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Chapter 4 Handout

The document covers the economics of money and banking, focusing on understanding interest rates, present value, and various credit market instruments. It explains key concepts such as nominal vs. real interest rates, yield to maturity, and the differences between simple loans, coupon bonds, and fixed-payment loans. Additionally, it includes review questions to reinforce the learning outcomes related to these topics.

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katman0425
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18 views22 pages

Chapter 4 Handout

The document covers the economics of money and banking, focusing on understanding interest rates, present value, and various credit market instruments. It explains key concepts such as nominal vs. real interest rates, yield to maturity, and the differences between simple loans, coupon bonds, and fixed-payment loans. Additionally, it includes review questions to reinforce the learning outcomes related to these topics.

Uploaded by

katman0425
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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E216 : Economics of MONEY AND

BANKING

Second grade
First term

Dr Doaa Akl Ahmed

Associate Professor of Economics

Benha University
Chapter 3

Understanding Interest
Rates
Learning outcome

1. Explain the present value concept and the meaning of the


term interest rate.

2. Present different ways of measuring the interest rate.

3. Distinguish between the four types of credit market


instruments

4. Explain the difference between nominal and real interest


rates.

5. Compute the yield to maturity for different credit market


instruments.
1. Measuring interest rate
Present value
• A dollar paid to you one year from now is less valuable than a
dollar paid to you today. Why?

• You can deposit a dollar in a savings account that earns interest


and have more than a dollar in one year.
• After 1 year: you will have $1 ×(1+i).

$100 Now $100 year from now

interest rate = 10%


$100
After 1 year: $100 ×(1+10%)=
100+10=110
1. Measuring interest rate
Some Basic Terminology

Principal: initial value of the loan.


Face value or par value is equal to a bond's price when it is first
issued.
Cash flows are the cash payments to the holder of debt
instruments.
Maturity date: is the date on which the principal amount of a
bond or another debt instrument becomes due and is repaid to
the investor.
1. Measuring interest rate

The simple loan: the lender provides the borrower with an amount of funds (called the
principal) that must be repaid to the lender at the maturity date, along with an additional
payment for the interest.

• Assume that you lend you friend a simple loan $100 for one
year.
• You would require her to repay the principal of $100 in one year
s time along with an additional payment for interest say, $10.
• Simple interest rate, i, is:
1. Measuring interest rate
𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤𝑠 = 𝑝𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙 × (1 + 𝑖)𝑛
i : interest rate, n= maturity date
Let i = .10
In one year $100 X (1+ 0.10) = $110
In two years $110 X (1 + 0.10) = $121
2
or 100 X (1 + 0.10)
In three years $121 X (1 + 0.10) = $133
3
or 100 X (1 + 0.10)
In n years
n
$100 X (1 + i )
1. Measuring interest rate

• the following timeline shows the cash flows of n years:

• Having $100 today as having $110 a year from now or $121 two
years from now (of course, as long as you are sure that the
borrower will pay you back).
✓ This process is called discounting the future.

PV = today's (present) value


CF = future cash flow (payment)
i = the interest rate
CF
PV = n
2. Measuring present value
Example 1:
With an interest rate of 6 percent, the present value of $100 next year
is approximately
A) $106.
B) $100.
C) $94.
D) $92.
2. Measuring present value
Example 2: What is the present value of $500.00 to be paid in
two years if the interest rate is 5 percent?
A) $453.51
B) $500.00
C) $476.25
D) $550.00
1. Measuring interest rate

• the yield to maturity is the most accurate measure of interest rates.

• Yield to maturity (YTM): is the total expected return of a bond if


it is held until the end of its lifetime.

• Different debt instruments have very different cash payments to


the holder (known as cash flows) with very different timing.
3.Four Types of Credit Market Instruments

• Coupon Bond
• Fixed Payment Loan
• Simple Loan
• Discount Bond

• These four types of instruments require payments at different


times:

1. Simple loans and discount bonds make payment only at their


maturity dates.

2. Fixed-payment loans and coupon bonds have payments


periodically until maturity.
3.Four Types of Credit Market Instruments

• A simple loan the lender provides the borrower with an amount of funds
(called the principal) that must be repaid to the lender at the maturity date,
along with an additional payment for the interest.

PV = today's (present) value


CF = future cash flow (payment)
i = the interest rate
CF
PV =
(1 + i ) n
3.Four Types of Credit Market Instruments
A simple loan example:

Solution
3.Four Types of Credit Market Instruments
• Discount bond (a 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.

• no interest payments; it just pays off the face value.


For any one year discount bond

F−P
𝑖=
𝑃
F = Face value of the discount bond
P = current price of the discount bond
3.Four Types of Credit Market Instruments

• 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.

• A coupon bond with $1000 face value, for example, might pay
you a coupon payment of $100 per year for ten years and at the
maturity date repay you the face value amount of $1000.
3.Four Types of Credit Market Instruments

• Fixed-payment loan: the lender provides the borrower with


an amount of funds, which must be repaid by making the
same payment every period (such as a month) consisting of
part of the principal and interest for a set number of years.
• LV = loan value
• FP = fixed yearly payment
• n = number of years until maturity

• The present value of the fixed-payment loan is calculated as


the sum of the present values of all payments
4.Distinction between nominal and real interest rates
Questions for review

1) The concept of ________ is based on the common-sense notion


that a dollar paid to you in the future is less valuable to you than a
dollar today.
A) present value
B) future value
C) interest
D) deflation

2) The present value of an expected future payment ________ as


the interest rate increases.
A) falls
B) rises
C) is constant
D) is unaffected
Questions for review

5) A ________ pays the owner a fixed coupon payment every


year until the maturity date, when the ________ value is repaid.
A) coupon bond; discount
B) discount bond; discount
C) coupon bond; face
D) discount bond; face

6) If a $5,000 coupon bond has a coupon rate of 13 percent, then


the coupon payment every year is
A) $650.
B) $1,300.
C) $130.
D) $13.
Questions for review

3) An increase in the time to the promised future payment


________ the present value of the payment.
A) decreases
B) increases
C) has no effect on
D) is irrelevant to

4) To claim that a lottery winner who is to receive $1 million per


year for twenty years has won $20 million ignores the process of
A) face value.
B) par value.
C) deflation.
D) discounting the future.
Questions for review

7) For a 3-year simple loan of $10,000 at 10 percent, the amount


to be repaid is
A) $10,030.
B) $10,300.
C) $13,000.
D) $13,310.

8) The present value of a fixed-payment loan is calculated as the


________ of the present value of all cash flow payments.
A) sum
B) difference
C) multiple
D) log

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