FIN2001 - FINANCIAL MARKETS

AND INSTITUTIONS

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 Chapter 2
INTEREST RATES

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 Content
§ Interest rates
§ Yield to maturity
§ Types of interest rate
§ Risk Structure of Interest Rates
§ Default
§ Liquidity
§ Taxes.
§ Term Structure of Interest Rates
§ Pure Expectation Theory
§ Segmented Markets Theory
§ Liquidity Premium Theory
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 Readings
① Chapter 3,4,5 Financial Markets and Institutions; Federic S.
Mishkin, Stanley G. Eakins; Pearson (2012).
② Chapter 2,3, Financial Markets and Institutions; Jeff Madura;
South-Western Cengage Learning (2010).
③ Giáo trình Tài chính – tiền tệ; TS. Nguyễn Hòa Nhân,
[Link].Lâm Chí Dũng, TS.Hồ Hữu Tiến, ThS.Võ Văn Vang,
ThS. Trịnh Thị Trinh, ThS. Đặng Tùng Lâm. Nhà xuất bản
Tài chính (2012).

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 2.1. Interest rates Measurement
n Interest rates are among the most closely watched
variables in the economy.
n It is imperative that you understand exactly what is
meant by the phrase interest rates.
n The concept known as yield to maturity (YTM) is the
most accurate measure of interest rates.

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 2.1. Interest rates Measurement
2.1.1 Present Value Introduction

n Different debt instruments have very different streams of cash

payments to the holder known as cash flows (CF).
n 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.
n This evaluation, where the analysis of the amount and timing of
a debt instrument’s cash flows lead to its yield to maturity or
interest rate, is called present value analysis.

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 2.1. Interest rates Measurement
2.1.1 Present Value Introduction

n Present discounted value is based on the common-sense notion

that a dollar of cash flow paid to you one year from now is worth
less than a dollar paid to you today.
n WHY?
n Because you could invest the dollar in a savings account that
earns interest and have more than a dollar in one year.
n 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.

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 2.1. Interest rates Measurement
2.1.1 Present Value Concept

n Simple loan
• For example, if you made your friend Jane a simple
loan of $100 for one year, you would require her to
repay the principal of $100 in one year’s time along
with an additional payment for interest; say, $10.

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 2.1. Interest rates Measurement
2.1.1 Present Value Concept

n Loan Principal: the amount of funds the lender provides to the

borrower. (100$)
n Maturity Date: the date the loan must be repaid; the Loan Term
is from initiation to maturity date. (1 year)
n Interest Payment: the cash amount that the borrower must pay
the lender for the use of the loan principal. (10$)
n 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. (?)
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 2.1. Interest rates Measurement
2.1.1 Present Value Concept

n If you make this $100 loan, at the end of year 1 you would
have $110, which can be rewritten as:
n 100+100×0,10=100×(1+0,10)=$110
n If you then lent out the $110, at the end of the second year
you would have: …
n At the end of the third year: …
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 2.1. Interest rates Measurement
2.1.1 Present Value Concept

n Simple Present Value:

𝐏𝐕=𝐂​ 𝐅/​(𝟏+𝐢)↑𝐧

PV : Present value
CF : Future cash flow
i : Interest rate
n : number of periods

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 2.1. Interest rates Measurement
2.1.2 Yield to Maturity

n Yield to maturity = interest rate that equates today's

value with present value of all future payments
𝐏𝐕=∑↑▒​𝐂 ​ 𝐅↓𝐧 /​(𝟏+​𝐢↓𝐘𝐌 )↑𝐧

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 2.1. Interest rates Measurement
2.1.2 Yield to Maturity

a. Simple Loans
𝐏𝐕=𝐂 ​ 𝐅/​(𝟏+​𝐢↓𝐘𝐌 )↑𝐧

PV = amount borrowed; CF = future cash flow

n = number of years

Ex: If Peter borrows $200 from his sister and next year she wants
$210 back from him, what is the yield to maturity on this loan?
200=​ 210/​ (1+​ 𝑖↓𝑌𝑀 )↑1 à ​ 𝑖↓𝑌𝑀 =​ 210/200 −1=0.05
(5%)
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 2.1. Interest rates Measurement
2.1.2 Yield to Maturity

b. Fixed payment Loans: are loans where the loan principal

and interest are repaid in several payments over the loan term.
𝐋𝐕=​ 𝐅𝐏/𝟏+​ 𝐢↓𝐘𝐌 +​ 𝐅𝐏/​ (𝟏+​ 𝐢↓𝐘𝐌 )↑𝟐 +​ 𝐅𝐏/​ (𝟏+​
𝐢↓𝐘𝐌 )↑𝟑 +…+​𝐅𝐏/​(𝟏+​𝐢↓𝐘𝐌 )↑𝐧

LV = loan value
FP = fixed yearly cash flow payment
n = number of years until maturity

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 2.1. Interest rates Measurement
2.1.2 Yield to Maturity

c. Coupon Bonds:
𝐏𝐕=​ 𝐂/​ (𝟏+​ 𝐢↓𝐘𝐌 )↑𝟏 +​ 𝐂/​ (𝟏+​ 𝐢↓𝐘𝐌 )↑𝟐 +​ 𝐂/​ (𝟏+​
𝐢↓𝐘𝐌 )↑𝟑 +…+​𝐂/​(𝟏+​𝐢↓𝐘𝐌 )↑𝐧 +​𝐅/​(𝟏+​𝐢↓𝐘𝐌 )↑𝐧

PV = price of coupon bond

C = yearly coupon payment
F = face value of the bond
n = years to maturity date

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 2.1. Interest rates Measurement
2.1.2 Yield to Maturity

d. Discount Bonds: A discount bond is a bond that is issued or

currently trading for less than its face value.
§ The yield-to-maturity calculation for a discount bond is similar to
that for the simple loan.
More general, for one-year discount bond:
𝐏=​𝐅/𝟏+​𝐢↓𝐘𝐌

F = face value of the discount bond

P = current price of the discount bond

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 2.2. Types of Interest rates
2.2.1. Real interest rate & Nominal interest rate

n Nominal interest rate refers to the stated interest rate

before adjustment for inflation.
n Real interest rate is interest rate adjusted for expected
changes in the price level.
n Fisher Effect equation: (1+i) = (1+ir)(1+πe)
FE equation can be rewritten as:
ir = i – πe
​𝑖↓𝑟 : Real interest rate
i : Nominal interest rate
​𝜋↑𝑒 : Expected inflation rate 17
2.2. Types of Interest rates
2.2.1. Real interest rate & Nominal interest rate

n If i = 5% and ​𝜋↑𝑒 = 0% then ​𝑖↓𝑟 = ?

n If i = 10% and ​𝜋↑𝑒 = 20% then ​𝑖↓𝑟 = ?

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2.2. Types of Interest rates
2.2.1. Real interest rate & Nominal interest rate

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 2.2. Types of Interest rates
2.2.2. Simple interest rates & Compound interest rates

n Simple interest: is calculated only on the principal amount of

a loan
𝐅=𝐏×(𝟏+𝐧×𝐢)
𝐒𝐢𝐦𝐩𝐥𝐞 𝐢𝐧𝐭𝐞𝐫𝐞𝐬𝐭=𝐏×𝐧×𝐢

F = Future value (including principal and interest)

P = Principal
i = annual simple interest rate in percentage terms
n = number of periods

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 2.2. Types of Interest rates
2.2.2. Simple interest rates & Compound interest rates

n Compound interest: is calculated on the principal amount and

also on the accumulated interest of previous periods, and can
thus be regarded as “interest on interest.”

𝐅=𝐏×​(𝟏+𝐢)↑𝐧
𝐂𝐨𝐦𝐩𝐨𝐮𝐧𝐝 𝐢𝐧𝐭𝐞𝐫𝐞𝐬𝐭=𝐏×​(𝟏+𝐢)↑𝐧 −𝐏

F = Future value (including principal and interest)

P = Principal
i = annual compound interest rate in percentage term
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n = number of periods
2.3. Risk Structure of Interest rates

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 2.3. Risk Structure of Interest rates

Factors Affecting Risk Structure of Interest Rates

§ Default Risk

§ Liquidity

§ Income Tax Considerations

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 2.3. Risk Structure of Interest rates
2.3.1. Default risk

n Default risk occurs when the issuer of the bond is unable or

unwilling to make interest payments when promised.
n Default-free bonds?
n The spread between the interest rates on bonds with default
risk and default-free bonds, called the risk premium, indicates
how much additional interest people must earn in order to be
willing to hold that risky bond.

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2.3. Risk Structure of Interest rates
2.3.1. Default risk

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Bond Ratings

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 2.3. Risk Structure of Interest rates
2.3.2. Liquidity

n A liquid asset is one that can be quickly and cheaply converted

into cash.
n The more liquid an asset is, the more desirable it is (higher
demand), holding everything else constant.
n Treasury bonds are the most liquid of all long-term bonds
because they are so widely traded that they are easy to sell
quickly and the cost of selling them is low.
n Corporate Bonds?

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2.3. Risk Structure of Interest rates
2.3.2. Liquidity

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 2.3. Risk Structure of Interest rates
2.3.3. Income Tax Consideration

n Interest payments on municipal bonds are exempt from federal

income taxes.

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 2.4. Term Structure of Interest Rates
2.4.1. Yield curve

Yield curve: a plot of the yield on bonds with differing

terms to maturity
n Upward-sloping: long-term rates are above short-term rates
n Flat: short-term rates and long-term rates are the same
n Inverted: long-term rates are below short-term rates

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2.4. Term Structure of Interest Rates
2.4.1. Yield curve

US Treasury Yield Curve

Source: Financial Markets and Institutions, 9th Edition, Jeff Madura, p.52 31
2.4. Term Structure of Interest Rates

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 2.4. Term Structure of Interest Rates
2.4.1. Yield curve

Facts theory of the term structure of interest rates:

1. Interest rates on bonds of different maturities move together
over time
2. When short-term interest rates are low, yield curves are more
likely to have an upward slope; when short-term rates are
high, yield curves are more likely to slope downward and be
inverted
3. Yield curves almost always slope upward

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 2.4. Term Structure of Interest Rates
2.4.1. Expectations Theory

§ The interest rate on a long-term bond will equal an average of the

short-term interest rates that people expect to occur over the life
of the long-term bond
§ Key Assumption: Bonds of different maturities are perfect
substitutes
§ Implication: Expected return on bonds of different maturities are
equal

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 2.4. Term Structure of Interest Rates
2.4.1. Expectations Theory

Investment strategies for two-period horizon:

§ Buy $1 of one-year bond and when matures buy another one-
year bond
§ Buy $1 of two-year bond and hold it

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 2.4. Term Structure of Interest Rates
2.4.1. Expectations Theory

§ Expected return from strategy 1:

(1 + i1,t)(1+ ie1,t+1) – 1 = 1+ i1,t + ie1,t+1 + i1,t * ie1,t+1 -1

§ Since ​ ​ 𝑖↓1,𝑡 ×𝑖↓1,𝑡+1↑𝑒 is also extremely small, expected

return is approximately: ​𝒊↓𝟏,𝒕 +​𝒊↓𝟏,𝒕+𝟏↑𝒆

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 2.4. Term Structure of Interest Rates
2.4.1. Expectations Theory

§ Expected return from strategy 2:

(1 + i2,t)2 – 1 = 1+ 2*i2,t + i22,t -1

§ Since ​ 𝑖↓2,𝑡↑2 is also extremely small, expected return is

approximately: 𝟐​𝒊↓𝟐, 𝒕

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 2.4. Term Structure of Interest Rates
2.4.1. Expectations Theory

n From implication above expected returns of two strategies are

equal. Therefore

𝐢​ i↓2,t𝟐,=𝐭(i= ​
𝐢
1,t ↓
+ 𝟏,𝐭
ie
​𝐢↓𝟏,𝐭+𝟏↑𝐞 /𝟐
+)/2
1,t+1

The two-period rate must equal the average of the two one-period
rates

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 2.4. Term Structure of Interest Rates
2.4.1. Expectations Theory

For bonds with longer maturities

​𝐢↓𝐧, 𝐭 =​𝐢↓𝟏,𝐭 +​𝐢↓𝟏,𝐭+𝟏↑𝐞 +​𝐢↓𝟏,𝐭+𝟐↑𝐞 +…+​𝐢↓𝟏,𝐭+𝐧

−𝟏↑𝐞 /𝐧
The n-period interest rate equal the average of the one-period interest
rates expected to occur over the n-period of the bond

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 2.4. Term Structure of Interest Rates
2.4.1. Expectations Theory

n Explains why the term structure of interest rates changes at

different times
n Explains why interest rates on bonds with different maturities
move together over time (fact 1)
n Explains why yield curves tend to slope up when short-term rates
are low and slope down when short-term rates are high (fact 2)
n Cannot explain why yield curves usually slope upward (fact 3)

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 2.4. Term Structure of Interest Rates
2.4.2. Segmented Markets Theory

n Key Assumption: Bonds of different maturities are not substitute

at all
n Implication: Markets are completely segmented; interest rate at
each maturity determined separately

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 2.4. Term Structure of Interest Rates
2.4.2. Segmented Markets Theory

n Investors have preferences for bonds of one maturity over another

n If investors generally prefer bonds with shorter maturities that
have less interest-rate risk, then this explains why yield curves
usually slope upward (fact 3)
n Does not explain fact 1 or fact 2

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 2.4. Term Structure of Interest Rates
2.4.3. Liquidity Premium Theory

n Key Assumption: Bonds of different maturities are substitutes,

but are not perfect substitutes
n Implication: Modifies Pure Expectations Theory with features
of Market Segmentation Theory

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 2.4. Term Structure of Interest Rates
2.4.3. Liquidity Premium Theory

n Investors prefer short rather than long bonds, must be paid

positive liquidity premium to hold long term bonds
n Results in following modification of Pure Expectations Theory:
​ 𝐢↓𝐧, 𝐭 =​ ​ 𝐢↓𝟏,𝐭 +​ 𝐢↓𝟏,𝐭+𝟏↑𝐞 +​ 𝐢↓𝟏,𝐭+𝟐↑𝐞 +…+​ 𝐢↓𝟏,𝐭+𝐧
−𝟏↑𝐞 /𝐧 +​𝐋𝐏↓𝟐

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 2.4. Term Structure of Interest Rates
2.4.3. Liquidity Premium Theory

n Explains All 3 Facts

n Explains fact 3—that usual upward sloped yield curve by
liquidity premium for long-term bonds
n Explains fact 1 and fact 2 using same explanations as pure
expectations theory because it has average of future short rates as
determinant of long rate

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2.4. Term Structure of Interest Rates
2.4.3. Liquidity Premium Theory

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FIGURE 6 Yield Curves and the Market’s Expectations of Future Short-
Term Interest Rates According to the Liquidity Premium (Preferred
Habitat) Theory

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FIGURE 6 Yield Curves and the Market’s Expectations of Future Short-
Term Interest Rates According to the Liquidity Premium (Preferred
Habitat) Theory

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