Transcript Chapter 3
What Do Interest Rates Mean? • Debt markets, or bond markets, allow governments (government bonds) and businesses (corporate bonds) to borrow to finance activities. • The interest rate (bonds/loans) is the cost of borrowing. • For savers, is the interest rate the income provided by bonds? Copyright © 2009 Pearson Prentice Hall. All rights reserved. 3-1 What Do Interest Rates Mean? • A financial adviser has just given you the following advice: “Long-term bonds are a great investment because their interest rate is over 10%”. • Is the financial adviser necessarily right? Copyright © 2009 Pearson Prentice Hall. All rights reserved. 3-2 What Do Interest Rates Mean? • Does coupon interest rate equal the yield to maturity of a financial instruments? • Does the return on a bond equal the interest rate on that bond? Copyright © 2009 Pearson Prentice Hall. All rights reserved. 3-3 Bond Markets & Interest Rates • There are many different types of interest rates, including mortgage rates, car loan rates, credit card rates, etc. • The level of these rates are important. For example, mortgage rates in the early part of 1983 exceeded 13%. Financing a house was quite expensive at this time. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 3-4 Interest Rates Copyright © 2009 Pearson Prentice Hall. All rights reserved. 3-5 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 Copyright © 2009 Pearson Prentice Hall. All rights reserved. 3-6 Different types of bonds/loans • Different debt instruments have very different streams of cash payments to the holder (known as cash flows), with very different timing. • Debt instruments are evaluated against one another based on the amount of each cash flow and the timing of each cash flow. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 3-7 Different types of bonds/loans • There are four basic types of credit instruments : 1. Simple Loan 2. Fixed Payment Loan 3. Coupon Bond 4. Discount Bond Copyright © 2009 Pearson Prentice Hall. All rights reserved. 3-8 Loan Terms • 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. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 3-9 Simple loans • Simple Loans require payment of one amount which equals the loan principal plus the interest. • In this loan, the lender provides the borrower with the principal, that must be repaid to the lender at the maturity date, along with an additional payment for the interest. • Many money market instruments are of this type Copyright © 2009 Pearson Prentice Hall. All rights reserved. 3-10 Fixed-payment loans • Fixed-Payment Loans are loans where the loan principal and interest are repaid in several payments, often monthly, in equal amounts over the loan term. • The loan must be repaid by making the same payment every period, consisting of part of the principal and interest • Auto loans and mortgages are frequently of the fixed-payment type Copyright © 2009 Pearson Prentice Hall. All rights reserved. 3-11 Coupon bonds • 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 • Corporate bonds are examples of coupon bonds Copyright © 2009 Pearson Prentice Hall. All rights reserved. 3-12 Discount bonds • A discount bond (or 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. • A discount bond does not make any interest payments. It just pays off the face value • In Italy, money goverment bonds (BOT) Copyright © 2009 Pearson Prentice Hall. All rights reserved. 3-13 Different types of instruments • Simple loans and discount bonds make payment only at their maturity dates • Fixed-payment loans and coupon bonds have payments periodically until maturity. • How would you decide which of these instruments provides you with more income? Copyright © 2009 Pearson Prentice Hall. All rights reserved. 3-14 Yield to Maturity • Yield to maturity = interest rate that equates today's value with present value of all future payments • Debt instruments are evaluated against one another based on the amount of each cash flow and the timing of each cash flow. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 3-15 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. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 3-16 Yield to Maturity: Loans 1. 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 loans? $100 $110 1 i i $110 $100 $100 $10 $100 Copyright © 2009 Pearson Prentice Hall. All rights reserved. .10 10 % 3-17 Yield to Maturity: Loans 2. Fixed Payment Loan (i = 12%) $1000 LV $126 1 i FP 1 i $126 1 i FP 1 i 2 2 Copyright © 2009 Pearson Prentice Hall. All rights reserved. $126 1 i FP 1 i 3 3 ... ... $126 1 i 25 FP 1 i n 3-18 Yield to Maturity: Bonds 3. Coupon Bond (Coupon rate = 10%) P P $100 1 i C 1 i $100 1 i 2 C 1 i 2 $100 1 i 3 C 1 i Copyright © 2009 Pearson Prentice Hall. All rights reserved. 3 ... ... $100 1 i 10 C 1 i n $1000 1 i 10 F 1 i n 3-19 Yield to Maturity: Bonds • There is one special case of a coupon bond: perpetuity or 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 simplifies to the following: P C i i C P Copyright © 2009 Pearson Prentice Hall. All rights reserved. 3-20 Yield to Maturity: Bonds 4. One-Year Discount Bond (P = $900, F = $1000) $900 i i $1000 1 i $1000 $900 $900 .111 11 .1% FP P Copyright © 2009 Pearson Prentice Hall. All rights reserved. 3-21 Relationship Between Price and Yield to Maturity 1. When bond is at par, yield equals coupon rate: If the bond is purchased at the par value of $ 1,000, its yield to maturity must equal the coupon rate 2. The yield is greater than the coupon rate when bond price is below its par value Copyright © 2009 Pearson Prentice Hall. All rights reserved. 3-22 Relationship Between Price and Yield to Maturity • It’s 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. • If the YTM rises, the price of the bond falls • If the YTM falls, the price of the bond rises Copyright © 2009 Pearson Prentice Hall. All rights reserved. 3-23 Current Yield ic C P • Current yield (CY) is just an approximation for YTM – easier to calculate. • If a bond’s price is near par and has a long maturity, then CY is a good approximation. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 3-24