The Economics of Money, Banking, and

Financial Markets
Eighth Canadian Edition

Chapter 4
The Meaning of Interest Rates

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in The Financial News …

CBC News Sept 16, 2022

The loonie has fallen to its lowest level in almost two years — here's why
– Loonie fell to near 75 cents US on Friday and analyst says it could go as low as 73 cents
US soon

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in The Financial News …

FINANCIAL POST Sept 14, 2022

U.S. inflation could push Bank of Canada to move policy rate higher than 4%

U.S. price pressures could embolden Canada’s central bank to move more

aggressively to fight inflation, economists say

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Learning Objectives
1. Calculate the present value of future cash flows and
the yield to maturity on the four types of credit
market instruments.
2. Recognize the distinctions among yield to maturity,
current yield, rate of return, and rate of capital gain.
3. Interpret the distinction between real and nominal
interest rates.

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 Bonds
• Generically, a financial security entitles the holder to periodic cash flows
• We will generically refer to a “bond” as a debt instrument where a borrower
promises to pay the holder of the bond (the lender) fixed and known
payments according to some pre-specified schedule
• Hence, bonds are known as fixed income securities
– Equity (stocks) offers unknown payout streams

• There are many different types of bonds. They differ according to

– Details of how bond is paid off, time to maturity, and default risk

• The yield to maturity is a measure of the interest rate on the bond, although
the interest rate is often not explicitly laid out. Will use terms interest rate
and yield interchangeably
• Want to understand how interest rates are determined and how and why
they vary across different characteristics of bonds

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Measuring Interest Rates
How can we compare cash payments (cash flows)
of different amounts and with different timing?
• Present Value:
– a dollar paid to you one year from now is less valuable
than a dollar paid to you today
– Consider a simple loan: Loan $100 today and require
$110 repayment in one year. The simple interest rate
is 10%.
– Equivalently: At an interest of 10%, the present value of
$110 in one year’s time is $100 today.

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Discounting the Future
Repeat simple loan example for other repayment
dates
– If repay in one year: $100×(1+0.10) = $110
– If repay in two years: $100×(1+0.10)2 = $121
– If repay in three years: $100×(1+0.10)3 = $133
– In general: $100×(1+i)n where i is the interest rate and
n is the number of years

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Simple Present Value
PV = today’s present value
CF = future cash flow or payment
i = discount rate (rate at which you discount future cash flows from a
security)
In other word, CF = PV * (1+i)^n

For a future cash flow CF how many dollars would be equivalent to you
today:

CF
PV 
(1  i ) n
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Present Value: Example 1

• Suppose you are promised $10 in period t+1

• You could put $1 in the bank in period t and earn i = 0.05

between t and t+1

• How many dollars would you need in the present to have $10 in
the future?

(1+i) PVt = CFt+1

PVt = CFt+1/(1+ i)

= 10/(1.05) = 9.5238

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 Present Value: Example 2

• Suppose you are promised $10 in period t+3

• You could put $1 in the bank in period t and earn i = 0.05 across each
set of adjacent periods between now and then

• If you put $1 in the bank in period t and kept it there (reinvesting any
interest income), you would have (1 + i) (1 + i) (1 + i) dollars in t + 3.
Hence, the present value of $10 three periods from now is:

PVt(1 + i) (1 + i) (1 + i) = CFt+3

PVt = CFt+3/(1+ i)3

= 10/(1.05)3 = 8.6384
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 Present Value and the Price of an Asset

• A financial asset is something which entitles the holder to periodic

payments (cash flows)
• The classical theory of asset prices is that the price of an asset is equal to
the present discounted value of all future cash flows
• The price of a bond (or any asset) is just the present discounted value of
cash flows

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Present Value and the Price of an Asset (cont’d)

• The yield is the discount rate you use to discount those future cash flows
• The yield is also equal to the expected or required return: not necessarily
equal to realized return if security is sold prior to maturity
• Key issue in asset pricing: how do you determine which yield to use to
discount cash flows and hence price an asset?
• Basic gist: the riskier an asset, the higher the required return you demand
to hold it, and therefore the more you discount future cash flows

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Yield to Maturity

• There are several common ways to calculate

interest rates; the most important is the yield to
maturity
– It is the interest rate that equates the present value of
all cash flow payments received from a debt instrument
with its value today (the current price)

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Four Types of Credit Market Instruments
1. Simple Loan
– One payment at the maturity date
2. Fixed Payment Loan
– Multiple fixed payments at pre-specified dates
3. Coupon Bond
– A bond that pays fixed amounts (the coupons) at fixed
dates, plus a final payment (the face value) at maturity
4. Discount Bond
– A bond that pays zero coupons, only a final payment at
maturity
– “Discount” since price typically less than face value
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Yield to Maturity on a Simple Loan
• The yield to maturity on a simple loan is just the contractual
interest rate
• For a one period loan, the yield to maturity is the same as the
rate of return
• Let P be the price of the loan, CF the payout after one year,
and i the interest rate. Then
P = CF/(1 + i)
1 + i = CF/P
i = (CF–P)/P
where CF– P is the return and (CF–P)/P is the rate of return
on the loan.
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Simple Loan: Example
PV = amount borrowed = $100
CF = cash flow in one year = $110
n = number of years (n = 1 in this case)

$110
$100 
(1  i )1
(1  i )1  $100  $110
$110
(1  i ) 
$100
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Fixed Payment Loan
LV = loan value
FP = fixed yearly payment
n = number of years until maturity

FP FP FP FP
LV     ... 
1  i (1  i ) (1  i )
2 3
(1  i ) n

Cannot solve this by hand, requires a computer

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Coupon Bond
P = price of coupon bond
C = yearly coupon payment
F = face value of the bond
n = years to maturity

C C C C F
P    ...  
1  i (1  i ) (1  i )
2 3
(1  i ) n
(1  i ) n

Cannot solve this by hand, requires a computer

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Yields to Maturity on a 10%-Coupon-Rate Bond
Maturing in Ten Years (Face Value = $1,000)
Table 4-1 Yields to Maturity on a 10%-Coupon-Rate Bond
Maturing in 10 Years (Face Value = $1000)

Price of Bond ($) Yield to Maturity (%)

1200 7.13
1100 8.48
1000 10.00
900 11.75
800 13.81

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Three Facts About Coupon Bonds
1. When the coupon bond is priced at its face
value, the yield to maturity equals the coupon
rate
2. The price of a coupon bond and the yield to
maturity are negatively related
– As the yield to maturity rises, the price of the bond falls
3. 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
Pc = price of the consol
C = yearly interest payment
ic = yield to maturity of the consol
C
ic 
Pc

• A bond with no maturity date that does not repay

principal but pays fixed coupon payments forever

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Discount Bond (or Zero-Coupon Bond)
A discount bond sells at a discount from face value
The yield to maturity on a discount bond is similar to a simple
loan, just with different maturities
F = face value of the discount bond
P = current price of the discount bond
n = maturity
P = F/(1+ i)n
1+ i = (F/P)1/n
i = (F/P)1/n -1

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A 1-Year Discount Bond

F = face value of the discount bond

P = current price of the discount bond

FP
i
P

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The Distinction Between Interest Rates and
Returns (1 of 3)
• How well a person does financially by holding a
bond for some period of time is the rate of return
– The return (R) depends on coupons received (C) and
the price for which the bond is eventually sold:

C Pt 1  Pt
R 
Pt Pt
C
 current yield  i c
Pt
Pt 1  Pt
 rate of capital gain  g
Pt
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The Distinction Between Interest Rates and
Returns (2 of 3)
• 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

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The Distinction Between Interest Rates and
Returns (3 of 3)
• 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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 Interest Rates (Yields) and Rates of Return:
An Example with a Discount Bond
• Suppose that you hold a discount bond with face value $1000, a
maturity of 30 years, and a current yield to maturity of 10%
• The current price of this bond is 1000/(1 +.10)30 = 57.31
• Suppose that interest rates stay the same after a year. Then the
bond has a price of 1000/(1 +.10)29 = 63.04
• Since there is no coupon payment, your one-year holding period
return (holding period is the length of time you hold the security)
is just the capital gain
R = (Pt+1 – Pt)/Pt = (63.04 – 57.31)/57.31 = .10
• If interest rates do not change, then the return and the yield to
maturity are the same.
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 Interest Rate Risk

• Continue with the same setup

• But now suppose that interest rates go up to 15% in period t+1
and are expected to remain there
• Then the price of the bond in period t+1 will be 1000/(1 +.15)29 =
17.37. That is, the bond price falls from 57.31 to 17.37
• Then your return is
R = (Pt+1 – Pt)/Pt = (17.37 – 57.31)/57.31 = - 0.69
• On a discount bond, an increase in interest rates exposes you
to capital loss

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One-Year Returns on Different-Maturity 10%-
Coupon-Rate Bonds When Interest Rates Rise from
10% to 20%
Table 4-2 One-Year Returns on Different-Maturity 10%-Coupon-
Rate Bonds When Interest Rates Rise from 10% to 20%

(1) Years to
Maturity when (2) Initial (4) Price (5) Rate of (6) Rate of Return
Bond is Current (3) Initial Next Year* Capital Gain [col (2) + col (5)]
Purchased Yield (%) Price ($) ($) (%) (%)
30 10 1000 503 −49.7 −39.7
20 10 1000 516 −48.4 −38.4
10 10 1000 597 −40.3 −30.3
5 10 1000 741 −25.9 −15.9
2 10 1000 917 −8.3 +1.7
1 10 1000 1000 0.0 +10.0

*Calculated with a financial calculator, using Equation 3.

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Interest-Rate Risk
The risk level associated with an asset’s return that
results from interest-rate changes is its 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 Inflation Rate
Let π be the inflation rate. The inflation rate from year t to
year t+1, πt, is the ratio of the change in the price level to
the initial price level:
πt = (Pt+1 − Pt)/Pt = ∆Pt/Pt

It follows that
πt · Pt = ∆Pt = Pt+1 − Pt
Pt+1 = (1 + πt) · Pt

where (1 + πt) is the inflation rate factor.

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The Nominal Interest Rate

• The dollar value of assets held as bonds rises over the

year by the factor 1 + it.

• The interest rate it is the dollar or nominal interest rate,

because it determines the change over time in the nominal
value of assets held as bonds.
• (1 + it) is called the nominal interest rate factor, and
gives the rate at which dollar amounts grow over time
when they are invested at it.

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Real and Nominal Interest Rates
• Nominal interest rates make no allowance for
inflation
• Real interest rates adjust for changes in price
level
– 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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 The Real Interest Rate
• The real interest rate, denoted by r, is the rate at which the
real value of assets held as bonds changes over time. It is
defined by
(1+ r) = (1+i)/(1+π)

where (1+ r) is the real interest rate factor.

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Fisher Equation (1 of 2)
i = nominal interest rate
r = real interest rate
πe = expected inflation rate

i  r  e

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Fisher Equation (2 of 2)
• When the real interest rate is low, there are
greater incentives to borrow
• Low interest rates reduces the incentives to lend
• The real interest rate is a better indicator of the
incentives to borrow or lend

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 Actual and Expected Inflation
• Since the future is unknown, people have to form forecasts or
expectations of inflation.
• Denote by πet the expectation of the inflation rate πt.
• The actual inflation rate, πt, will usually deviate from its
expectation, πet, and the forecast error—or unexpected
inflation—will be nonzero.
• Agents try to keep the errors as small as possible.
• Therefore, they use available information on past inflation and
other variables to avoid systematic mistakes. Expectations
formed this way are called rational expectations.
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 Actual and Expected Real Interest Rates
r = i − π and r e = i − πe

Subtract the 2nd equation from the 1st to get

r – r e = i − π – ( i − πe )
= - (π – πe)

• Where (π – πe) is the inflation forecast error. Hence, errors

in forecasting π, generate errors of the opposite sign in
forecasting r. Note that
 If π > πe then r < r e
 If π < πe then r > r e
 If π = πe then r =Copyright
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38
Measuring Expected Inflation

1. Ask a sample of people about their expectations.

2. Use the hypothesis of rational expectations, which says
that expectations correspond to optimal forecasts, given
the available information. Then use statistical techniques to
gauge these optimal forecasts.
3. Use market data to infer expectations of inflation.

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Indexed Bonds
• December 10, 1991, when the government of
Canada began to issue indexed bonds.
• Indexed bonds are bonds whose interest and
principal payments are adjusted for changes in the
price level
• These bonds guarantee the real interest rate over
the maturity of each issue.

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Indexed Bonds -- An Example
Example
Consider a real return bond with a face value of $1000 and a
coupon yield of 2%.

If π = 3%, then to account for inflation, after a year the

principal will be increased by 3%, from $1000 to $1030. The
coupon yield is still 2%, but applies to the new principal of
$1030, instead of $1000. Hence, the coupon payment will
increase from $20 to $20.60 (=.02  $1030).

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FIGURE 4-1 Real and Nominal Interest Rates (Three-
Month Treasury Bill), 1953–2020

Nominal and real interest rates often do not move together. When U.S. nominal rates were high in the 1970s, real rates
were actually extremely low—often negative.
Sources: Nominal rates from Federal Reserve Bank of St. Louis FRED database: fred.stlouisfed.org/series/TB3MS and
fred.stlouisfed.org/series/CPIAUCSL. 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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