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FINA 30203

by: Rachel Fikse

FINA 30203 FINA 30203

Rachel Fikse
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Money and Banking
Dr. Ed Ireland

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Chapter 3 (Interest Rates and Rates of Return) Reading Notes
Money and Banking
Dr. Ed Ireland
Class Notes
Money and Banking




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This 0 page Class Notes was uploaded by Rachel Fikse on Wednesday January 20, 2016. The Class Notes belongs to FINA 30203 at Texas Christian University taught by Dr. Ed Ireland in Spring 2016. Since its upload, it has received 55 views. For similar materials see Money and Banking in Finance at Texas Christian University.


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Date Created: 01/20/16
Money and Banking Chapter 3 Interest Rates and Rates of Return I Introduction a Default risk on a US Treasury bond is effectively zero b Interest rates are determined by the interaction between the interest rate borrowers ie the US Treasury are willing to pay and the interest rate investors are willing to accept in exchange for lending their funds c Important factor expected in ation rate i The higher in ation the lower the purchasing power of the dollars with which the borrower will repay the investor d During the financial crisis the Fed had taken a number of steps that resulted in a large increase in the money supply e In buying a Tbill you do not face default risk but you will face interestrate risk the risk that the price of your bond will uctuate in response to changes in market interest rates II The Interest Rate Present Value and Future Value a Why Do Lenders Charge Interest on Loans i Interest rate cost of credit ii Opportunity cost the value of what you have to give up to engage in an activity 1 The IR interest rate has to cover the opportunity cost of supplying credit iii The interest charged on a loan is the result of 1 Compensation for in ation 2 Compensation for default risk 3 Compensation for the opportunity cost of waiting to spend your money b Most Financial Transactions Involve Payments in the Future i This fact causes a problem how is it possible to compare dijferent transactions 1 The IR provides a link between the financial present and the financial future c Compounding and Discounting i Future value the value at some future time of an investment made today 1 Compounding the process of earning interest on interest as savings accumulate over time ii Present value the value today of funds that will be received in the future 1 Funds in the future are worth less than funds in the present so funds in the future have to reduced discounted to nd their present value 2 Time value of money TVM the way that the value of a payment changes depending on when the payment is received 3 Discounting the process of finding the present value of funds that will be received in the future iii Note 1 i is the compounding factor used to calculate the FV of money we invest today ll i is the discount factor used to calculate the PV of money to be received in the future iv Points about Discounting 1 Present value PV is sometimes called presented discounted value a Emphasizes that in converting dollars received in the future into their equivalent value in dollars today we are discounting or reducing the value of the future dollars 2 The further in the future a payment is to be received the smaller its present value 3 The higher the interest rate we use to discount future payments the smaller the present value of the payments a For any given IR the further in the future a payment is received the smaller its PV 4 The present value of a series of future payments is simply the sum of the discounted value of each individual payment d Discounting and the Prices of Financial Assets i Discounting lets us compare financial assets by giving us a means of determining the PV of payments to be received at different times in the future ii Gives us a way of determining the prices of financial assets III Debt Instruments and Their Prices a The price of a nancial asset is equal to the PV of the payments to be received from owning it i Debt instruments credit market instruments xedincome assets methods of financing debt including simple loans discount bonds coupon bonds and fixed payment loans 1 Include loans granted by banks and bonds issued by corporations and governments 2 IOUs promises by the borrower both to pay interest and repay principal to the lender ii Equities a claim to ownership of a firm common stock issued by a corporation b Loans Bonds and the Timing of Payments i 4 basic categories of debt instruments 1 Simple loan a debt instrument in which the borrower receives from the lender an amount called the principal and agrees to repay the lender the principal plus interest on a specific date when the loan matures a Most common is a shortterm business loan from a bank commercial and industrial loan 2 Discount bond a debt instrument in which the borrower repays the amount of the loan in a single payment at maturity but receives less than the face value of the bond initially a Interest paid on the loan is the difference between the amount repaid and the amount borrowed b Most common types are US savings bonds US Treasury bills and zerocoupon bonds 3 Coupon bond a debt instrument that requires multiple payments of interest on a regular basis such as semiannually or annually and a payment of the face value at maturity a Face valuepar value amount to be repaid by the bond issuer the borrower at maturity typically 1000 b Coupon annual fixed dollar amount of interest paid by the issuer of the bond to the buyer 0 Coupon rate value of the coupon expressed as a of the par value of the bond d Current yield the value of the coupon expressed as a percentage of the current price of the bond e Maturity length of time before the bond expires and the issuer makes the face value payment to the buyer 4 Fixedpayment loan a debt instrument that requires the borrower to make regular periodic payments of principal and interest to the lender a Payments are of equal amounts and include both interest and principal b At maturity the borrower has completely repaid the loan and there is no lumpsum payment of principal 0 Common examples home mortgages student loans and car loans d Borrower repay some principal with each loan payment which reduces the chances of a borrower defaulting on the entire amount of the principal IV Bond Prices and Yield to Maturity a Bond Prices i P 62 for calculations b Yield to Maturity i Important factor in making a choice between two investments is determining the IR you will receive on each ii Can use the PV calculation to find the IR on each investment iii Yield to maturity YTM the interest rate that makes the present value of the payments from an asset equal to the asset s price today 1 Based on the concept of PV and is the IR measure that economists firms and investors use most often 2 Unless indicated otherwise whenever economists or investors refer to the IR on a nancial asset the IR they mean is the YT M 3 Allows investors to compare different types of debt instruments 0 Yields to Maturity on Other Debt Instruments i Simple loans 1 Need to find the IR that makes the lender indifferent bw having the amount of the loan today or the final payment at maturity 2 Equation on p 64 3 The YTM and the IR specified on the loan are the m ii Discount bonds 1 Can use the same equation to find the YTM on the discount bond that was used in the case of the simple loan iii Fixedpayment loans 1 Similar to calculating the YTM on a coupon bond 2 Equation p 65 3 If i is the YTM on a fixedpayment loan the amount of the loan today equals the PV of the loan payments discounted at rate i iv Perpetuities l Pays a fixed coupon but does not mature 2 Main example is the consol was at one time issued by the British government V The Inverse Relationship Between Bond Prices and Bond Yields a What Happens to Bond Prices When Interest Rates Change i Companies vary the coupon rates on the bonds it sells based on conditions in the bond market ii Once firm issues a bond its coupon rate does not change iii Price of a financial security is equal to the PV of the payments to be received from owning the security 1 Need to know what YTM to use iv Capital gain an increase in the market price of an asset v Capital loss a decrease in the market price of an asset b Bond Prices and Yields to Maturity Move in Opposite Directions i 2 important points 1 If IR on newly issued bonds rise the prices of existing bonds will fall 2 If IR on newly issued bonds fall the prices of existing bonds will rise a In other words yields to maturity and bond prices move in opposite directions ii The economic reasoning behind the inverse relationship bw bond prices and yields to maturity is that if IR rise existing bonds issued when IR were lower become less desirable to investors and their prices fall and vice versa iii The inverse relationship bw YTMs and bond prices should also hold for other debt instruments c Secondary Markets Arbitrage and the Law of One Price i Financial arbitrage the process of buying and selling securities to profit from price changes over a brief period of time 1 Profits made form financial arbitrage are called arbitrage pro ts ii The prices of securities should adjust so that investors receive the same yields on comparable securities iii Law of one price identical products should sell for the same price everywhere VI Interest Rates and Rates of Return a Return the total earnings from a security for a bond during a holding period of one year the coupon payment plus the change in the price of the bond b Rate of return R the return on a security as a of the initial price for a bond during a holding period of one year the coupon payment plus the change in the price of a bond divided by the initial price c A General Equation for the Rate of Return on a Bond i Rate of Return Current Yield Rate of Capital Gain 1 R CouponInitial price Change in priceInitial price ii 3 important points about Rates of Return d VII 1quot 1 In calculating R use the price at the beginning of the year to calculate the current yield 2 A capital gainloss is incurred on a bond even if you do not sell the bond at the end of the year If you sell the bond you have a realized capital gain or loss If you do not sell the bond you gain or loss is unrealized a In either case the price of you bond has increased or decreased and needs to be included when calculating the rate of return on your investment 3 If you buy a coupon bond neither the current yield nor the YTM may be a good indicator of R you will receive as a result of holding the bond during a particular time period bc do not take into account your potential capital gainloss InterestRate Risk and Maturity i Interestrate risk the risk that the price of a financial asset will uctuate in response to changes in market interest rates 1 The more years until a bond matures the more years the buyer of the bond will potentially be receiving a belowmarket coupon rate and therefore the lower the price a buyer would be willing to pay Nominal Interest Rates vs Real Interest Rates a Nominal interest rate an interest rate that is not adjusted for changes in purchasing power Real interest rate an interest rate that is adjusted for changes in purchasing power Lendersborrowers much make savinginvesting decisions on the basis of what they expect the real IR to be i The expected real interest rate r nominal IR expected rate of in ation ii If in ation rate is greater than the expected in ation rate the real interest rate will be less than the expected real interest rate 1 Borrowers gain 2 Lenders lose Economists often measure the nominal interest rate as the interest rate on US Tbills that mature in 3 months Nominal and real IR tend to rise and fall together De ation a sustained decline in the price level Indexed bonds issued by US Treasury to address investors concerns about the effects of in ation on real interest rates i Called TIPS Treasury In ationProtected Securities ii Treasury increases the principal as the price level measured by consumer price index increases iii Interest rate remains fixed but because it is applied to a principal amount that increases with in ation the IR also increases with in ation


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