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1
Chapter Outline
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Overview of Interest rates
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1. Overview of Interest rates
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Present value
¤A dollar paid to you one year from now is less
valuable than a dollar paid to you today
¤Why?
o A dollar deposited today can earn interest and
become $1 x (1+i) one year from today.
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Discounting the Future
Let i = .10
In one year $100 X (1+ 0.10) = $110
In two years $110 X (1 + 0.10) = $121
or 100 X (1 + 0.10) 2
In three years $121 X (1 + 0.10) = $133
or 100 X (1 + 0.10)3
In n years
$100 X (1 + i ) n
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Simple Present Value
PV = today's (present) value
CF = future cash flow (payment)
i = the interest rate
CF
PV = n
(1 + i)
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Time Line
Cannot directly compare payments scheduled in different points in the
time line
Year 0 1 2 n
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Four Types of Credit Market
Instruments
¤Simple Loan
¤Fixed Payment Loan
¤Coupon Bond
¤Discount Bond
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Yield to Maturity
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Simple Loan
PV = amount borrowed = $100
CF = cash flow in one year = $110
n = number of years = 1
$110
$100 =
(1 + i )1
(1 + i ) $100 = $110
$110
(1 + i ) =
$100
i = 0.10 = 10%
For simple loans, the simple interest rate equals the
yield to maturity
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Fixed Payment Loan
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Coupon Bond
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Coupon Bond
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Table 1 Yields to Maturity on a 10%-Coupon-Rate
Bond Maturing in Ten Years
(Face Value = $1,000)
¤ 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
related
¤ The yield to maturity is greater than the coupon rate when the bond
price is below its face value
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Consol or Perpetuity
¤ A bond with no maturity date that does not repay principal but
pays fixed coupon payments forever
P = C / ic
Pc = price of the consol
C = yearly interest payment
ic = yield to maturity of the consol
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Discount Bond
For any one year discount bond
F-P
i=
P
F = Face value of the discount bond
P = current price of the discount bond
The yield to maturity equals the increase
in price over the year divided by the initial price.
As with a coupon bond, the yield to maturity is
negatively related to the current bond price.
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Rate of Return
The payments to the owner plus the change in value
expressed as a fraction of the purchase price
C P - Pt
RET = + t +1
Pt Pt
RET = return from holding the bond from time t to time t + 1
Pt = price of bond at time t
Pt +1 = price of the bond at time t + 1
C = coupon payment
C
= current yield = ic
Pt
Pt +1 - Pt
= rate of capital gain = g
Pt
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Rate of Return and Interest Rates
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Interest-Rate Risk
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Real and Nominal Interest Rates
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¤ Would a dollar tomorrow be worth more to you today when the
interest rate is 20% or when it is 10%?
¤ 2. You have just won $20 million in the state lottery, which
promises to pay you $1 million (tax free) every year for the
next 20 years. Have you really won $20 million?
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¤ 4. If the security in Problem 3 sold for $3,500, is the yield to
maturity greater or less than 10%? Why?
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¤ 7. What is the yield to maturity on a simple loan for $1 million
that requires a repayment of $2 million in five years’ time?
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2. Loanable Funds Theory
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Loanable Funds Theory
(cont d)
¤ Business demand for loanable funds
o Businesses demand loanable funds to invest in fixed assets
and short-term assets
o Businesses evaluate projects using net present value (NPV):
n
CFt
NPV = -INV +
t =1 (1
å
+ k ) t
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Loanable Funds Theory (cont d)
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Loanable Funds Theory (cont d)
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Loanable Funds Theory (cont d)
Dh Db
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Loanable Funds Theory (cont d)
Dg Dm
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Loanable Funds Theory (cont d)
Df
Foreign Demand
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Loanable Funds Theory (cont d)
DA
Aggregate Demand
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Loanable Funds Theory (cont d)
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Loanable Funds Theory (cont d)
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Loanable Funds Theory (cont d)
SA
Aggregate Supply
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Loanable Funds Theory
(cont d)
DA = Dh + Db + Dg + Dm + Df
SA = Sh + Sb + Sg + Sm + S f
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Loanable Funds Theory (cont d)
SA
DA
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3. Economic Forces That Affect Interest
Rates
¤Economic growth
o Shifts the demand schedule outward (to the right)
o There is no obvious impact on the supply schedule
ü Supply could increase if income increases as a result of the
expansion
o The combined effect is an increase in the equilibrium
interest rate
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Loanable Funds Theory (cont d)
SA
i2
DA2
DA
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Economic Forces That Affect Interest Rates
(cont d)
¤Inflation
o Shifts the supply schedule inward (to the left)
ü Households increase consumption now if inflation is
expected to increase
o Shifts the demand schedule outward (to the right)
ü Households and businesses borrow more to purchase
products before prices rise
42
Loanable Funds Theory (cont d)
SA2 SA
i2
i
DA2
DA
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Economic Forces That Affect Interest Rates
(cont d)
¤Fisher effect
o Nominal interest payments compensate savers for:
ü Reduced purchasing power
ü A premium for forgoing present consumption
o The relationship between interest rates and expected
inflation is often referred to as the Fisher effect
44
Economic Forces That Affect Interest
Rates (cont d)
i = E (INF ) + i R
i R = i - E (INF )
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Economic Forces That Affect Interest Rates
(cont d)
¤Money supply
o If the Fed increases the money supply, the supply of
loanable funds increases
ü If inflationary expectations are affected, the
demand for loanable funds may also increase
o If the Fed reduces the money supply, the supply of
loanable funds decreases
o During 2001, the Fed increased the growth of the
money supply several times
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Economic Forces That Affect Interest Rates
(cont d)
¤Money supply (cont d)
o September 11
ü Firms cut back on expansion plans
ü Households cut back on borrowing plans
ü The demand of loanable funds declined
o The weak economy in 2001–2002
ü Reduced demand for loanable funds
ü The Fed increased the money supply growth
ü Interest rates reached very low levels
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Economic Forces That Affect Interest Rates
(cont d)
¤ Budget deficit
¤ A high deficit means a high demand for loanable funds by the
government
¤ Shifts the demand schedule outward (to the right)
¤ Interest rates increase
¤ The government may be willing to pay whatever is necessary to borrow
funds, but the private sector may not
¤ Crowding-out effect
¤ The supply schedule may shift outward if the government creates more
jobs by spending more funds than it collects from the public
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Economic Forces That Affect Interest Rates
(cont d)
¤Foreign flows of funds
¤ The interest rate for a currency is determined by the demand
for and supply of that currency
¤ Impacted by the economic forces that affect the equilibrium interest
rate in a given country, such as:
¤ Economic growth
¤ Inflation
¤ Shifts in the flows of funds between countries cause
adjustments in the supply of funds available in each country
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Economic Forces That Affect Interest
Rates (cont d)
¤ Explaining the variation in interest rates over time
¤ Late 1970s: high interest rates as a result of strong economy and
inflationary expectations
¤ Early 1980s: recession led to a decline in interest rates
¤ Late 1980s: interest rates increased in response to a strong economy
¤ Early 1990s: interest rates declined as a result of a weak economy
¤ 1994: interest rates increased as economic growth increased
¤ Drifted lower for next several years despite strong economic growth,
partly due to the U.S. budget surplus
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4. Forecasting Interest Rates
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Forecasting Interest Rates
(cont d)
¤To forecast future interest rates, the net
demand for funds (ND) should be
forecast:
ND = DA - SA
[
= Dh + Db + Dg + Dm + Df ]
- [Sh + Sb + Sg + Sm +S ]
f
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Forecasting Interest Rates (cont d)
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