Part Two: Fundamentals of Financial Markets

Part Two
Fundamentals
of Financial
Markets
Chapter 3
What Do Interest
Rates Mean
and What Is
Their Role
in Valuation?
Copyright 2009 Pearson Prentice Hall. All rights reserved. 3-3
Chapter Preview
Interest rates are among the most closely
watched variables in the economy. It is
imperative that what exactly is meant by
the phrase interest rates is understood.
In this chapter, we will see that a concept
known as yield to maturity (YTM) is the
most accurate measure of interest rates.
Chapter Preview
Any description of interest rates entails an
understanding certain vernacular and
definitions, most of which will not only
pertain directly to interest rates but will also
be vital to understanding many other
foundational concepts presented later in
the text.
Chapter Preview
So, in this chapter, we will develop a better
understanding of interest rates. We examine the
terminology and calculation of various rates, and
we show the importance of these rates in our lives
and the general economy. Topics include:
Measuring Interest Rates
The Distinction Between Real and Nominal
Interest Rates
The Distinction Between Interest Rates and Returns
Present Value Introduction
Different debt instruments have very different
streams of cash payments to the holder (known
as cash flows), with very different timing.
All else being equal, debt instruments are
evaluated against one another based on the
amount of each cash flow and the timing of each
cash flow.
This evaluation, where the analysis of the amount
and timing of a debt instruments cash flows lead
to its yield to maturity or interest rate, is called
present value analysis.
Present Value
The concept of present value (or present
discounted value) is based on the
commonsense 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 could invest the dollar in a
savings account that earns interest and have
more than a dollar in one year.
The term present value (PV) can be extended to
mean the PV of a single cash flow or the sum of a
sequence or group of cash flows.
Present Value Applications
There are four basic types of credit
instruments which incorporate present
value concepts:
1. Simple Loan
2. Fixed Payment Loan
3. Coupon Bond
4. Discount Bond
Present Value Concept:
Simple Loan Terms
Loan Principal: the amount of funds the lender provides to
the borrower.
Maturity Date: the date the loan must be repaid; the Loan
Term is from initiation to maturity date.
Interest Payment: the cash amount that the borrower
must pay the lender for the use of the loan principal.
Simple Interest Rate: the interest payment divided by the
loan principal; the percentage of principal that must be
paid as interest to the lender. Convention is to express on
an annual basis, irrespective of the loan term.
Simple loan of $100
Year: 0 1 2 3 n
$100 $110 $121 $133 100(1+i)
n

PV of future $1=
$1
1+ i ( )
n
Present Value Concept: Simple Loan
Simple Loan (cont.)
The previous example reinforces the
concept that $100 today is preferable to
$100 a year from now since todays $100
could be lent out (or deposited) at 10%
interest to be worth $110 one year from
now, or $121 in two years or $133 in
three years.
Yield to Maturity: Loans
Yield to maturity = interest rate that equates
today's value with present value of all
future payments
1. Simple Loan Interest Rate (i = 10%)
$100 = $110 1+i ( )
i =
$110 $100
$100
=
$10
$100
= .10 = 10%
Present Value of Cash Flows: Example
Fixed-Payment Loan Terms
Simple Loans require payment of one
amount which equals the loan principal plus
the interest.
Fixed-Payment Loans are loans where the
loan principal and interest are repaid in
several payments, often monthly, in equal
dollar amounts over the loan term.
Fixed-Payment Loan Terms
Installment Loans, such as auto loans and
home mortgages are frequently of the
fixed-payment type.

The general definition of yield is the return
an investor will receive by holding a bond to
maturity
if you buy a savings bond with a $100 face value for $50
today (this is a $50 discount), but you have to wait for 20
years before it is actually worth $100. It implies that you
earn an uncompounded 2.5% per annum. If you buy a
$100 face value bond at par (or $100) and earn 2.5% per
annum it is the same rate

Yield to Maturity: Bonds
3. Coupon Bond (Coupon rate = 10% = C/F)
P =
$100
1+ i ( )
+
$100
1 + i ( )
2
+
$100
1+ i ( )
3
+ . .. +
$100
1+ i ( )
10
+
$1000
1 + i ( )
10
P =
C
1+ i ( )
+
C
1 + i ( )
2
+
C
1+ i ( )
3
+ ... +
C
1+ i ( )
n
+
F
1 + i ( )
n
Consol: Fixed coupon payments of $C forever
P =
C
i
i =
C
P
Yield to Maturity: Bonds
4. One-Year Discount Bond (P = $900, F = $1000)
$900 =
$1000
1 + i ( )

i =
$1000$900
$900
= .111=11.1%
i =
F P
P
Relationship Between Price
and Yield to Maturity
Three interesting facts in Table 3-1
1. When bond is at par, yield equals coupon rate
2. Price and yield are negatively related
3. Yield greater than coupon rate when bond price
is below par value
Relationship Between Price
and Yield to Maturity
Its also straight-forward to show that the value of
a bond (price) and yield to maturity (YTM) are
negatively related. If i increases, the PV of any
given cash flow is lower; hence, the price of the
bond must be lower.
Current Yield
A simple yield calculation that is often used
to calculate the yield on both bonds and the
dividend yield for stocks is the current yield

if you purchased a bond with a par value of
$100 for $95.92 and it paid a coupon rate
of 5%, this is how you'd calculate its current
yield

Current Yield

Current Yield = Annual Dollar Interest Paid X 100%
Market Price
Current Yield
Current yield (CY) is just an approximation for
YTM easier to calculate. However, we should
be aware of its properties:
1. If a bonds price is near par and has a long
maturity, then CY is a good approximation.
2. A change in the current yield always signals
change in same direction as yield to maturity
i
c
=
C
P
i
db
=
(F - P)
F

360
(number of days to maturity)
i
db
=
$1000- $900
$1000

360
365
= .099 = 9.9%
Two Characteristics
1. Understates yield to maturity; longer the maturity,
greater is understatement
2. Change in discount yield always signals change in
same direction as yield to maturity
Yield on a Discount Basis
One-Year Bill (P = $900, F = $1000)
Bond Page of the Newspaper
Global perspective
In November 1998, rates on Japanese 6-
month government bonds were negative!
Investors were willing to pay more than
they would receive in the future.
Best explanation is that investors found the
convenience of the bills worth something
more convenient than cash. But that can
only go so far the rate was only slightly
negative.
Distinction Between Real
and Nominal Interest Rates
Real interest rate
1. Interest rate that is adjusted for expected
changes in the price level
i
r
= i t
e
2. Real interest rate more accurately reflects
true cost of borrowing
3. When the real rate is low, there are greater
incentives to borrow and less to lend
and Nominal Interest Rates
Real interest rate
i
r
= i t
e
We usually refer to this rate as the ex ante real
rate of interest because it is adjusted for the
expected level of inflation. After the fact, we
can calculate the ex post real rate based on the
observed level of inflation.
and Nominal Interest Rates (cont.)
If i = 5% and
e
= 0% then
i
r
= 5%0%= 5%
i
r
=10%20%= 10%
If i = 10% and
e
= 20% then
U.S. Real and Nominal Interest Rates
Sample of current rates and indexes
http://www.martincapital.com/charts.htm
Distinction Between Interest Rates
and Returns
Rate of Return: we can decompose returns
into two pieces:
g i
P
P P
c
t
t t
+ =
+
=
+1
C
Return
t
c
P
C
i =
where = current yield, and
t
t t
P
P P
=
+1
g
= capital gains.
Key Facts about the Relationship
Between Rates and Returns
Sample of current coupon rates
and yields on government bonds
http://www.bloomberg.com/markets/iyc.html
Maturity and the Volatility
of Bond Returns
Key findings from Table 3-2
1. Only bond whose return = yield is one with
maturity = holding period
2. For bonds with maturity > holding period, i | P +
implying capital loss
3. Longer is maturity, greater is price change
associated
with interest rate change
of Bond Returns (cont.)
Key findings from Table 3-2 (continued)
4. Longer is maturity, more return changes with
change in interest rate
5. Bond with high initial interest rate can still have
negative return if i |
of Bond Returns (cont.)
Conclusion from Table 3-2 analysis
1. Prices and returns more volatile for long-term
bonds because have higher interest-rate risk
2. No interest-rate risk for any bond whose
maturity equals holding period
Reinvestment Risk
1. Occurs if hold series of short bonds over
long holding period
2. i at which reinvest uncertain
3. Gain from i |, lose when i +
Calculating Duration
i =10%, 10-Year 10% Coupon Bond
Calculating Duration
i = 20%, 10-Year 10% Coupon Bond
DUR = t
CP
t
1 + i ( )
t
t =1
n
CP
t
1 + i ( )
t
t =1
n
Formula for Duration

Key facts about duration
1. All else equal, when the maturity of a bond
lengthens, the duration rises as well
2. All else equal, when interest rates rise, the
duration of a coupon bond fall
Formula for Duration
1. The higher is the coupon rate on the bond,
the shorter is the duration of the bond
2. Duration is additive: the duration of a
portfolio of securities is the weighted-
average of the durations of the individual
securities, with the weights equaling the
proportion of the portfolio invested in each
%AP ~ DUR
Ai
1+i
%AP ~6.76
0.01
1+0.10
%AP ~0.0615= 6.15%
Duration and Interest-Rate Risk
i | 10% to 11%:
Table 3-4, 10% coupon bond
Duration and
Interest-Rate Risk (cont.)
i | 10% to 11%:
20% coupon bond, DUR = 5.72 years
%AP ~5.72
0.01
1+0.10
%AP ~0.0520= 5.20%
The greater is the duration of a security, the
greater is the percentage change in the
market value of the security for a given
change in interest rates
Therefore, the greater is the duration of a
security, the greater is its interest-rate risk
Duration and
Interest-Rate Risk (cont.)
Chapter Summary
Measuring Interest Rates: We examined
several techniques for measuring the
interest rate required on debt instruments.
The Distinction Between Real and Nominal
Interest Rates: We examined the meaning
of interest in the context of price inflation.
Chapter Summary (cont.)
The Distinction Between Interest Rates and
Returns: We examined what each means
and how they should be viewed for asset
valuation.

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Formula for Duration

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