perpetuity.xlsx

© 2013 Pearson Education, Inc. All rights reserved.4-51 Interest Rates P=price of bond when auctioned/issued F=face value of bond C=dollar value of annual coupon payment n=years to maturity date In Money & Banking, the discount rate is market rate of interest i on a loan: called the Yield to Maturity zero-coupon bond

© 2013 Pearson Education, Inc. All rights reserved.4-52 Interest Rates P=price of bond when auctioned/issued F=face value of bond C=0 n=years to maturity date 0 0 0 0 In Money & Banking, the discount rate is market rate of interest i on a loan: called the Yield to Maturity zero-coupon bond

© 2013 Pearson Education, Inc. All rights reserved.4-53 Interest Rates P=price of bond when auctioned/issued F=face value of bond n=years to maturity date In Money & Banking, the discount rate is market rate of interest i on a loan: called the Yield to Maturity zero-coupon bond

© 2013 Pearson Education, Inc. All rights reserved.4-54 Interest Rates P=price of bond when auctioned/issued F=face value of bond n=years to maturity date In Money & Banking, the discount rate is market rate of interest i on a loan: called the Yield to Maturity zero-coupon bond

© 2013 Pearson Education, Inc. All rights reserved.4-55 Interest Rates In Money & Banking, the discount rate is market rate of interest i on a loan: called the Yield to Maturity zero-coupon bond Example: Compute the interest rate on a $1000 bond that matures in nine years and costs $850 today.

© 2013 Pearson Education, Inc. All rights reserved.4-60 Interest Rates In Money & Banking, the discount rate is market rate of interest i on a loan: called the Yield to Maturity zero-coupon bond Example: If you require a minimum of 5% on safe investments, what price are you willing to pay for a $1000 bond that matures in nine years?

© 2013 Pearson Education, Inc. All rights reserved.4-64 Interest Rates P=payment to borrower after the loan is signed C=cash payoff of loan’s principal and interest n=years to maturity date simple loan In Money & Banking, the discount rate is market rate of interest i on a loan: called the Yield to Maturity

© 2013 Pearson Education, Inc. All rights reserved.4-65 Interest Rates simple loan In Money & Banking, the discount rate is market rate of interest i on a loan: called the Yield to Maturity Example: If the annual interest rate is 10%, do you prefer $500 five years from now or $800 ten years from now? The present value of getting $500 five years is The present value of getting $800 ten years is

© 2013 Pearson Education, Inc. All rights reserved.4-66 Interest Rates simple loan In Money & Banking, the discount rate is market rate of interest i on a loan: called the Yield to Maturity Example: If the annual interest rate is 10%, do you prefer $500 five years from now or $800 ten years from now? The present value of getting $500 five years is The present value of getting $800 ten years is

© 2013 Pearson Education, Inc. All rights reserved.4-67 Interest Rates simple loan In Money & Banking, the discount rate is market rate of interest i on a loan: called the Yield to Maturity Example: If the annual interest rate is 10%, do you prefer $500 five years from now or $800 ten years from now? The present value of getting $500 five years is $310.46 The present value of getting $800 ten years is $308.43

© 2013 Pearson Education, Inc. All rights reserved.4-70 Interest Rates P=price of bond when auctioned/issued F=face value of bond n=1 period In Money & Banking, the discount rate is market rate of interest i on a loan: called the Yield to Maturity discount bond

© 2013 Pearson Education, Inc. All rights reserved.4-74 Interest Rates In Money & Banking, the discount rate is market rate of interest i on a loan: called the Yield to Maturity discount bond Example: Compute the interest rate on a $1000 bond that matures in one year and costs $850 today.

© 2013 Pearson Education, Inc. All rights reserved.4-79 Interest Rates In Money & Banking, the discount rate is market rate of interest i on a loan: called the Yield to Maturity discount bond Example: What is the interest rate on a 10-year, $1000 bond that you purchased for $850 nine years after it was issued by the Treasury Department?

© 2013 Pearson Education, Inc. All rights reserved.4-82 Interest Rates In Money & Banking, the discount rate is market rate of interest i on a loan: called the Yield to Maturity discount bond Example: What price are you willing to pay for a $1000 bond that matures in one year, if you require 5% interest?

© 2013 Pearson Education, Inc. All rights reserved.4-86 Interest Rates P=price of bond when auctioned/issued C=cash payoff of loan’s principal and interest n=1 period In Money & Banking, the discount rate is market rate of interest i on a loan: called the Yield to Maturity simple loan

© 2013 Pearson Education, Inc. All rights reserved.4-87 Interest Rates In Money & Banking, the discount rate is market rate of interest i on a loan: called the Yield to Maturity Example: If you borrow $200 and you agree to pay the lender $205 at the end of the month, what is the monthly interest rate? What is the annual interest rate? simple loan

© 2013 Pearson Education, Inc. All rights reserved.4-88 Interest Rates In Money & Banking, the discount rate is market rate of interest i on a loan: called the Yield to Maturity simple loan Example: If you borrow $200 and you agree to pay the lender $205 at the end of the month, what is the monthly interest rate? What is the annual interest rate?

© 2013 Pearson Education, Inc. All rights reserved.4-94 Interest Rates In Money & Banking, the discount rate is market rate of interest i on a loan: called the Yield to Maturity Example: If your mom lends you $200 and you agree to pay her $250 when you get paid at the end of the month, what is the monthly interest rate? What is the annual interest rate? simple loan

© 2013 Pearson Education, Inc. All rights reserved.4-95 Interest Rates In Money & Banking, the discount rate is market rate of interest i on a loan: called the Yield to Maturity Example: If your mom lends you $200 and you agree to pay her $250 when you get paid at the end of the month, what is the monthly interest rate? What is the annual interest rate? simple loan

© 2013 Pearson Education, Inc. All rights reserved.4-96 Interest Rates In Money & Banking, the discount rate is market rate of interest i on a loan: called the Yield to Maturity simple loan Example: If your mom lends you $200 and you agree to pay her $250 when you get paid at the end of the month, what is the monthly interest rate? What is the annual interest rate?

© 2013 Pearson Education, Inc. All rights reserved.4-102 1.The price of a bond falls 2.The rate of return (R) is the return on a bond held for a given period of time R = yield to maturity only if it is held for all n periods as interest rates rise. no Interest- Rate Risk Bond Properties

© 2013 Pearson Education, Inc. All rights reserved.4-103 1.The price of a bond falls 2.The rate of return (R) is the return on a bond held for a given period of time R = yield to maturity only if it is held for all n periods R ≠ yield to maturity if the bond is held less than n periods o If a coupon bond is purchased and held for its final year, as interest rates rise. Bond Properties

© 2013 Pearson Education, Inc. All rights reserved.4-109 1.The price of a bond falls 2.The rate of return (R) is the return on a bond held for a given period of time R = yield to maturity only if it is held for all n periods R ≠ yield to maturity if the bond is held less than n periods o If a zero-coupon bond is purchased and held for its final year, as interest rates rise. Bond Properties

© 2013 Pearson Education, Inc. All rights reserved.4-110 1.The price of a bond falls 2.The rate of return (R) is the return on a bond held for a given period of time R = yield to maturity only if it is held for all n periods R ≠ yield to maturity if the bond is held less than n periods o If a zero-coupon bond is purchased and held for its final year, as interest rates rise. Bond Properties

© 2013 Pearson Education, Inc. All rights reserved.4-111 1.The price of a bond falls 2.The rate of return (R) is the return on a bond held for a given period of time R = yield to maturity only if it is held for all n periods R ≠ yield to maturity if the bond is held less than n periods o If a coupon bond is purchased and held for its final year, and its purchase price equals its face value, as interest rates rise. F F F Bond Properties

© 2013 Pearson Education, Inc. All rights reserved.4-112 1.The price of a bond falls 2.The rate of return (R) is the return on a bond held for a given period of time R = yield to maturity only if it is held for all n periods R ≠ yield to maturity if the bond is held less than n periods o If a coupon bond is purchased and held for its final year, and its purchase price equals its face value, F as interest rates rise. F c Bond Properties

© 2013 Pearson Education, Inc. All rights reserved.4-113 1.The price of a bond falls 2.The rate of return (R) is the return on a bond held for a given period of time R = yield to maturity only if it is held for all n periods R ≠ yield to maturity if the bond is held less than n periods o If a coupon bond is held for one year and sold before it matures, as interest rates rise. t t t P t+1 Bond Properties

© 2013 Pearson Education, Inc. All rights reserved.4-114 1.The price of a bond falls 2.The rate of return (R) is the return on a bond held for a given period of time R = yield to maturity only if it is held for all n periods R ≠ yield to maturity if the bond is held less than n periods o If a zero-coupon bond is held for one year and sold before it matures, as interest rates rise. t t t P t+1 Bond Properties

© 2013 Pearson Education, Inc. All rights reserved.4-115 1.The price of a bond falls 2.The rate of return (R) is the return on a bond held for a given period of time R = yield to maturity only if it is held for all n periods R ≠ yield to maturity if the bond is held less than n periods o If a coupon bond is held for one year, and sold before it matures for the same price it was purchased, as interest rates rise. Bond Properties

© 2013 Pearson Education, Inc. All rights reserved.4-116 3.A rise in interest rates is associated with a fall in bond prices, resulting in a capital loss if time to maturity is longer than the holding period 4.The more distant a bond’s maturity, the greater the size of the percentage price change associated with an interest-rate change 5.The more distant a bond’s maturity, the lower the rate of return the occurs as a result of an increase in the interest rate 6.Even if a bond has a substantial initial interest rate, its return can be negative if interest rates rise Bond Properties

© 2013 Pearson Education, Inc. All rights reserved.4-117 3.A rise in interest rates is associated with a fall in bond prices, resulting in a capital loss if time to maturity is longer than the holding period 4.The more distant a bond’s maturity, the greater the size of the percentage price change associated with an interest-rate change 5.The more distant a bond’s maturity, the lower the rate of return the occurs as a result of an increase in the interest rate 6.Even if a bond has a substantial initial interest rate, its return can be negative if interest rates rise 100 1000 100 = 1000 c = 10%, n = 5, F = $1,000 Bond Properties

© 2013 Pearson Education, Inc. All rights reserved.4-118 = 1000 3.A rise in interest rates is associated with a fall in bond prices, resulting in a capital loss if time to maturity is longer than the holding period 4.The more distant a bond’s maturity, the greater the size of the percentage price change associated with an interest-rate change 5.The more distant a bond’s maturity, the lower the rate of return the occurs as a result of an increase in the interest rate 6.Even if a bond has a substantial initial interest rate, its return can be negative if interest rates rise c = 10%, n = 5, F = $1,000 = 741 100 1000 100 M&B_bond_properties.xlsx Bond Properties

© 2013 Pearson Education, Inc. All rights reserved.4-119 3.A rise in interest rates is associated with a fall in bond prices, resulting in a capital loss if time to maturity is longer than the holding period 4.The more distant a bond’s maturity, the greater the size of the percentage price change associated with an interest-rate change 5.The more distant a bond’s maturity, the lower the rate of return the occurs as a result of an increase in the interest rate 6.Even if a bond has a substantial initial interest rate, its return can be negative if interest rates rise 7.Prices and returns for long-term bonds are more volatile than those for shorter-term bonds Interest- Rate Risk Bond Properties

© 2013 Pearson Education, Inc. All rights reserved.4-1 Money & Banking Video 03—Interest Rates Understanding interest rates ( Chapter 4) Hal W. Snarr 8/20/2015.

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© 2013 Pearson Education, Inc. All rights reserved.4-1 Money & Banking Video 03—Interest Rates Understanding interest rates ( Chapter 4) Hal W. Snarr 8/20/2015.

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Presentation on theme: "© 2013 Pearson Education, Inc. All rights reserved.4-1 Money & Banking Video 03—Interest Rates Understanding interest rates ( Chapter 4) Hal W. Snarr 8/20/2015."— Presentation transcript:

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