Interest Rates

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BUS 362 Financial Institutions and
Markets
Week 3: Interest Rates
Assoc. Prof. Hülya Hazar
Faculty of Economics and Administrative Sciences, Department of
Business Administration
[email protected]
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Financial Institutions and Markets
1. Interest Rate
2. Present Value
3. Yield to Maturity
4. Types of Loans
5. Nominal vs Real Interest Rate
6. Fisher Effect
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Financial Institutions and Markets
Present Value
• The concept of present value (or present discounted value)
is based on the commonsense notion that a dollar of cash
flow paid to you one year from now is less valuable to you
than a dollar paid to you today.
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Financial Institutions and Markets
Present Value Applications:
• Simple Loan
Fixed Payment Loan
• Coupon Bond
• Discount Bond
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Financial Institutions and Markets
Yield to Maturity: Loans
• Yield to maturity = interest rate that equates today’s value
with present value of all future payments
• Examples:
1. Simple Loan Interest Rate (i = 10%)
$100 = $110 / (1 + i), or I = 10%
2. What is the present value of $250 to be paid in two
years if the interest rate is 15%?
$250 / (1 + 0.15)2 = $250 / 1.3225 = $189.04
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Financial Institutions and Markets
Simple Loans require payment of one amount which equals
the loan principal plus the interest.
Fixed-Payment Loans are loans where the loan principal and
interest are repaid in several payments, often monthly, in equal
dollar amounts over the loan term.
Installment Loans, such as auto loans and home mortgages
are frequently of the fixed-payment type.
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Financial Institutions and Markets
Real interest rate:
• Interest rate that is adjusted for expected changes in the
price level
ir = i − e
• Real interest rate more accurately reflects true cost of
borrowing
• When the real rate is low, there are greater incentives to
borrow and less to lend
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Financial Institutions and Markets
Example:
ir = i - e
• If i = 5% and e = 0% then
5% − 0% = 5%
• If i = 10% and e = 20% then
10% − 20% = − 10%
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Financial Institutions and Markets
Distinction Between Interest Rates and Returns:
Rate of Return: we can decompose returns into two pieces:
Return = C/Pt + (Pt+1 – Pt)/Pt
Return = Current Yield + Capital Gain Yield
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10.

Financial Institutions and Markets
An asset is a piece of property that is a store of value. Facing
the question of whether to buy and hold an asset or whether to
buy one asset rather than another, an individual must consider
the following factors:
Wealth, the total resources owned by the individual,
including all assets
Expected return (the return expected over the next period)
on one asset relative to alternative assets
Risk (the degree of uncertainty associated with the return)
on one asset relative to alternative assets
Liquidity (the ease and speed with which an asset can be
turned into cash) relative to alternative assets
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Financial Institutions and Markets
The quantity demanded of an asset differs by factor.
Wealth: Holding everything else constant, an increase in
wealth raises the quantity demanded of an asset
Expected return: An increase in an asset’s expected return
relative to that of an alternative asset, holding everything
else unchanged, raises the quantity demanded of the asset
Risk: Holding everything else constant, if an asset’s risk
rises relative to that of alternative assets, its quantity
demanded will fall
Liquidity: The more liquid an asset is relative to alternative
assets, holding everything else unchanged, the more
desirable it is, and the greater will be the quantity
demanded
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12.

Financial Institutions and Markets
Supply and Demand for Bonds:
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Financial Institutions and Markets
Market Conditions:
• Market equilibrium occurs when the amount that people are
willing to buy (demand) equals the amount that people are
willing to sell (supply) at a given price
• Excess supply occurs when the amount that people are
willing to sell (supply) is greater than the amount people are
willing to buy (demand) at a given price
• Excess demand occurs when the amount that people are
willing to buy (demand) is greater than the amount that
people are willing to sell (supply) at a given price
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Financial Institutions and Markets
Changes in e: The Fisher Effect:
If e
1. Relative Re , Bd shifts in to left
2. Bs , Bs shifts out to right
3. P , i
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Financial Institutions and Markets
Summary of the Fisher Effect:
• If expected inflation rises from 5% to 10%, the expected
return on bonds relative to real assets falls and, as a result,
the demand for bonds falls.
• The rise in expected inflation also means that the real cost of
borrowing has declined, causing the quantity of bonds
supplied to increase.
• When the demand for bonds falls and the quantity of bonds
supplied increases, the equilibrium bond price falls.
• Since the bond price is negatively related to the interest rate,
this means that the interest rate will rise.
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Subjects Covered
1. Interest Rate
2. Present Value
3. Yield to Maturity
4. Types of Loans
5. Nominal vs Real Interest Rate
6. Fisher Effect
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References
Readings:
Chapter 3 and 4
Reference Book:
Mishkin, Frederic S. Financial Markets and Institutions. Eighth Edition.
UK: Pearson, 2016.
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Financial Institutions and Markets
See you next week…
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