Chapter 2: Interest Rates

Content
1. Interest rate
2. Time value of money
3. Application of time value of money
 INTEREST RATES:
INTERPRETATION
•Interest represents the return, or compensation, a lender demands before
agreeing to lend money.

•Interest is normally expressed in percentage terms, called the interest rate

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Interest rates: interpretation
Example 2.1.1:
◦ if you lend $100 for one year
◦ the return you require for doing so is $10
◦ The interest rate you are charging for the loan is: $10/$100=.10 or 10%

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Interest rates: interpretation
Note:
◦ When mentioned, interest rates are usually quoted as annually interest rates.
◦ The interest rate, in any situation, is called the nominal interest rate.

Ex: if the bank say the interest rate for a home loan is 12%, it means:
◦ the interest rate is 12% per year and
◦ it is nominal interest rate.

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Interest rate: Interpretation
Interest rates can be explained in three ways:
◦ Required rates of return: the minimum rate of return an investor must receive in order to accept the
investment.
◦ Discount rates: the rate used to discount the future amount to find its value today.
◦ Opportunity costs: the value the investor forgo by choosing a particular course of action.

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Interest rate: Interpretation
Example 2.1.2: You agree to lend $9,500 now and receive back $10,000 a year later.
◦ If $9,500 today and $10,000 a year later are equivalent in value, then $10,000 - $9,500 = $500 is the
required compensation for receiving $10,000 in one year later than now.
◦ The interest rate – the required compensation stated as a rate of return – is: $500/$9,500 = 0.0526 or
5.26%

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Interest rate: Interpretation
Example 2.1.2 (cont):

$500/$9,500 = 5,26%
◦ Is the Required rates of return that the investor agree for his investment.

◦ Is the Discount rates at which we discount the $10,000 future amount to find its present value.

◦ Is the Opportunity costs as if the investor does not lend $9,500 but use it today, he would have
forgone earning 5.26% on the money.

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INTEREST RATES: RISK
STRUCTURE
Components of interest rates:
◦ Real risk-free interest rate
◦ Inflation premium
◦ Default risk premium
Norminal interest rate
◦ Maturity risk premium
◦ Illiquidity risk premium Risk premium +
Inflation
Real
risk-
free
intere
st
rates
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Interest rate: Risk structure
Interest rate: Risk structure
Real rate of interest Real rate of interest:
Expected inflation • compensates for the
Default risk lenders’ lost
Maturity risk opportunity to
Illiquidity risk consume.

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Interest rate: Risk structure
Real rate of interest Expected inflation:
• inflation erodes the
Expected inflation
purchasing power of
Default risk
money.
Maturity risk • expected inflation is
Illiquidity risk added to the real
rate of interest to
protect the lender’s
purchasing power.

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Interest rate: Risk structure
Expected inflation:

Example 2.1.3:
◦ If you loan someone $1,000 and they pay it back one year later with 2% interest, you will have $1,020.

◦ But if prices have increased by 4%, then something that would have cost $1,000 at the beginning of the
loan will now cost $1,000(1.04)=$1,040.
◦ You, therefore, haven’t improved your purchasing power by lending the money.

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Interest rate: Risk structure
Expected inflation:

Example 2.1.3:
◦ If you loan someone $1,000 and you charge a 2% real rate of return and 4% for expected inflation, when
they pay it back one year later with 10% interest, you will have $1,060.
◦ If prices have increased by 4%, then something that would have cost $1,000 at the beginning of the loan
will now cost $1,000(1.04)=$1,040.
◦ You, now, have $1,060 so you have increased your purchasing power by $20(=1060-1040).

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Interest rate: Risk structure
Real rate of interest Nominal risk free rate:
Expected inflation • the real rate of interest +
expected inflation = nominal
Default risk
risk free interest rate ->
Maturity risk indicate the risk free rate.
Illiquidity risk • this is considered “risk-free”
because we have not included
any premiums for the risks
associated with lending
money.

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Interest rate: Risk structure
Nominal interest rate:
Example 2.1.3:
◦ In our $1,000 loan example, the nominal interest risk-free rate is 6% (=2% + 4%)

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Interest rate: Risk structure
Default risk:
Real rate of interest • a default occurs when a
Expected inflation borrower fails to pay the
interest and principal on a loan
Default risk
on time.
Maturity risk • the default risk premium is the
Illiquidity risk extra compensation lenders
demand for assuming the risk of
default.
• the greater the chance of
default, the greater the interest
rate the investor demands and
the issuer must pay.

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Interest rate: Risk structure
Default risk:
Example 2.1.3:
◦ In our $1,000 loan example, the nominal risk-free interest rate is 6%
◦ If you are not sure about the reputation of the borrower, or the borrower is having financial difficulties,
you would demand an extra of compensation – default risk premium – say, 2%
◦ Total interest rate demanded is now: 2% + 4% + 2% = 8%

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Interest rate: Risk structure
Real rate of interest Maturity risk:
• if interest rates rise, lenders
Expected inflation
may find that their loans are
Default risk
earning rates that are lower
Maturity risk than what they could get on
Illiquidity risk new loans.
• maturity risk premium can be
either positive or negative.

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Interest rate: Risk structure
Maturity risk:
Example 2.1.3:
◦ In our $1,000 loan example, if you think the interest rates will rise before the loan comes due, you might
demand an extra compensation for the expected rising, say 1%
◦ Total interest rate demanded is now: 2% + 4% + 2% + 1% = 9%

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Interest rate: Risk structure
Real rate of interest Illiquidity risk:
Expected inflation
• investment that are easy to
sell without losing value are
Default risk
more liquid.
Maturity risk • the extra interest that
Illiquidity risk lenders demand to
compensate for the lack of
liquidity is the illiquidity risk
premium.

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Interest rate: Risk structure
Illiquidity risk:

Example 2.1.3:
◦ Sometimes lenders sell loans to others after making them.

◦ In our $1,000 loan example, you probably not be able to sell your loan to anyone else and have to hold
until maturity, you may require another 1% to compensate for the lack of liquidity.
◦ Total interest rate demanded is now: 2% + 4% + 2% + 1% +1% = 10%

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Interest rate: Risk structure
Determination of Rates:
i=i*+IRP+DRP+MP+ILP

i = the nominal, or observed rate on security

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Yield curve
An yield curve is the connection of points:
◦ One kind of security

◦ Each point: interest rate matches with maturity date

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Yield curve
The graph
◦ X axis: Time to maturity

◦ Y axis: Yield to maturity

◦ The line represents YTMs for different maturities for securities with the same
risk

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Treasury yield curve

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Yield curve
Yield curves can be used to show
◦ Interest rates for different maturities
◦ Interest rates for different risk levels or providers:
◦ Ex:
◦ AAA Corporate bonds vs Treasury bonds
◦ AAA Corporate bonds vs Junk bonds
◦ AAA Corporate bonds vs Municipal bonds

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Yield curve

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SIMPLE VS COMPOUND
RETURNS
Simple return:
◦ Return only earned on investment

Compound return:
◦ Return earned on investment and accrued interest

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Assumptions
Investment $1,000
Interest rate 6%
Number of years 3

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Assumptions
Invest $1,000 and earn 6,0% simple interest for 3 years.
Invest $1,000 and earn 6,0% compound interest for 3 years.

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Simple interest
Year Original Annual Cumulative
principal interest interest
1 $1,000 $60 $60
2 $60 $120
3 $60 $180

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Compound interest
Year Original Annual Cumulative
principal interest interest
1 $1,000 $60 $60
2 $1,060 $63.60 $123.6
3 $1,123.6 $67.42 $191.02

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Compound interest
The value of total amount $1,123.60 at the end of year 2 could be break into 3 components:
Beginning amount (principal) $1,000
Interest for 1st year based on principal 60
(1,000*0.06)
Interest for 2nd year based on principal 60
(1,000*0.06)
Interest for 2nd year based on interest earned 3.60
in the 1st year (60*0.06)
Total of principal and interest after year 2 $1,123.60
(1,000*(1+0.06)*(1+0.06))

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Simple vs compound interest
•If earnings are paid out, the investor must reinvest the cash outflows at the
same rate to get the compound interest.

•If earnings are reinvested in the investment, the investment is said to earn a
compound rate of return.

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Summary
•Time value of money is starting point for most of things in finance.
• We need firstly study time value of money when studying finance.

• All financial decisions are made basing on time value of money (to compare which provides more
money).

•Interest rate is an important concept in time value of money.

•We need to understand about compound interest, as it is used to calculate time value of money.