Interest Rates
Hillary Ekisa, PhD
Strathmore Institute of Mathematical Sciences
Strathmore University
September 15, 2025
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Preview
❑ Before we can go on with the study of money,
banking, and financial markets, we must understand
exactly what the phrase interest rates means. In this
Lecture, we see that a concept known as the yield to
maturity is the most accurate measure of interest
rate.
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Learning Objectives
❑ Calculate the present value of future cash flows
and the yield to maturity on the four types of
credit market instruments.
❑ Recognize the distinctions among yield to
maturity, current yield, rate of return, and rate
of capital gain.
❑ Interpret the distinction between real and
nominal interest rates.
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Measuring Interest Rates
❑ Present value: a dollar paid to you one year
from now is less valuable than a dollar paid to
you today.
❖ Why: a dollar deposited today can earn
interest and become $1×(1+i) one year
from today.
❖ To understand the importance of this
notion, consider the value of a $20 million
lottery payout today versus a payment of
$1 million per year for each of the next 20
years. Are these two values the same?
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Future Cash Flow (Payment)
Let i = .10 (interest rate per annum)
Let Present Value (PV)=$100
In one year: $100 × (1 + 0.10) = $110
In two years: $110 × (1 + 0.10) = $121
or $100 × (1 + 0.10)2
In three years: $121 × (1 + 0.10) = $133
or $100 × (1 + 0.10)3
In n years
Future Cash Flow(CF)=PV × (1 + i)n
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Simple Present Value (1 of 2)
PV = today’s (present) value
CF = future cash flow (payment)
i = the interest rate
Equation 1:
CF
PV =
(1 + i )n
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Simple Present Value (2 of 2)
❑ Cannot directly compare payments scheduled in different
points in the time line.
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Four Types of Credit Market Instruments
❑ Simple Loan
❑ Fixed Payment Loan
❑ Coupon Bond
❑ Discount Bond
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Yield to Maturity
❑ Yield to maturity: the interest rate that equates
the value of cash flow payments received from a
debt instrument with its value today.
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Yield to Maturity on a Simple Loan
PV = amount borrowed = $100
CF = cash flow in one year = $110
n = number of years = 1
$110
$100 =
(1 + i )1
(1 + i ) $100 = $110
$110
(1 + i ) =
$100
i = 0.10 = 10%
For simple loans, the simple interest rate equals the
yield to maturity
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Fixed-Payment Loan
❑ The same cash flow payment every period throughout the
life of the loan.
LV = loan value
FP = fixed yearly payment
n = number of years until maturity
Equation 2:
FP FP FP FP
LV = + 2
+ 3
+ ... +
1 + i (1 + i ) (1 + i ) (1 + i )n
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Coupon Bond (1 of 6)
❑ Using the same strategy used for the fixed-payment loan:
P = price of coupon bond
C = yearly coupon payment
F = face value of the bond
n = years to maturity date
Equation 3:
C C C C F
P= + 2
+ 3
+. . . + +
1+ i (1+ i ) (1+ i ) n
(1+ i ) (1+ i )n
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Coupon Bond (2 of 6)
❑ A coupon bond is
identified by four
pieces of information:
1. Face value
2. Agencies that issue
this bond
3. Maturity date
4. The coupon rate
Source: [Link]
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Coupon Bond (3 of 6)
❑ When the coupon bond is priced at its face value, the yield to
maturity equals the coupon rate.
❖ We can show the statement by using simple algebra:
∙ ∙ ∙
𝑃= + 2
+ 3
…+
1+ 1+ 1+ 1+
1 1
1− 1+
1 1+
→ 1− 𝑃= 𝑃∙ if 𝑃 =
1+ 1
1−1+
=
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Coupon Bond (4 of 6)
❑ The price of a coupon bond and the yield to
maturity are negatively related.
❑ The yield to maturity is greater than the coupon
rate when the bond price is below its face value.
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Coupon Bond (5 of 6)
Table 1 Yields to Maturity on a 10%-Coupon-Rate Bond Maturing
in Ten Years (Face Value = $1,000)
Price of Bond ($) Yield to Maturity (%)
1,200 7.13
1,100 8.48
1,000 10.00
900 11.75
800 13.81
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Coupon Bond (6 of 6)
❑ Consol or perpetuity: a bond with no maturity date that does
not repay principal but pays fixed coupon payments forever.
𝑃 = /
𝑃 = price of the consol
= yearly interest payment
= yield to maturity of the consol
One can rewrite the equation as: = /𝑃
For coupon bonds, this equation gives the current yield, an easy
way to calculate approximation to the yield to maturity
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Discount Bond
For any one year discount bond
F − P
i=
P
F = Face value of the discount bond
P = Current price of the discount bond
The yield to maturity equals the increase in price over the
year divided by the initial price.
As with a coupon bond, the yield to maturity is negatively
related to the current bond price.
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The Distinction Between Interest Rates and
Returns (1 of 4)
Rate of Return:
The payments to the owner plus the change in value
expressed as a fraction of the purchase price
C P − Pt
RET = + t +1
Pt Pt
RET = return from holding the bond from time t to time t + 1
Pt = price of bond at time t
Pt +1 = price of the bond at time t + 1
C = coupon payment
C
= current yield = ic
Pt
Pt +1 − Pt
= rate of capital gain = g
Pt
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The Distinction Between Interest Rates and
Returns (2 of 4)
❑ 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.
❑ Interest rates do not always have to be positive as evidenced
by recent experience in Japan and several European states.
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The Distinction Between Interest Rates and
Returns (3 of 4)
❑ The more distant a bond’s maturity, the lower the rate
of return that 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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The Distinction Between Interest Rates and
Returns (4 of 4)
Table 2 One-Year Returns on Different-Maturity 10%-Coupon-
Rate Bonds When Interest Rates Rise from 10% to 20%
(1) (2) (3) (5)
Years to Maturity Initial Initial (4) Rate of (6)
When Bond Is Current Price Price Next Capital Gain Rate of Return
Purchased Yield (%) ($) Year* ($) (%) [col (2) + col (5)] (%)
30 10 1,000 503 −49.7 −39.7
20 10 1,000 516 −48.4 −38.4
10 10 1,000 597 −40.3 −30.3
5 10 1,000 741 −25.9 −15.9
2 10 1,000 917 −8.3 +1.7
1 10 1,000 1,000 0.0 +10.0
*Calculated with a financial calculator, using Equation 3.
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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.
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The Distinction Between Real and Nominal Interest
Rates
❑ Nominal interest rate makes no allowance for
inflation.
❑ Real interest rate is adjusted for changes in
price level so it 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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Fisher Equation
i = ir + e
i = nominal interest rate
ir = real interest rate
e = expected inflation rate
When the real interest rate is low,
there are greater incentives to borrow and fewer incentives to lend.
The real interest rate is a better indicator of the incentives to
borrow and lend.
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Figure 1 Real and Nominal Interest Rates (Three-Month
Treasury Bill), 1953–2017
Sources: Nominal rates from Federal Reserve Bank of St. Louis FRED database:
[Link] 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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