Chapter 4

The Economics of Money, Banking, and
Financial Markets
Thirteenth Edition
Global Edition
Chapter 4
The Meaning of Interest
Rates
Copyright © 2022, 2019, 2016 Pearson Education, Ltd. All Rights Reserved
Preview
• Before we can go on with the study of money, banking,
and financial markets, we must understand exactly what
the phrase interest rates means. In this chapter, we see
that a concept known as the yield to maturity is the most
accurate measure of interest rate.
Learning Objectives
4.1 Calculate the present value of future cash flows and the
yield to maturity on the four types of credit market
instruments.
4.2 Recognize the distinctions among yield to maturity,
current yield, rate of return, and rate of capital gain.
4.3 Interpret the distinction between real and nominal
interest rates.
Measuring Interest Rates
• Present value: a dollar paid to you one year from now is
less valuable than a dollar paid to you today.
– Why: a dollar deposited today can earn interest and
become one year from today.
– To understand the importance of this notion, consider
the value of a $20 million lottery payout today versus a
payment of $1 million per year for each of the next 20
years. Are these two values the same?
Present Value
Let i = .10
In n years
Simple Present Value (1 of 2)
PV = today’s (present) value
CF = future cash flow (payment)
i = the interest rate
Simple Present Value (2 of 2)
• Cannot directly compare payments scheduled in different
points in the time line
How Much Is That Jackpot Worth? (1 of 2)
• Assume that you just hit the $20 million jackpot in the
New York State Lottery, which promises you a payment of
$1 million every year for the next 20 years. You are
clearly excited, but have you really won $20 million?
How Much Is That Jackpot Worth? (2 of 2)
• Assume that you just hit the $20 million jackpot in the New
York State Lottery, which promises you a payment of $1
million every year for the next 20 years. You are clearly
excited, but have you really won $20 million?
• No, not in the present value sense. In today’s dollars, that
$20 million is worth a lot less.
• (Clue: assume an interest rate of 10% and work out the
present value of $20 million over ten years)
Four Types of Credit Market Instruments
• Simple Loan
• Fixed Payment Loan
• Coupon Bond
• Discount Bond
Yield to Maturity
• Yield to maturity: the interest rate that equates the
present value of cash flow payments received from a
debt instrument with its value today
Yield to Maturity on a Simple Loan
PV = amount borrowed = $ 100
CF = cash flow in one year = $ 110
n = number of years = 1
For simple loans, the simple interest rate equals the yield to
maturity
Fixed-Payment Loan
The same cash flow payment every period throughout the
life of the loan
LV = loan value
FP = fixed yearly payment
n = number of years until maturity
Coupon Bond (1 of 4)
Using the same strategy used for the fixed-payment loan:
P = price of coupon bond
C = yearly coupon payment
F = face value of the bond
n = years to maturity date
• When the coupon bond is priced at its face value, the
yield to maturity equals the coupon rate.
• The price of a coupon bond and the yield to maturity are
negatively related.
• The yield to maturity is greater than the coupon rate
when the bond price is below its face value.
Table 1 Yields to Maturity on a 10%-Coupon-Rate Bond
Maturing in Ten Years (Face Value = $1,000)
Price of Bond ($) Yield to Maturity (%)

1,200 7.13
1,100 8.48
1,000 10.00
900 11.75
800 13.81
• Consol or perpetuity: a bond with no maturity date that
does not repay principal but pays fixed coupon payments
forever
C = yearly interest payment
can rewrite above equation as this:

For coupon bonds, this equation gives the current yield, an
easy to calculate approximation to the yield to maturity
Discount Bond
For any one year discount bond
F = Face value of the discount bond

P = Current price of the discount bond
The yield to maturity equals the increase in price over the
year divided by the initial price.
As with a coupon bond, the yield to maturity is negatively
related to the current bond price.
The Distinction Between Interest Rates
and Returns (1 of 4)
• Rate of Return:
The payments to the owner plus the change in value expressed as a
fraction of the purchase price
RET = return from holding the bond from time t to time t + 1

price of bond at time t
price of the bond at time t + 1
C = coupon payment
• The return equals the yield to maturity only if the holding
period equals the time to maturity.
• A rise in interest rates is associated with a fall in bond
prices, resulting in a capital loss if time to maturity is
longer than the holding period.
• The more distant a bond’s maturity, the greater the size of
the percentage price change associated with an interest-
rate change.
• Interest rates do not always have to be positive as
evidenced by recent experience in Japan and several
European states.
• The more distant a bond’s maturity, the lower the rate of
return the occurs as a result of an increase in the interest
rate.
• Even if a bond has a substantial initial interest rate, its
return can be negative if interest rates rise.
Table 2 One-Year Returns on Different-Maturity 10%-Coupon-Rate
Bonds When Interest Rates Rise from 10% to 20%
(1) (6)
Years to (2) (5) Rate of
Maturity Initial (3) (4) Rate of Return
When Bond Current Yield Initial Price Price Next Capital Gain [col (2) + col
Is Purchased (%) ($) Year* ($) (%) (5)] (%)
30 10 1,000 503 negative 49.7 negative 39.7
2 10 1,000 917 negative 8

+1.7
1 10 1,000 1,000 0.0 +10.0
*Calculated with a financial calculator, using Equation 3.

Maturity and the Volatility of Bond
Returns: Interest-Rate Risk
• Prices and returns for long-term bonds are more volatile
than those for shorter-term bonds.
• There is no interest-rate risk for any bond whose time to
maturity matches the holding period.
The Distinction Between Real and
Nominal Interest Rates
• Nominal interest rate makes no allowance for inflation.
• Real interest rate is adjusted for changes in price level
so it more accurately reflects the cost of borrowing.
– Ex ante real interest rate is adjusted for expected
changes in the price level
– Ex post real interest rate is adjusted for actual
changes in the price level
Fisher Equation
i = nominal interest rate
When the real interest rate is low, there are greater

incentives to borrow and fewer incentives to lend. The real
interest rate is a better indicator of the incentives to borrow
and lend.
Figure 1 Real and Nominal Interest Rates
(Three-Month Treasury Bill), 1953–2020
Sources: Nominal rates from Federal Reserve Bank of St. Louis F RED database: https://fred.stlouisfed.org/series/TB3MS
and https://fred.stlouisfed.org/series/CPIAUCSL . The real rate is constructed using the procedure outlined in
Frederic S. Mishkin, “The Real Interest Rate: An Empirical Investigation,” Carnegie-Rochester Conference Series on
Public Policy 15 (1981): 151–200. This procedure involves estimating expected inflation as a function of past interest
rates, inflation, and time trends, and then subtracting the expected inflation measure from the nominal interest rate.

Chapter 4

Uploaded by

Copyright:

Available Formats

Chapter 4

Uploaded by

Document Information

Original Description:

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Chapter 4

Uploaded by

Copyright:

Available Formats

The Economics of Money, Banking, and

Price of Bond ($) Yield to Maturity (%)

C = yearly interest payment

can rewrite above equation as this:

F = Face value of the discount bond

RET = return from holding the bond from time t to time t + 1

20 10 1,000 516 negative 48.4 negative 38.4

10 10 1,000 597 negative 40.3 negative 30.3

5 10 1,000 741 negative 25.9 negative 15.9

2 10 1,000 917 negative 8

*Calculated with a financial calculator, using Equation 3.

i = nominal interest rate

When the real interest rate is low, there are greater

You might also like