Money, Banking and the

Financial Markets (HS5340)

Understanding the Interest

Rates

DR. PRAMOD KUMAR NAIK

1
Learning Objectives
•Time value of money

•Interest rates: Nominal vs Real

•Bond Valuations: The concepts of Present value and Future values of Bond

•Current Yield, YTM, Capital Gain, Rate of Returns..

2
Time Value of Money
Interest rate:
• Most closely looked macroeconomic variable
• It may directly or indirectly affect our everyday life
• They affect the household’s personal decisions
• Whether to consume or save? Whether to buy a house or purchase a bond? etc.
• Also affect the economic decisions of businesses and households
• Whether to use their funds to invest in new equipment for factories or to save rather than
spend their money.
• Thus we must understand the concepts of interest rate, how to measure and
determine this?

3
Time Value of Money
•“ A rupee in hand today is worth more than a rupee tomorrow”
Why?
•You could have invested it elsewhere and earned some income
• If you could earn 10% int. in a saving account in a bank the rupee
today would be worth Rs. 1.10 a year from today.

4
Interest rate
•Why does your saving deserve interest payments?
Two reasons:
1. The presence of inflation
◦ Your one rupee can buy more today in terms of real goods than in the future
◦ So you demand an interest rate to compensate for the loss of purchasing power

2. Most people prefer present consumption to future consumption (even in

the absence of inflation)
◦ To get you to postpone the consumption for the future the borrower offers you
some compensation in the form of an interest rate

5
Interest rate
❖How much would you need to be offered?
❖It depends upon how strong your preference for current
consumption is.
❖Stronger the preference higher will be the int. rate.

6
 Nominal vs. Real Interest rate
•Nominal Int. Rate: The interest rate in terms of monetary term
•Real Int. Rates: The int. rate in terms of baskets of goods.
• Interest rate that is adjusted by subtracting expected changes in the price level (inflation) so that it more accurately reflects
the true cost of borrowing
• More precisely referred to as the ex ante real interest rate
• The real interest rate reflects the rate of time preference for current goods over future goods
• It reflects the change in purchasing power

𝑖 = 𝑟 + 𝜋𝑒
Fisher’ Equation
⇒ 𝑟 = 𝑖 − 𝜋𝑒

7
Nominal vs. Real Interest rate
oWhy this definition make sense?
oSuppose you have made a simple one-year loan with 5% int. rate
o Nominal interest rate (i) = 5 %, expected inflation = 3 %
oThen real interest rate = 2%
oIf you make loan you can earn 2 % int. rate in real terms , i.e, the interest you earned in terms of real
goods and service is 2%
oNow, suppose that i rise to 8% and also expected inflation increases to 10% over the course of a year.
oThe r = -2%.
oYou are 2% worse off in real term

8
Nominal vs. Real Interest rate
➢If you are a lender, what would you do?
➢Clearly, you would be less eager to make a loan
➢But, if you are a borrower then…
➢You are better off
Note:
When the real interest rate is low, there are greater incentives
to borrow and fewer incentives to lend.

9
Return
oIs it same as int. rate?
oMany people think that the interest rate on a bond tells them all
they need to know about how well-off they are as a result of
owning it.
oIf the investor thinks he is better off when he owns a long term
bond yielding a 10% int. rate and the int. rate rises to 20% he will
have a rude awakening.
oIf he has to sell the bond he has to suffer huge loss.

10
 Return
oHow well a person does by holding a bond or any other security over a particular time
period is accurately measured by the return or the rate of return
𝑃𝑎𝑦𝑚𝑒𝑛𝑡 𝑡𝑜 𝑡ℎ𝑒 𝑂𝑤𝑛𝑒𝑟+𝑇ℎ𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑖𝑡𝑠 𝑣𝑎𝑙𝑢𝑒
o𝑅𝑎𝑡𝑒 𝑜𝑓 𝑅𝑒𝑡𝑢𝑟𝑛 =
𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑖𝑛𝑔 𝑝𝑟𝑖𝑐𝑒

So a Rs. 1000 face value bond with Coupon rate of 10% is bought for Rs. 1000 and held it
for one year then sold it for Rs. 1200

The payment to owner are the early coupon payment of Rs. 100 and the change in its value
1200 -1000 = 200

Now, one year holding period returns for this bond = 30% (using the formula)
100 + 200
= 0.30
1000
So the return on the bond is not necessarily equal to the int. rate on the bond
11
Expected Return
If there is uncertainty about your return to be earned, then
We measure the return not as the int. rate but as an expected
return
There are three components
1. The expected inflation
2. A real interest rate
3. A premium for uncertainty

12
Expected Return
➢Other things being equal the values of cashflows in the future
time periods will decrease, as:
oThe preference for current consumption increase
oExpected inflation increase
oThe uncertainty in the cashflow increase

13
General formula
𝐶 + 𝑃𝑡+1 − 𝑃𝑡
𝑅𝑡 = C= Coupon payments
𝑃𝑡 P = Price of the Bond
𝐶 𝑃𝑡+1 − 𝑃𝑡
⇒ + = 𝑖𝑐 + 𝑔
𝑃𝑡 𝑃𝑡

Current Yield Rate of Capital

gain

14
Cashflows and Time line
Cashflow:
A cashflow is either cash that we expect to receive (cash inflow) or
cash we expect to payout (cash outflow)

15
Cashflows and Time line
Time line:
It shows the timing and amount for each cash flow
Period 1
100 100 100 100 100
0 1 2 3 4 5

• Here, 0 refers to the present

• We have no cashflow at time 0,
• But we have 500 in Nominal cash flow over the next 5 years.

16
A period of time and a point in
time
oThe cash flow that we received at the point in time 1 refers to the cash flow
that occurs at the end of period 1.
oIn time value terms,
oCash flow at the beginning of year 2 is equivalent to the cashflow at the end of
year 1.

17
Discounting and Compounding
•The process of converting cash flow today or in the future into cash flow even
further into the future is called Compounding
• It Yields the Future Value
•To convert the cash flow in the future into cash flow today is Discounting
• It yields the Present Value

18
Computing the Future Value

Compounding: earning interest on interest

Example
Assume that you are the owner of a company and that you have Rs. 50,00,000 in a bank with an int. rate
of say 6% per annum
Over time that investment will increase in value
Thus at the end of 1 year you will get Rs. 53,00,000
◦ i.e. future value at the end of 1 year is = 5000000*(1+0.06) = 53,00,000

At the end of year 2 you will have 56,18,000

◦ i.e. 5000000*(1.06)(1.06) = 5000000*(1.06)^2

At the end of 10 years you will have Rs. 89,54,200 i.e. 5000000*(1.06)^10

19
Computing the Future Value:

In general, the value of cash flow today (CF0) at the end of the future period (t) when the discount
rate is given as = CF*(1+i)^t

Or
𝐹𝑉 = 𝑃𝑉(1 + 𝑖) 𝑡

The future value will increase with t and increase as the (i) increases

20
Exercise 1
Suppose you locate a two-year investment that pays 14% per year. If you invest Rs. 5,00,000.

1. How much you will have at the end of two years?

2. How much of this is simple interest?

3. How much is compound interest?

21
Exercise 1
Solution:

At the end of 1st year you will have 5,00,000*(1+0.14) = 5,70,000

If you have reinvested the entire amount, then, at the end of the 2nd year = 6,49,800

The total interest you earn is 6,49,800 – 500000 = 149800.

Simple interest rate you earned is 14% of 500000 = 70000 multiplied by 2 = 140000

Thus 149800 – 140000 = 9800 results from compounding

22
Try this on your own!
You have located an investment that pays 12%. The rate sounds good to you. So you like to invest
$400.

1. How much will you have in 3 years?

2. How much will you have in 7 years?

3. At the end of 7 years, how much will you have earned?

4. How much of that interest resulted from compounding?

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Try this on your own (solved)
You have located an investment that pays 12%. The rate sounds good to you. So you like to invest
$400.

1. How much will you have in 3 years? ($561.97)

2. How much will you have in 7 years? ($884.27)

3. At the end of 7 years, how much will you have earned? ($484.27)

4. How much of that interest resulted from compounding? ($148.27)

24
Computing the Future Value:

Why do we care about the future value of an investment?

Ans: To compare the other investment opportunities and the risk and
uncertainty
It would help the investor to make sound investment decisions (financial
planning), and help to set realistic goals
We can use future value to establish achievable goals and craft a savings or
investment plan to reach them

25
Calculating the Present Value
Discounting
Recall:
If you invest Rs. 100 in a bank that pays int. rate of say r=7% a year after 2 year the value of your investment would
be 100*(1.07)^2 = 114.49,
Similarly for 5 years you would have 140.25!
The Future Value formula

𝐹𝑉 = 𝐶𝐹(1 + 𝑟)𝑡

The FV will increase as t increases and as r increases.

Now just turn this around and ask how much you need to invest today in order to get 114.49 at the end of 2 years.
114.49 Discount Factor
𝑃𝑉 = = 100 Or The present
1.07 2
value interest
𝐶𝐹 1 factor (PVIF)r,t
So the formula for PV is 𝑃𝑉 = or 𝐶𝐹
1+𝑟 𝑡 1+𝑟 𝑡

26
The frequency of discounting and
compounding
oThe interest may be compounded more frequently, monthly or semiannually.

oConsider the investment of Rs. 50,000 in the bank earning 6% a year. The future value at the end
of 10 years would be Rs. 89,542.38.

oThe assumption, here, is that the bank computed interest income at the end of the year.

oWhat if the bank computes interest every six months?

o In such case the future value of your investment would be = 50000(1+(0.06/2))20 = Rs. 90,306

oIf the compounding were done every month then

= 50000(1+(0.06/12))120 = Rs. 90,970

27
The frequency of discounting and
compounding
•In general, the future value of a cash flow where there are t compound periods each years and n
is the no of years, then

n×t
stated annual interest
FV=cashflow today× 1+
t

28
Effective interest rate
❑This is the actual rate or the usage rate calculated when compounding occurs

oAlthough the stated annual interest rate is 6% in our example the effective annual interest
rate is higher when the compound occurs every six months.

oFor ex, the effective interest rate is

0.06 2
1+ 2
− 1 = 6.09%

𝑠𝑡𝑎𝑡𝑒𝑑 𝑎𝑛𝑛𝑢𝑎𝑙 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 𝑡

oIn general, the effective interest rate = 1 + −1
𝑡

29
Valuing an Investment
Opportunity
•How do you decide whether an investment opportunity is worth undertaking?

•Let us Understand this through an example.

•Suppose you own a small company that is contemplating construction of a suburban office block.

•The cost of buying the land and constructing the building is Rs. 7000000

•The real estate adviser forecasts and suggests you that you will be able to sell the property next
year for Rs. 8000000.

30
• For simplicity you will assume initially that this Rs. 8000000 is a sure
thing. (no risk)
• So the expected profit = Rs. 1000000
• The rate of return in this case therefore 14.3%.
• So you can either invest the Rs. 7000000 in office block and sell it
after 1 year for Rs. 8000000.
Or
• You can pay cash out to shareholders who can invest in their own.

31
• The risk-free rate is 7%
• If they invest in a safe asset such as GSec you can earn 7% return.
Or
• If they invest in the risky asset that can offer them a 12%.

• What is the opportunity cost of capital?

• 7% or 12%
• Ans: 7%

The office block project is definitely a go.

• Because it will earn a safe return of 14.3% as compare to 7% in the
financial market.

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• But how much the Rs 8000000 worth today?

• We need to compute PV
• 8000000/1.07 =74,76,635.5

• So here, suppose that you bought the land and paid for
the construction, you decided to sell your project. How
much could you sell it for?

• If you expect Rs. 8000000 next year for sure, then, your
property ought to be worth today Rs. 74,76,635.5

33
If you try to sell it for more than this, nobody will
purchase.
Of course, You can sell it for less.

But why should you do that when the market value is

more?

So Rs. 74,76,635.5 is the only feasible price at present

that satisfies both buyer and seller.

Note: The present value of property is also its market

price.

34
Net Present Value (NPV)
The office building worth Rs. 74,76,635.5 but that does not mean 74,76,635.5 better off.

You invested Rs. 7000000.

The NPV = PV-initial investment

Rs. 74,76,635.5 – Rs. 7000000 = 476635

Your office block development is worth more than its costs

It make a net contribution to value and increase your wealth.

Technically,
𝐶𝐹𝑡
𝑁𝑃𝑉 = − 𝐶𝐹0
(1 + 𝑟)𝑡

35
Annuity and Perpetuity

36
Annuities
•An annuity is a stream of constant cash flow (payment or receipt ) that occurs
at regular intervals for a specific period.
•For ex, the premium payment of Life insurance, car loan, or simply EMI
•Two types of annuities:
1. ordinary annuity: cash flow that occurs at the end of each period
2. annuity due: cash flow that occurs at the beginning of the period

37
Annuities
•Ex., Investing Rs 50000 today at 6 %. How much is it worth at the end of 10
years?
•Assume instead that you intend to set aside Rs. 5000 at the end of each year
for the next 10 years at 6%.
•The amount set aside each year (Rs. 5000) is the annual cash flow on the
annuity.
5000 5000 5000 5000 5000 5000 5000 5000 5000 5000

0 1 9 10

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Compounding an Annuity
How much will you have at the end of the 10th year?
We could estimate the future value of each deposit at the end of the 10th year

So future value of 5000 invested in year 1

= 5000(1.06)9 = 8,447

Future value of 5000 invested in the year 2

= 5000(1.06)8 = 7969

Compute it for all the 10 years and add them up.

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Compounding an Annuity
Thus cumulated future value
5000(1.06)9 + 5000(1.06)8 + 5000(1.06)7 + 5000(1.06)6 + 5000(1.06)5 + 5000(1.06)4
+ 5000(1.06)3 + 5000(1.06)2 + 5000(1.06)1 + 5000(1.06)0

= 5000(1.069 + 1.068 + 1.067 + 1.066 + 1.065 + 1.064 + 1.063 + 1.062 + 1.061 + 1.060 )

1.0610 − 1
= 5000 = 65904
0.06

40
Compounding annuity
oIn general,

oWith annuity (A), n = year, r = interest rate, we have the formula for the Future Value of
an annuity
(1 + 𝑟)𝑛 − 1
𝐹𝑉(𝐴,𝑟,𝑛) = 𝐴
𝑟
(1 + 𝑟)𝑛 − 1
= 𝐹𝑉𝐼𝐹𝐴𝑛,𝑟
𝑟
oWhat if the cash flow occurred at the beginning of each year?

oEach cash flow would earn an additional year of interest. In this case

(1 + 𝑟)𝑛 − 1
𝐹𝑉(𝐴,𝑟,𝑛) = 𝐴(1 + 𝑟)
𝑟

41
Discounting an Annuity
oFinding out today’s value of a future payment series.

oIn general, the present value of an annual cash flow (A) each year for n years with a discount rate
r can be calculated as

oPV of an annuity =
1
1−
(1 + 𝑟)𝑛
𝑃𝑉 𝐴, 𝑟, 𝑛 = 𝐴
𝑟
𝑜𝑟
1 − (1 + 𝑟)−𝑛
𝐴
𝑟

42
 Growing Annuity

oA growing annuity is a cash flow that grows at a constant rate for a specified
period of time.
oIn general, PV of a growing annuity can be computed as

(1 + 𝑔)𝑛
1−
(1 + 𝑟)𝑛
= 𝐴(1 + 𝑔)
𝑟−𝑔
where,
A = current cash flow
g = expected growth rate
r = discount rate
n = duration of the annuity

43
 Growing Annuity

oFV of a growing annuity can be computed as

(1 + 𝑟)𝑛 − (1 + 𝑔)𝑛
𝐹𝑉 = 𝐴
𝑟−𝑔
where,
A = current cash flow
g = expected growth rate
r = discount rate
n = duration of the annuity

44
 Perpetuity

❑A stream of cash flow that never terminates

❑No fixed maturity date.

❑So a perpetuity is an annuity of infinite duration.

❑PV of perpetuity
1
1−
(1 + 𝑟)∞
=𝐴
𝑟
𝐴
=
𝑟

45
Annuity and Perpetuity

Annuity Perpetuity
1. An annuity is a stream of 1. A stream of cash flow that never
constant cash flow that occurs terminates
at a regular interval. 2. Term is unending
2. Term is specified 3. Simple interest rate is used
3. Compounding interest is used 4. Rarely used
4. Very frequently used in market 5. Dividend of Preference share,
5. Examples, premium for LIC, EMI, Rent. Some scholarships etc.
Rent received etc.

46
The Concept of Asset Valuation

49
Some Related Concepts
Book value and market value
Book Value Market Value
• The value of business according to its • Market value of an asset is simply the
book or financial statement. market price at which the asset trade
• It is calculated from balance sheet in the market
Total Asset, Total Liabilities • [e.g. shares outstanding*current stock
• The book value of an asset is simply price]
the accounting value of the asset • This is the price at which the security
• The historical cost of an asset less the traded in the financial market
accumulated depreciation or • Often market value is higher than book
amortization as the case may be. value

50
Book Value Vs. Market Value
If the book value > market value,
◦ The company loose confidence.
◦ The market does not believe that the company is worth the value
on its books.
If market value > book value
◦ The market assign a higher value to the company/firm
Company’s market value is always fluctuates in relation to book
value.

51
Intrinsic value
Intrinsic value:
◦ The intrinsic value of the security is the present value of the
cash flow stream expected from the security, discounted at a
rate of return appropriate for the risk associated with it.
◦ It is a measure of what an asset is worth.
◦ If the market is efficient then the market price of the security
should hover around its intrinsic value.

52
Current Yield of a Bond
oCurrent market price may differ from its face value.

oi.e. A bond having face value of Rs. 1000 may be selling at a discount at, say, Rs.
900 or may be selling at a premium, say Rs.1150.

Annual Interest
CurrentYield= × 100
Current Market Price
𝐼𝑛𝑡
= × 100
𝑃0

53
Current Yield
oIf a bond of face value Rs. 1000 and a coupon rate of 12% is currently selling
for Rs. 800.

o Then current yield of bond would be (120/800)*100 = 15%.

❖The current yield would be higher than the coupon rate when the bond is
selling at a discount.

❖The current yield would be lower than the coupon rate when the bond is
selling at a premium.

54
Current Yield
Limitations:
oIt reflects only coupon interest rate
oIt does not consider the capital gain (loss) that an investor will
realize if the bond is purchased at a discount (premium) and held
till maturity.
oIt also ignores the time value of money
oIt is a simplistic measure of yield

55
YTM
Suppose, you face a decision to choose between two potential investments:

1. A three-year, Rs. 1,000 face value coupon bond with a price of Rs. 1,050 and
a coupon rate of 8%

2. A two-year, Rs. 1,000 face value coupon bond with a price of Rs. 980 and a
coupon rate of 6%

You need to calculate the rate of interest you will receive on each

56
YTM
For 1. r = 6.1%

For 2. r = 7.1%

•These calculations show us that even though Bond 1 may appear to be a better
investment because it has a higher coupon rate than Bond 2, Bond 1’s higher
price means that it has a significantly lower interest rate than Bond 2.

•So, if you wanted to earn the highest interest rate on your investment, you would
choose Bond 2

The interest rate You just Calculated is known as YTM which equates the
present value of the payments from an asset with the asset’s price today

57
YTM
•The yield to maturity is based on the concept of present value and
is the interest rate measure that economists, firms, and investors
use most often.
•It is considered as the most accurate measure of interest rate
• It is important to note that unless they indicate otherwise, whenever
economists or investors refer to the interest rate on a financial asset, the
interest rate they mean is the yield to maturity.

•Calculating yields to maturity for alternative investments allows

investors to compare different types of debt instruments.

58
 YTM
So what is Yield to Maturity (YTM)?
oIt is the compounded rate of return an investor is expected to
realize from a bond purchased at the current market price and
held to maturity.
oIt is the internal rate of return (IRR) earned from holding a bond
till maturity

59
YTM
The YTM is calculated differently for different credit market
instruments
YTM on a Simple Loan:
If Ram borrows Rs. 1000 from his friend and next year he wants
to Rs 1100 from Ram. What is the YTM on this loan
1100 1100
1000 = ⇒ 1+𝑟 = ⇒ 𝑟 = 0.10
1+𝑟 1000

For simple loans the simple interest rate equals the YTM

60
 YTM for a Coupon Bond
oIt is the interest rate that make the present value of the cash flows receivable from owning the bond
equal to the price of the bond.

oMathematically,
o It is the interest rate which satisfy the following equation

𝐶1 𝐶2 𝐶𝑛 𝑀
𝑀𝑃 = + 2
+. . . . . . . + 𝑛
+
1 + 𝑟 (1 + 𝑟) (1 + 𝑟) (1 + 𝑟)𝑛
where,
MP = market price of the bond
C = Annual interest (Rs)
M = maturity value (Rs)
n = no. of year left to maturity 𝑛
r = YTM (the rate of interest) 𝐶𝑡 𝑀
𝑀𝑃 = ෍ +
(1 + 𝑌𝑇𝑀)𝑡 (1 + 𝑌𝑇𝑀)𝑛
𝑡=1
oThis equation can be written as where,
Ct = cash inflow from the bond throughout the holding period
M =maturity value at the end of the period

61
Calculation of YTM
YTM is calculated as the internal rate of return (IRR) that equates the present value of all future
cash flows (interest and principal) to the current price of the bond.

Illustration: Through the process of trial and error:

◦ Consider a Rs 1000 par value bond carrying a coupon rate of 9% matures after 8 years. The bond is
currently selling for Rs. 800. What is the YTM on this bond?

Note:
YTM > Coupon rate if the market price is lower than par or if the bond is selling at discount.
YTM < coupon rate if the bond is selling at premium.

62
 Solution

𝐶𝑡 𝑀
The YTM is the value of r in the following equation 𝑀𝑃 = σ𝑛𝑡=1 +
(1+𝑌𝑇𝑀)𝑡 (1+𝑌𝑇𝑀)𝑛
8
90 1000
800 = ෍ +
(1 + 𝑟)𝑡 (1 + 𝑟)8
𝑡=1
= 90(present value of anuuity factor (r,8years))
+1000(present valueof interest factor (r, 8 years)

Since the market value is lower than the face value , it indicate that YTM would be higher than
the coupon rate. 8
90 1000
800 = ෍ +
(1 + 0.12)𝑡 (1 + 0.12)8
Lets start at r = 12% 𝑡=1
= 90(PVIFA12%, 8yr )+1000(PVIF12% ,8yr )
= 90(4.968)+1000(0.404) =851.0

Since this value is greater than Rs 800 we may have to try a higher value of r.
63
 Since this value is greater than Rs 800 we may have to try a higher value of r.
Using r = 14%
8
90 1000
800 = ෍ +
(1 + 0.14)𝑡 (1 + 0.14)8
𝑡=1
= 90(PVIFA14%, 8yr )+1000(PVIF14% ,8yr )
= 90(4.639)+1000(0.351) =768.1

Since this value is less than Rs 800 a lower value of r may be tried

Lets try r = 13%

8
90 1000
800 = ෍ +
(1 + 0.13)𝑡 (1 + 0.13)8
𝑡=1
= 90(PVIFA13%, 8yr )+1000(PVIF13% ,8yr )
= 90(4.800)+1000(0.376) =808

Thus r lies b/w 13% and 14%

Using a linear interpolation in the range 13% to 14% we can find

808 − 800
0.13 + (0.14 − 0.13) = 0.132
808 − 768.1

64
 Approximation formula
oCertainly you don’t like the trial and error!!!
oIf you do not want trial and error, then you can use an approximation formula
𝐶 + (𝑀 − 𝑃)/𝑛
𝑌𝑇𝑀 ≈
0.4𝑀 + 0.6𝑃
where,
YTM = yield to maturity
C = Annual interest payment
M = Maturity value of the bond
P = current price of the bond
n = year to maturity

Thus 𝑌𝑇𝑀 =
90 + (1000 − 800)/8
= 13.1%
(0.4 × 1000) + (0.6 × 800)

65
 Approximation formula
Using the same formula you can calculate the YTM for the problems

80 + (1000 − 1050)/3
𝑌𝑇𝑀 = = 6.1%
(0.4 × 1000) + (0.6 × 1050)

60 + (1000 − 980)/2
𝑌𝑇𝑀 = = 7.1%
(0.4 × 1000) + (0.6 × 980)

66
 Advantages and Limitation of YTM
Advantages:

oIt considers the current coupon income as well as the capital gain or loss the investor will realize if
the bond held till maturity.

oIt takes into consideration the timing of the cash flow.

Limitations:

It do not account for taxes that investor pays on the bond

◦ In this case YTM is known as gross redemption yield

Also it does not account for purchasing and selling costs if any.

The actual return depend on the price of the bond when it is sold.
◦ The market can fluctuate substantially.

67
Bond Valuation
Assumptions:

oThe coupon interest rate is fixed.

oThe coupon payment are made annually and next coupon payment is receivable exactly a year
form now.

oThe bond will be redeemed at par on maturity.

68
 Bond Valuation
The value of bond is equal to the present value of the cash flow expected from it.

The value of bond can be calculated as:

𝑛
𝐶𝑡 𝑀
𝑃0 = ෍ +
(1 + 𝑟)𝑡 (1 + 𝑟)𝑛
𝑡=1

Since the stream of coupon payment is an ordinary annuity we can apply the formula for PV of
annuity. Hence

𝑃 = 𝐶 × 𝑃𝑉𝐼𝐹𝐴𝑟,𝑛 + 𝑀 × 𝑃𝑉𝐼𝐹𝑟,𝑛

69
 Illustration

Consider a 10 year, 12% coupon bond with a par value Rs 1000. assume that the
required rate of return for this bond is 13%. What is the value of bond?
Ans. The cash flows for this bond are:
▪10 annual coupon payment of Rs. 120
▪Rs. 1000 principal repayment 10 year from now.
Applying the formula 𝑃 = 120 × 𝑃𝑉𝐼𝐹𝐴13%,10𝑦𝑟𝑠 + 1000 × 𝑃𝑉𝐼𝐹13%,10𝑦𝑟𝑠
= 120 × 5.426 + 1000 × 0.295
= 651.1 + 295 = 946.1

70
 Relationship between coupon rate, required
yield and price

➢As time progresses, interest rates change in the marketplace.

➢The case flow of the bond, however, stays the same.
➢As a result, the value of the bond will fluctuate.
➢A basic property of the bond is that its price varies inversely with yield.
➢Reason:
➢As the required yield ↓ → the PV of cash flow↑. Hence the price ↑.
➢Conversely, as the required yield ↑ → the PV of cash flow↓. Hence the price ↓.

➢So when the interest rate rises, the PV of the bond’s remaining cash flow declines, and the bond is
worth less.
➢When the interest rate falls, the bond is worth more.

71
Consider a bond carrying a coupon rate of 14% issued 3 years ago for Rs. 1000 (par value) by a co. the
original maturity of the bond was 10 years.

3 years have already passed, so the residual maturity is now 7 years.

The rate of interest has fallen in the last 3 years, and the investor now expects a 10% from this bond.
What is the price of this bond now?

7
140 1000
𝑃0 = ෍ +
(1.10)𝑡 (1.10)7
𝑡=1

1
1− 1
(1.10)7
= 140 × + 1000 ×
0.10 (1.10)7
= 1194.5

72
What is the logic here?
The fact that the required return on such a bond has fallen by 10% means that
If you had Rs 1000 to invest, you could buy new bonds like the said company, except
that these bonds would pay Rs. 100 rather than Rs 140 by way of interest.

So, as an investor, you would prefer 140 to 100.

You would be willing to pay more than 1000 for this bond to enjoy its higher coupon.

If all investors behave similarly, and as a result, the bond would be bid up in price
1194.5.

At this price, the bond would provide a 10% return.

73
Take another look
Assume that you expect an interest rate rise to 18%.
The price of the bond would then be Rs. 848.5
(check with calculation)

Therefore,

1. Coupon rate > required yield when Price > Par (Premium bond)
2. Coupon rate < required yield when Price < Par (Discount bond)
3. Coupon rate = required yield when Price = Par

74
Behavior of Interest Rates
oHow can standard supply-demand analysis be applied to bond markets to
determine equilibrium prices, interest rates, and quantities?

oWhat kinds of factors cause movements along the demand/supply curves for
bonds?

oWhat kinds of factors cause shifting of the demand and supply curves for
bonds?

oHow is the equilibrium bond price and/or quantity of bonds affected by

these shifts?

76
Supply and Demand for Bonds
Ceteris Paribus,

For any particular type of bond, the market price P moves inversely to the market interest rate
(yield to maturity) i on this type of bond.

• At higher prices P, the quantity demanded of bonds is lower—buyers are discouraged

• At higher prices P, the quantity supplied of bonds is higher—sellers are encouraged

77
Bond Market Equilibrium
oOccurs at a price P where the amount of bonds Bd that people are willing to buy (demand) equals
the amount Bs that people are willing to sell (supply).

oIf P is such that Bd = Bs, then P is called a market equilibrium (or market clearing) bond price.

oIf P is such that Bd > Bs (excess demand), then demanders (buyers) will tend to bid up P to the
equilibrium price.

oIf P is such that Bd < Bs (excess supply), then suppliers (sellers) will tend to bid down P to the
equilibrium price.

78
 Supply and demand for Bonds
Price of Bonds, P • Let’s consider the demand for one-year discount bonds,
1000 With excess supply Bond which make no coupon payments but pay the owner
(i=0%) price falls to P* BS the $1,000 face value in a year.
A • If the bond sells for $950, the interest rate and
950 I
expected return is 5.3%
(i=5.3%)
B • If the holding period is one year, then, the return on the
900 H bonds is known absolutely and is equal to the interest
(i=11.1%) rate as measured by the YTM.
P = 850
*
C • This means that the expected return on this bond is
(i=17.6%) equal to the interest rate i i.e. = (1000-950)/950 = 5.3%
800 G • Assume that at this 5.3% interest rate and expected
D
(i=25%) return corresponding to a bond price of $950, and the
quantity of bonds demanded is $100 billion.
750 F E
The equilibrium occurs when BD = BS.
(i=33%) With excess Demand
Bond price rises to P* So the equilibrium Price is $850 with i = 17.6%
BD
✓ An important feature of the analysis here is that supply and demand
are always described in terms of stocks (amounts at a given point in
time) of assets, not in terms of flows.
100 200 300 400 500
B* Quantity of Bonds, B

79
CHANGES IN EQUILIBRIUM INTEREST RATES

oWe will now use the supply and demand framework for bonds to analyze why interest rates
change.
oTo avoid confusion, it is important to make the distinction between movements along a
demand (or supply) curve and shifts in a demand (or supply) curve.
oWhen quantity demanded (or supplied) changes as a result of a change in the price of
the bond (or, equivalently, a change in the interest rate), we have a movement along the
demand (or supply) curve.
oA shift in the demand (or supply) curve, occurs when the quantity demanded (or
supplied) changes at each given price (or interest rate) of the bond in response to a
change in some other factor besides the bond’s price or interest rate.
oWhen one of these factors changes, causing a shift in the demand or supply curve, there
will be a new equilibrium value for the interest rate.

80
Other Factors Affecting the Demand for Bonds

❑Wealth — the total value of all owned financial and real assets (including human capital)

Positively related to the quantity of Bonds demanded.

Holding everything else constant, an increase in wealth raises the quantity demanded of an
asset.

❑Expected Returns —the return rate expected on bonds relative to alternative assets

Positively related

An increase in an asset’s expected return relative to that of an alternative asset, ceteris

paribus, raises the quantity demanded of the asset.

81
Other Factors Affecting the Demand for Bonds

❑Risk—the degree of risk or uncertainty associated with the real return rate on bonds relative to
alternative assets

Negatively related (for risk-averse investor)

holding everything else constant, if an asset’s risk rises relative to that of alternative assets,
its quantity demanded will fall

❑Liquidity—the ease and speed with which bonds can be turned into cash relative to alternative assets

Psitively Related

Holding everything else unchanged, the more liquid an asset is relative to alternative assets
the more desirable it is, and the greater the quantity demanded will be

82
Shifts in the Bond Demand Curve
Wealth

•In a business cycle expansion, with growing income and wealth, the demand for bonds
rises and the demand curve for bonds shifts to the right.

•In a recession, when income and wealth are falling, the demand for bonds falls, and the
demand curve shifts to the left.

83
Shifts in the Bond Demand Curve
Expected Interest Rate or the Expected Return

oFor a one-year discount bond and a one-year holding period, the expected return and the interest
rate are identical, so nothing other than today’s interest rate affects the expected return.

oFor bonds with maturities of greater than one year, the expected return may differ from the interest
rate.

If people began to think that interest rates would be higher in the future than they had originally
anticipated, the expected return today on long-term bonds would fall, and the quantity demanded
would fall at each interest rate.

o Higher expected future interest rates lower the expected return for long-term bonds, decrease
the demand, and shift the demand curve to the left.
o Lower expected future interest rates increase the demand for long-term bonds and shift the
demand curve to the right

84
 Shifts in the Bond Demand Curve
• Expected Inflation Rate

• A change in expected inflation is likely to alter expected returns on physical assets/real assets

• An increase in the expected rate of inflation lowers the expected return on bonds, causing their demand to decline
and the demand curve to shift to the left.

• Risk

If prices in the bond market become more volatile, the risk associated with bonds increases, and bonds become a
less attractive asset.

An increase in the riskiness of bonds causes the demand for bonds to fall and the demand curve to shift to the left.

An increase in the riskiness of alternative assets causes the demand for bonds to rise and the demand curve to shift
to the right

• Liquidity

Increased liquidity of bonds results in an increased demand for bonds, and the demand curve shifts to the right.

85
Shifts in the Bond Supply Curve
Holding Constant All Other Factors, Including Price,

❑Expected profitability of investment opportunities— In an expansion, the supply curve for bonds shifts
to the right.

❑Expected inflation rate— Given an increase in the expected inflation rate, the supply curve for bonds
shifts to the right.

❑Government deficit— Given an increase in the government budget deficit, the supply curve for bonds
shifts to the right.

❑Business Taxes – Tax reduces the profitability of investment. An increase in business tax reduce the supply
of bond. The supply curve will shift to left.

86
 The “Fisher Effect”
•An increase in the expected inflation rate (πe) that lowers the expected real interest rate ir = i - πe will
(all else equal)
– shift left the demand curve for bonds;
− shift right the supply curve for bonds;
− hence result in an increase in i .

•This prediction, that πe and i will tend to move together over time, is called the FISHER EFFECT.

87
 Changes in the Interest Rate Due to a Change in Expected Inflation: The
Fisher Effect

For a given interest rate (and bond price), when expected inflation increases, the real cost of borrowing
falls; hence, the quantity of bonds supplied increases at any given bond price.

•An increase in expected inflation causes the supply of bonds to increase and the supply curve to shift to the
right

•A decrease in expected inflation causes the supply of bonds to decrease and the supply curve to shift to the
left.

88
 Changes in the Interest Rate Due to a Change in Expected
Inflation: The Fisher Effect
BS1
Price of Bonds, P When expected inflation rises, the supply curve shifts
BS2 from BS1 to BS2, and the demand curve shifts from BD1
1 to BD2.
P1

The equilibrium moves from point 1 to point 2, causing

2 the equilibrium bond price to fall from P1 to P2 and the
P2
equilibrium interest rate to rise.
BD1
BD2

Quantity of Bonds, B

89
Changes in the Interest Rate Due to a Business Cycle Expansion
oIn a business cycle expansion,
o Total production ↑ → national income ↑ → Firm’s willing to borrow ↑ because they are likely to
have many profitable investment opportunities for which they need financing.
o Hence, at a given bond price, the supply of bonds will increase.
o This means that during a business cycle expansion, the supply curve for bonds shifts to the
right.

oWhat happened to the demand?

o As the economy expands, wealth is likely to increase, and the demand for bonds will rise as well.
o The demand curve will shift to the right.

90
 Changes in the Interest Rate Due to a Business Cycle Expansion

Price of Bonds, P In a business cycle expansion, when income

BS1 and wealth are rising, the demand curve
Bs2
shifts rightward
from BD1 to BD2.

P1 1 • If supply shifts more than demand, bond

P2 2
price P decreases (i rises). As in the figure.

BD2 • If demand shifts more than supply, bond

BD1 price P increases (i falls).

• In either case, the quantity of bonds sold ↑

Quantity of Bonds, B

91
Why do interest rates fall during a
Recession?
At the beginning of an economic recession, households and firms expect that levels of production and
employment will be lower than usual for a period of time.

Households will experience declining wealth, and firms will become more pessimistic about the future
profitability of investing in physical capital.

The declining household wealth causes the demand curve for bonds to shift to the left.

Firms’ declining expectations of the profitability of investments in physical capital cause them to issue
fewer bonds, which shifts the supply curve for bonds to the left.

The equilibrium bond price rises as long as the supply curve for bonds shifts more than the demand curve.

Thus the equilibrium interest rate falls.

92
Why do interest rates fall during a
Recession?
An economic downturn reduces household
Price of Bonds, P Bs2 wealth and decreases the demand for bonds at
BS1 any bond price.
The bond demand curve shifts to the left, from
D1 to D2.
2
P2 The fall in expected profitability reduces lenders’
P1 1 supply of bonds at any bond price.
The bond supply curve shifts to the left, from S1
to S2.
BD1
In the new equilibrium is at 2, the bond price rises
BD2
from P1 to P2 (i fall)
Quantity of Bonds, B

93