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Mishkin Chapter 2

This document covers the fundamentals of financial markets, focusing on interest rates and their role in valuation. It explains concepts such as present value, yield to maturity, and the distinction between nominal and real interest rates, along with their implications for saving, investing, and borrowing. Additionally, it discusses interest-rate risk, duration, and how these factors influence the volatility of bond returns.

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Sundus Waqar
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7 views39 pages

Mishkin Chapter 2

This document covers the fundamentals of financial markets, focusing on interest rates and their role in valuation. It explains concepts such as present value, yield to maturity, and the distinction between nominal and real interest rates, along with their implications for saving, investing, and borrowing. Additionally, it discusses interest-rate risk, duration, and how these factors influence the volatility of bond returns.

Uploaded by

Sundus Waqar
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PPTX, PDF, TXT or read online on Scribd
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Session 2

Fundamentals of Financial Markets


What do Interest Rates Mean and What is Their Role in Valuation?
Learning Objectives
By the end of this chapter, students will be able to:
1.Explain the Role of Interest Rates – Understand their impact on personal,
business, and economic decisions.
2.Define and Measure Interest Rates – Describe yield to maturity and how it
applies to financial instruments.
3.Differentiate Interest Rate vs. Rate of Return – Analyze why a bond’s interest
rate may not reflect its actual return.
4.Distinguish Nominal and Real Interest Rates – Explain the effect of inflation
on interest rates.
5.Apply Interest Rate Concepts – Evaluate their influence on saving, investing,
and borrowing decisions
Present Value
• The concept of present value (or present discounted value) is based
on the notion that a dollar of cash flow paid to you one year from
now is less valuable to you than a dollar paid to you today.
• This notion is true because you can deposit a dollar in a savings
account that earns interest and have more than a dollar in one year
Four Types of Credit Market
Instruments

Fixed
Simple loan
Payment loan

Discount
Coupon Bond
Bond
Yield to Maturity
Yield to Maturity is the interest rate that equates the present value of
cash flows received from a debt instrument with its value today

To understand the yield to maturity better, we now look at how it is


calculated for the four types of credit market instruments
Example 3.2 Simple Loan
If Pete borrows $100 from his sister and next year she wants $110 back from him,
what is the yield to maturity on this loan?

An important point to recognize is that for simple loans, the simple interest rate
equals the yield to maturity.
Alternate Way
Alternate Way
Relationship Between YTM and
Value
CR=YTM Par Value
Value
CR>YTM Premium

CR<YTM Discount
YTM
Perpetuity / Consol
It is a perpetual bond with no maturity date and no repayment of principal that
makes fixed coupon payments of $C forever.
The formula in Equation 3 for the price of a perpetuity, Pc, simplifies to the
following:

We can rewrite the formula as


Discount Bond
• The yield-to-maturity calculation for a discount bond is similar to that
for the simple loan
• Let us consider a discount bond such as a one-year U.S. Treasury bill,
which pays a face value of $1,000 in one year’s time. If the current
purchase price of this bill is $900, then equating this price to the
present value of the $1,000 received in one year, using Equation 1,
gives
Discount Bond
• The yield to maturity equals the increase in price over the year F – P divided by the initial price P.

• In normal circumstances, investors earn positive returns from holding these securities and so they sell at a
discount, meaning that the current price of the bond is below the face value.

• Therefore, F – P should be positive, and the yield to maturity should be positive as well.

• However, this is not always the case, as extraordinary events in Japan indicated (see the Global box
below).
The Distinction Between Real and
Nominal Interest Rates
The Fisher equation states that the nominal interest rate equals the
real interest rate plus the expected rate of inflation

Rearranging terms, we find that the real interest rate equals the
nominal interest rate minus the expected inflation rate
The Distinction Between Real and
Nominal Interest Rates
• The distinction between real and nominal interest rates is important
because the real interest rate, which reflects the real cost of
borrowing, is likely to be a better indicator of the incentives to borrow
and lend
• When the real interest rate is low, there are greater incentives to
borrow and fewer incentives to lend.
Real and Nominal Interest Rate
Pakistan
Real interest rate (%) in Pakistan was reported at -1.4052 % in 2021, according to
the World Bank collection of development indicators, compiled from officially
recognized sources.

https://www.dawn.com/news/1740099
The Distinction Between Interest
Rates and Return
• How well a person does by holding a bond or any other security over
a particular time period is accurately measured by the rate of return.
• For any security, the rate of return is defined as the payments to the
owner plus the change in its value, expressed as a fraction of its
purchase price
Rate of Return
• A convenient way to rewrite the return formula in Equation 9 is to
recognize that it can be split into two separate terms

• The first term is the current yield (the coupon payment over the
purchase price):
Rate of Return
The second term is the rate of capital gain, or the change in the bond’s
price relative to the initial purchase price

Hence the formula has two parts:


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 because in this case the price at the end
of the holding period is already fixed at the face value.
• The change in interest rates can then have no effect on the price at
the end of the holding period for these bonds, and the return will
therefore be equal to the yield to maturity known at the time the
bond is purchased
Reinvestment Risk
• If an investor’s holding period is longer than the term to maturity of
the bond, the investor is exposed to a type of interest-rate risk called
reinvestment risk
• Reinvestment risk occurs because the proceeds from the short-term
bond need to be reinvested at a future interest rate that is uncertain
To Sum It Up:
• Bonds whose term to maturity is longer than the holding period are subject to
interest-rate risk: Changes in interest rates lead to capital gains and losses that
produce substantial differences between the return and the yield to maturity
known at the time the bond is purchased.
• Interest-rate risk is especially important for long-term bonds, where the capital
gains and losses can be substantial.
• This is why long-term bonds are not considered to be safe assets with a sure
return over short holding periods.
• Bonds whose term to maturity is shorter than the holding period are also subject
to reinvestment risk.
• Reinvestment risk occurs because the proceeds from the short-term bond need
to be reinvested at a future interest rate that is uncertain
Duration
• Duration, the average lifetime of a debt security’s stream of payments
• Macaulay realized that he could measure the effective maturity of a coupon bond
by recognizing that a coupon bond is equivalent to a set of zero-coupon discount
bonds

• The duration of this set of zero-coupon bonds is the weighted average of the
effective maturities of the individual zero-coupon bonds, with the weights
equaling the proportion of the total value represented by each zero-coupon bond.
How to Calculate Duration?
Refer to Excel
Key Points For Duration
• All else being equal, the longer the term to maturity of a bond, the longer its
duration

• All else being equal, when interest rates rise, the duration of a coupon bond falls
• When the interest rate is higher, the cash payments in the future are discounted more
heavily and become less important in present-value terms relative to the total present
value of all the payment.

• All else being equal, the higher the coupon rate on the bond, the shorter the
bond’s duration
• The explanation is that a higher coupon rate means that a relatively greater amount of the
cash payments is made earlier in the life of the bond, and so the effective maturity of the
bond must fall.
Portfolio Durations
• The duration of a portfolio of securities is the weighted average of the
durations of the individual securities, with the weights reflecting the
proportion of the portfolio invested in each
• This fact about duration is often referred to as the additive property
of duration, and it is extremely useful because it means that the
duration of a portfolio of securities is easy to calculate from the
durations of the individual securities
Example
Duration and Interest-Rate Risk
• Duration is a particularly useful concept because it provides a good
approximation, particularly when interest-rate changes are small, for
how much the security price changes for a given change in interest
rates, as the following formula indicates:
Duration
• The greater the duration of a security, the greater the percentage
change in the market value of the security for a given change in
interest rates.
• Therefore, the greater the duration of a security, the greater its
interest-rate risk

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