FIN2001 - FINANCIAL MARKETS

AND INSTITUTIONS

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 Chapter 2
INTEREST RATES

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 Content

§ Interest rates
§ Types of interest rate
§ Yield to maturity
§ Risk Structure of Interest Rates
§ Term Structure of Interest Rates

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 Readings
① Chapter 3,4,5 Financial Markets and Institutions; Federic
S. Mishkin, Stanley G. Eakins; Pearson (2017).
② Chapter 2,3, Financial Markets and Institutions; Jeff
Madura; South-Western Cengage Learning (2015).

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 2.1. Interest rates
n Interest rates are among the most closely watched
variables in the economy.
n Interest rates also affect the economic decisions of
businesses and households
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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 2.2. Types of Interest rates
2.2.1. Real interest rate & Nominal interest rate
lai suat dinh danh

n Nominal interest rate refers to the stated interest rate

before adjustment for inflation.
lai suat thuc
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
wher𝑒 𝑖! : real interest rate
i: nominal interest rate
𝜋 " : expected inflation rate
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2.2. Types of Interest rates
2.2.1. Real interest rate & Nominal interest rate

n If i = 5% and 𝜋 ! = 0% then 𝑖" = ?

n If i = 10% and 𝜋 ! = 20% then 𝑖" = ?

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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
so tien goc cua 1 khoan vay
lsuat don
n Simple interest: is calculated only on the principal
amount of a loan
𝐅 = 𝐏×(𝟏 + 𝐧×𝐢)
𝐒𝐢𝐦𝐩𝐥𝐞 𝐢𝐧𝐭𝐞𝐫𝐞𝐬𝐭 = 𝐏×𝐧×𝐢

where 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
lsuat kep

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

where: F = future value (including principal and interest)

P = principal
i = annual compound interest rate in percentage term
n = number of periods
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 2.3. Interest rates Measurement
2.3.1 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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 2.3. Interest rates Measurement
2.3.1 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 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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 2.3. Interest rates Measurement
2.3.1 Present Value Introduction

Ø 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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 2.3. Interest rates Measurement
2.3.1 Present Value Introduction

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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 2.3. Interest rates Measurement
2.3.1 Present Value Introduction

n If you make this $100 loan, at the end of year 1 you would
have $110, which can be rewritten as:
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: 100 ×(1 + 0,10)!= $121
n At the end of the third year: 100 ×(1 + 0,10)"= $133,1
n At the end of n year: 100 ×(1 + 0,10)#

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 2.3. Interest rates Measurement
2.3.1 Present Value Introduction

n Simple Present Value: tinh gia tri hien tai cua mot khoan tien trong tuong lai

𝐂𝐅
𝐏𝐕 =
(𝟏 + 𝐢)𝐧

where PV: Present value

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

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 2.3. Interest rates Measurement
2.3.2 Yield to Maturity
ty suat hoi doai

n Yield to maturity (iYM) is interest rate that equates today's

value with present value of all future payments
lam gtri hien tai= gia tri hien tai trong tuong lai

𝐂𝐅𝐧
𝐏𝐕 = .
(𝟏 + 𝐢𝐘𝐌 )𝐧

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 2.3. Interest rates Measurement
2.3.2 Yield to Maturity

no don
1. Simple Loans: the lender provides the borrower with
an amount of funds, which must be repaid to the lender at
the maturity date along with an additional payment for
the interest.
𝐂𝐅
𝐏𝐕 =
(𝟏 + 𝐢𝐘𝐌)𝐧

PV = amount borrowed; CF = future cash flow

n = number of period

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 2.3. Interest rates Measurement
2.3.2 Yield to Maturity

1. Simple Loans:
Example: 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?

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 2.3. Interest rates Measurement
2.3.2 Yield to Maturity
khoan vay thanh toan co dinh

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

and interest are repaid in several payments over the loan
tra trong nhieu dot
term.
𝐅𝐏 𝐅𝐏 𝐅𝐏 𝐅𝐏
𝐋𝐕 = + 𝟐+ 𝟏+𝐢 𝟑 + ⋯+ 𝟏 + 𝐢 𝐧
𝟏 + 𝐢𝐘𝐌 𝟏 + 𝐢𝐘𝐌 𝐘𝐌 𝐘𝐌

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

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 2.3. Interest rates Measurement
2.3.2 Yield to Maturity

2. Fixed payment Loans:

Example:
1. Suppose the loan is $1000 and the yearly cash flow payment
is $85.81 for next 25 years. What is the yield to maturity of
this loan?
2. You decide to purchase a new home and need a $100,000
mortgage. You take out a loan from the bank that has an
interest rate of 7%. What is the yearly payment to the bank to
pay off the loan in 20 years?

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 2.3. Interest rates Measurement
2.3.2 Yield to Maturity
trai phieu co tuc
3. Coupon Bonds: pays the owner of the bond a fixed interest
ngay dao han
payment (coupon payment) every year until the maturity date,
when a specified final amount (face value or par value) is
repaid.
𝐂 𝐂 𝐂 𝐂 𝐅
𝐏𝐕 = 𝟏+ 𝟏+𝐢 𝟐+ 𝟏+𝐢 𝟑 + ⋯+ 𝟏 + 𝐢 𝐧+ 𝟏+𝐢 𝐧
𝟏 + 𝐢𝐘𝐌 𝐘𝐌 𝐘𝐌 𝐘𝐌 𝐘𝐌

PV = price of coupon bond

C = yearly coupon payment
F = face value or par value of the bond
n = years to maturity date
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 2.3. Interest rates Measurement
2.3.2 Yield to Maturity

3. Coupon Bonds:
Example: Find the price of a 10% coupon bond with a face
value of $1,000, a 12.25% yield to maturity, and eight years to
maturity.

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 2.3. Interest rates Measurement
2.3.2 Yield to Maturity
trai phieu uu dai

4. 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.
𝐅
𝐏=
(𝟏 + 𝐢𝐘𝐌))
F = face value of the discount bond
P = current price of the discount bond
n = years to maturity date

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 2.3. Interest rates Measurement
2.3.2 Yield to Maturity

4. Discount Bonds:
Example: Let’s consider a discount bond with a face value of
$1,000 in one year’s time. If the current purchase price of this
bill is $900, what is the yield to maturity of this bond?

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2.4. Risk Structure of Interest rates

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 2.4. Risk Structure of Interest rates

Factors Affecting Risk Structure of Interest Rates

q Default Risk rui ro mac dinh
tinh thanh khoan
xem xet ve thue thu nhap
q Liquidity
q Income Tax Considerations

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 2.4. Risk Structure of Interest rates
2.4.1. 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.
su chenh lech giua tp rui ro va tp k rui ro la phan thuong rui ro, lai them
neu nguoi ta san long chap nhan nguy hiem

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2.4. Risk Structure of Interest rates
2.4.1. Default risk

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2.4. Risk Structure of Interest rates
2.4.1. Default risk

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 2.4. Risk Structure of Interest rates
2.4.2. 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.
tp chinh phu
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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2.4. Risk Structure of Interest rates
2.4.2. Liquidity

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 2.4. Risk Structure of Interest rates
2.4.3. Income Tax Consideration
thu nhap sau thue

n Investors concern the after-tax income more than

loi nhuan truoc thue
earnings before tax. mien thue

n Once the bond is the tax-exempt security that raises

after-tax expected return, investors will get more profit.
n Reversely, the profit of investment decreases because
the security is not tax-exempt.

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2.4. Risk Structure of Interest rates
2.4.3. Income Tax Consideration

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 cau truc lai suat

2.5. Term Structure of Interest Rates

2.5.1. Yield curve duong cong lai suat

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

terms to maturity
nghieng len cao hon
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
dao nguoc

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2.5. Term Structure of Interest Rates
2.5.1. Yield curve

US Treasury Yield Curve

Source: Financial Markets and Institutions, 9th Edition, Jeff Madura, p.52 36
 2.5. Term Structure of Interest Rates
2.5.1. 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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 2.5. Term Structure of Interest Rates
2.5.2. 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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 2.5. Term Structure of Interest Rates
2.5.2. Expectations Theory

Investment strategies for two-period horizon:

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

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 2.5. Term Structure of Interest Rates
2.5.2. Expectations Theory

1. 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*,, ×𝑖*,,-* is also extremely small, expected return is
approximately: 𝒊𝟏,𝒕 + 𝒊𝒆𝟏,𝒕-𝟏

2. Expected return from strategy 2:

(1 + i2,t)2 – 1 = 1+ 2*i2,t + i22,t -1
!
Since 𝑖!,, is also extremely small, expected return is
approximately: 𝟐𝒊𝟐,𝒕

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 2.5. Term Structure of Interest Rates
2.5.2. Expectations Theory

n From implication above expected returns of two

strategies are equal. Therefore

𝐢𝟏,𝐭 + 𝐢𝐞𝟏,𝐭&𝟏
𝐢𝟐,𝐭 =
𝟐
The two-period rate must equal the average of the two
one-period rates

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 2.5. Term Structure of Interest Rates
2.5.2. Expectations Theory

For bonds with longer maturities

𝐢𝟏,𝐭 + 𝐢𝐞𝟏,𝐭&𝟏 + 𝐢𝐞𝟏,𝐭&𝟐 + ⋯ + 𝐢𝐞𝟏,𝐭&𝐧(𝟏
𝐢𝐧,𝐭 =
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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 2.5. Term Structure of Interest Rates
2.5.2. 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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 2.5. Term Structure of Interest Rates
2.5.3. Segmented Markets Theory
ly thuyet thi truong phan doan

n The interest rate for each bond with a different maturity

is then determined by the supply of and demand for that
loi suat ki vong
bond, with no effects from expected returns on other
bonds with other maturities. ki han
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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 2.5. Term Structure of Interest Rates
2.5.3. 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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 2.5. Term Structure of Interest Rates
2.5.4. Liquidity Premium Theory li thuyet phi thanh khoan

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

short-term interest rates expected to occur over the life of the
phi thanh khoan
long-term bond plus a liquidity premium (also referred to as a
term premium) that responds to supply-and-demand conditions
phan anh dieu kien cung cau
for that bond
n Key Assumption: Bonds of different maturities are substitutes,
thay the
but are not perfect substitutes
n Implication: Modifies Pure Expectations Theory with features
of Market Segmentation Theory
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 2.5. Term Structure of Interest Rates
2.5.4. 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:

𝐢𝟏,𝐭 + 𝐢𝐞𝟏,𝐭&𝟏 + 𝐢𝐞𝟏,𝐭&𝟐 + ⋯ + 𝐢𝐞𝟏,𝐭&𝐧(𝟏

𝐢𝐧,𝐭 = + 𝐋𝐏𝟐
𝐧

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 2.5. Term Structure of Interest Rates
2.5.4. 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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2.5. Term Structure of Interest Rates
2.5.4. 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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