Chapter 6: Measuring and Calculating Interest Rates and Financial Asset Prices

Units of Measurement for Interest Rates - Security dealers usually quote two prices for an
and Security Prices. asset.
- The higher ask price is the dealer’s selling
- The interest rate is the price that is charged to a price, while the lower bid price is the dealer’s
borrower for the loan of money. buying price.
- The difference between the bid and ask prices-
known as the spread- provides the dealer’s return
for creating a market for the security.

Measures of the Rate of Return (Yield) on

- Interest Rate are usually expressed as
annualized percentages. However, both 360-day
a Financial Asset.
and 365-day are commonly used.
- The coupon rate of a security is the
Example 1: contracted interest rate that the security issuer
agrees to pay at the time the security is issued.
An investor buys a government bond worth
100,000 and receives 8,000 annual interest.
Example:
Interest Rate = (8,000/10,000) x 100 = 8%
A bond with par value of $1000 and a coupon
Example 2: rate of 9% pays an annual coupon of $90.
A corporation raises funds by borrowing 500,000
from financial institutions and pays 50,000 - The current yield of a security is the ratio of
interest. the annual income (dividends or interest)
generated by the security to its market value.
Interest Rate = (50,000/500,000) x 100 = 10%
- A basis point is a unit used in finance to describe Example:
small changes in interest rates.
The current yield of a share of common stock
1 basis point = 0.01% selling for $30 in the market and paying an
100 basis points = 1%
annual dividend of $3 to the shareholder is
$3/$30 = 0.10, or 10%.
Formula: Basis Points (bps) = Change in x 100
- The yield to maturity of a financial asset is
Example:
the rate of interest that the market is prepared
A central bank increases interest rates from 5% to to pay today for the financial asset
5.25%
- It is the rate that equates the purchase price
Change= 5.25% - 5.00% = 0.25% (P) with the present value of all the expected
In basis points = 0.25 x 100 = 25 basis points annual net cash flows (CF) from the asset.

- The prices of common and preferred stock are

measured today in many markets in terms of
dollars and decimal fractions of a dollar.
Example: - A bond trades at a discount from par if its
price is less than its par value, i.e. if its current
$40.25 share (versus $40 ¼ in the recent past)
yield to maturity is higher than its coupon
- Bond prices are usually expressed in points and rate.
fractions of a point, which each point
representing $1 on a $10 for a $1000 bond. - A bond trades at a premium over par if its
price is more than its par value, i.e. if its
Example:
current yield to maturity is lower than its
A bond priced at 97 is selling for $97 on a $100 coupon rate.
basis, or $970 for each $1000 in face value.
- A bond trades at par if its price equals its
par value, i.e. if the current market interest
rate on comparable securities equals its would ignore Company A’s 6% bond in favor of
coupon rate. the competitors' 7% offer. To make their 6% bond
attractive again, Company A must sell it at a
- The holding-period yield is the rate of return discounted price—in this case, dropping the
from an investment over its actual or planned market value to approximately ₱857,143. By
holding period. lowering the price, the fixed annual interest
payment of ₱60,000 now represents an effective
- It is the discount rate equalizing the 7% yield.
purchase price (P0) of a financial asset with
all the discounted net cash flows (CF)
received from the asset from the time the
asset is purchased until the time it is sold (in
period n).

Yield-Asset Price Relationship

- The price of a security and its yield or rate

of return are inversely related – a rise in yield
implies a decline in price, while a fall in yield Example: HIGH SUPPLY FOR LOANABLE
implies a rise in the security’s price. FUNDS
Suppose Construction Company A issued a 10-
- This inverse relationship can be seen by
year bond last year with a 9% fixed coupon rate
noting that investing funds in financial assets and a face value of ₱1,000,000, meaning it pays
can be viewed from two different ₱90,000 annually. However, because the BSP has
perspectives – now increased the money supply, new similar
construction bonds are entering the market with
1. the borrowing and lending of money, only a 6% interest rate. Because Company A’s
bond offers a superior 9% return compared to the
2. the buying and selling of securities. new 6% benchmark, it becomes a highly sought-
after asset, leading investors to bid its price up
above its original par value. To acquire this bond,
a buyer must now pay a Premium Price—
specifically approximately ₱1,327,433. By
dividing the fixed ₱90,000 payment by this
higher purchase price, the investor’s effective
Yield is pushed down to match the current market
environment.

Interest Rate Charged or Paid by Institutional

Lenders.
- The simple interest method assesses interest
charges on a loan only for the period of time that
the borrower has actual use of the borrowed
funds.
- Interest = principal x rate x term
Example: HIGH DEMAND FOR LOANABLE
FUNDS
Construction Company A issued a bond last year
with a fixed 6% coupon rate and a face value of
₱1,000,000. However, due to a sudden building
boom in Batangas, three other competing firms
are now desperate for capital and are offering new
bonds at a 7% interest rate. As an investor, you
naturally want the highest return possible, so you
Example: Interest = ₱10,000 x 0.04 = ₱400
Ms. Santos, a freelance graphic designer in Net proceeds = ₱10,000 - ₱400 = ₱9,600
Batangas, requires ₱5,000 to upgrade her
The effective interest rate is
professional software subscriptions. She avails of
a credit line from a Digital Bank that utilizes the
Simple Interest method at a rate of 5% for one
month.
Interest = principal x rate x term - The compounding of interest means that the
lender or depositor earns interest income on both
= 5,000 x 0.05 x 1
the principal amount and any accumulated
= ₱250 interest.

= ₱5,250 - The formula for calculating the future value of a

financial asset earning compound interest is:
- In the add-on rate approach, interest is
calculated on the full principal of the loan, and the
sum of interest and principal payments is divided
by the number of payments to determine the
dollar amount of each payment.
- In a single payment loan, the simple interest and FV = future value of the asset
add-on methods give the same interest rate. P = principal value of the asset
However, as the number of installment payments
increases, the borrower pays a higher effective r = annual interest rate
rate under the add-on method.
m = manual compounding frequency
Example:
t = term of the asset in years
Mr. Bautista decides to purchase a new laptop
Example:
worth ₱30,000 for his daughter. He signs an
installment contract with a Sales Finance John invests $5,000 in a bank that offers 4%
Company using a 3% monthly add-on rate for 12 annual interest, compounded annually, for 3
months. years.

Interest + Principal/ Number of payments P = 5,000 (principal)

r = 0.04 (annual interest rate)
Interest: ₱30,000 x 0.03 x 12 = ₱10,800
m = 1 (compounded annually)
= ₱30,000 + 10,800 = ₱40,800
t = 3 years
= ₱40,800/12

= ₱3,400
- The U.S. Consumer Credit Protection Act of
- The discount method determines the total
1968 (Truth in Lending) requires lending
interest charged to the customer on the basis of
institutions to calculate and tell the borrower the
the amount to be repaid. However, the borrower
annual percentage rate (APR) he or she is
receives as proceeds of the loan only the
actually paying.
difference between the total amount owed and the
interest bill. - The constant ratio formula usually gives a close
approximation to the true APR.
Hence, the effective interest rate is

m = number of payments in a year

Example:
c = annual interest cost
Mrs. Cruz experiences a sudden medical
N = total number of payments
emergency and needs cash immediately. She
pawns a piece of jewelry with an appraisal value P = principal of the loan
of ₱10,000 at a local pawnshop. The institution
uses a 4% discount rate for a one-month term.
Example: Example:
A borrower takes a loan of $10,000. The total You deposited money with:
interest paid over the life of the loan is $2,000.
i = 500
The loan is to be paid monthly for 2 years.
b = 10,000
m = 10,000
d = 30 days
c = 2,000
N = 12
P = 12 x 2 = 24

- Each monthly payment of a home mortgage

loan first covers in full the monthly interest on the
outstanding principal. The remainder is then
applied to the principal of the loan, such that the
amount owed is reduced progressively.

L = total amount owned

r = annual loan interest rate
t = number of years of the loan
Example:
A person borrows P1,000,000 at 6% annual
interest for 20 years. Find the monthly payment.
L = 1,000,000
r = 0.06
t = 20

- The U.S. Truth in Savings Act of 1991 requires

depository institutions to use the daily average
balance in a customer’s deposit over each
interest-crediting period to determine the
customer’s annual percentage yield (APY) for
that deposit account.
i = interest earned
b = daily average balance
d = term in days