The Economics of Money, Banking, and
Financial Markets
Twelfth Edition
Chapter 4
The Meaning of Interest
Rates
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Preview
• Before we can go on with the study of money, banking,
and financial markets, we must understand exactly what
the phrase interest rates means. In this chapter, we see
that a concept known as the yield to maturity is the most
accurate measure of interest rate.
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Learning Objectives
• Calculate the present value of future cash flows and the
yield to maturity on the four types of credit market
instruments.
• Recognize the distinctions among yield to maturity, current
yield, rate of return, and rate of capital gain.
• Interpret the distinction between real and nominal interest
rates.
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Measuring Interest Rates
• Present value: a dollar paid to you one year from now is
less valuable than a dollar paid to you today.
– Why: a dollar deposited today can earn interest and
become $1×(1+i) one year from today.
– To understand the importance of this notion, consider
the value of a $20 million lottery payout today versus a
payment of $1 million per year for each of the next 20
years. Are these two values the same?
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Present Value
Let i = .10
In one year: $100 × (1 + 0.10) = $110
In two years: $110 × (1 + 0.10) = $121
or $100 × (1 + 0.10)2
In three years: $121 × (1 + 0.10) = $133
or $100 × (1 + 0.10)3
In n years
$100 × (1 + i)n
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Simple Present Value (1 of 2)
PV = today’s (present) value
CF = future cash flow (payment)
i = the interest rate
CF
PV =
(1 + i )n
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Simple Present Value (2 of 2)
• Cannot directly compare payments scheduled in different
points in the time line
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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
• Yield to maturity: the interest rate that equates the
present value of cash flow payments received from a debt
instrument with its value today
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Yield to Maturity on a 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
The same cash flow payment every period throughout the
life of the loan
LV = loan value
FP = fixed yearly payment
n = number of years until maturity
FP FP FP FP
LV = + + + . . . +
1 + i (1 + i )2 (1 + i )3 (1 + i )n
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Coupon Bond (1 of 4)
Using the same strategy used for the fixed-payment loan:
P = price of coupon bond
C = yearly coupon payment
F = face value of the bond
n = years to maturity date
C C C C F
P= + + +. . . + +
1+ i (1+ i )2 (1+ i )3 (1+ i )n (1+ i )n
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Coupon Bond (2 of 4)
• 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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Coupon Bond (3 of 4)
Table 1 Yields to Maturity on a 10%-Coupon-Rate Bond
Maturing in Ten Years (Face Value = $1,000)
Price of Bond ($) Yield to Maturity (%)
1,200 7.13
1,100 8.48
1,000 10.00
900 11.75
800 13.81
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Coupon Bond (4 of 4)
• 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
can rewrite above equation as this: ic = C/Pc
For coupon bonds, this equation gives the current yield, an
easy to calculate approximation to the yield to maturity
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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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The Distinction Between Interest Rates and
Returns (1 of 4)
• 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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The Distinction Between Interest Rates and
Returns (2 of 4)
• The return equals the yield to maturity only if the holding
period equals the time to maturity.
• 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.
• The more distant a bond’s maturity, the greater the size of
the percentage price change associated with an interest-
rate change.
• Interest rates do not always have to be positive as
evidenced by recent experience in Japan and several
European states.
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The Distinction Between Interest Rates and
Returns (3 of 4)
• 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.
• Even if a bond has a substantial initial interest rate, its
return can be negative if interest rates rise.
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The Distinction Between Interest Rates and
Returns (4 of 4)
Table 2 One-Year Returns on Different-Maturity 10%-Coupon-
Rate Bonds When Interest Rates Rise from 10% to 20%
(1) (2) (3) (4) (5) (6)
Years to Maturity Initial Initial Price Rate of Rate of Return
When Bond Is Current Price Next Capital Gain [col (2) + col (5)]
Purchased Yield (%) ($) Year* ($) (%) (%)
30 10 1,000 503 −49.7 −39.7
20 10 1,000 516 −48.4 −38.4
10 10 1,000 597 −40.3 −30.3
5 10 1,000 741 −25.9 −15.9
2 10 1,000 917 −8.3 +1.7
1 10 1,000 1,000 0.0 +10.0
*Calculated with a financial calculator, using Equation 3.
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Maturity and the Volatility of Bond
Returns: Interest-Rate Risk
• Prices and returns for long-term bonds are more volatile
than those for shorter-term bonds.
• There is no interest-rate risk for any bond whose time to
maturity matches the holding period.
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The Distinction Between Real and Nominal
Interest Rates
• Nominal interest rate makes no allowance for inflation.
• Real interest rate is adjusted for changes in price level so
it more accurately reflects the cost of borrowing.
– Ex ante real interest rate is adjusted for expected
changes in the price level
– Ex post real interest rate is adjusted for actual changes
in the price level
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Fisher Equation
i = ir + e
i = nominal interest rate
ir = real interest rate
e = expected inflation rate
When the real interest rate is low,
there are greater incentives to borrow and fewer incentives to lend.
The real interest rate is a better indicator of the incentives to
borrow and lend.
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Figure 1 Real and Nominal Interest Rates
(Three-Month Treasury Bill), 1953–2017
Sources: Nominal rates from Federal Reserve Bank of St. Louis FRED database:
http://research.stlouisfed.org/fred2/. The real rate is constructed using the procedure outlined in Frederic
S. Mishkin, “The Real Interest Rate: An Empirical Investigation,” Carnegie-Rochester Conference Series
on Public Policy 15 (1981): 151–200. This procedure involves estimating expected inflation as a function
of past interest rates, inflation, and time trends, and then subtracting the expected inflation measure from
the nominal interest rate.
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