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Chapter 4

The Meaning of
Interest Rates

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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.

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Time Value of Money


Future Value of a Lump Sum Payment used to calculate the future balance in a
savings account or at maturity of a CD.
Example: What is the FV of a $5,000.00 CD
at your bank, for five years, paying 4%?
Present Value = $5,000.00
Interest Rate = 4%
Term = 5
After 5 years the CD will be worth $6,083.26
Banks must express this as the APY of the CD
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Time Value of Money


Future Value of an Annuity
Much like calculation of the FV of a lump
sum, but also assumes additions of an equal
dollar amount.
Used to calculate future value of contribution
plans, such as an IRA or 401(k)
(See example)
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Time Value of Money


Present Value of a Lump Sum
Used to Calculate the Prices of Treasury
Bills, which are sold at a discount.
Example, what would a one year Treasury
Bill with a maturity value of $10,000.00 cost
today to yield a 2% return?
Ans: $9,803.92

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Time Value of Money


Current Value of an Annuity
Used to calculate the monthly payment for a
term loan

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CAR LOAN AMORTIZATION SCHEDULE


(NET PRESENT VALUE OF AN ANNUITY)

Amount

$10,000.00

Interest Rate

Payment

$443.21

6.00%

Months

24

Interest

Principal

Beginning Balance

$10,000.00
1

$50.00

$393.21

$9,606.79

$48.03

$395.18

$9,211.61

$46.06

$397.15

$8,814.46

$44.07

$399.14

$8,415.32

$42.08

$401.13

$8,014.19

$40.07

$403.14

$7,611.05

$38.06

$405.15

$7,205.90

$36.03

$407.18

$6,798.72

$33.99

$409.22

$6,389.50

10

$31.95

$411.26

$5,978.24

11

$29.89

$413.32

$5,564.92

12

$27.82

$415.39

$5,149.53

13

$25.75

$417.46

$4,732.07

14

$23.66

$419.55

$4,312.52

15

$21.56

$421.65

$3,890.87

16

$19.45

$423.76

$3,467.12

17

$17.34

$425.87

$3,041.24

18

$15.21

$428.00

$2,613.24

19

$13.07

$430.14

$2,183.10

20

$10.92

$432.29

$1,750.80

21

$8.75

$434.46

$1,316.35

22

$6.58

$436.63

$879.72

23

$4.40

$438.81

$440.91

24

$2.20

$440.91

$-

$636.94

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Some definitions
Maturity Date the date a bond matures, or
in other words, redeemed.
Face Value the stated amount of a bond,
or what the issuer will pay the holder at the
bonds maturity. E.g., a bond with a FV of
$20,000.00 will pay the holder $20,000.00
at its maturity.

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Some definitions
Coupon rate (CPN) - the interest rate paid
on the FV of a bond, expressed on an annual
basis. E.g., a bond with a FV of $10,000.00
and coupon rate of 4% will pay the bond
holder $400.00 annually in interest.
Price the current market price of a bond,
expressed in $ per hundred.

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Some Definitions
Market Value (MV) (or Total Value) of a bond
its Face Value multiplied by its Price.
Discount if the MV of a bond purchased, or
trading at, is below its Face Value, it is
selling at a discount.
Premium - if the MV of a bond purchased, or
trading at, is above its Face Value, it is
selling at a premium.
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Some definitions
Par the bond is selling for its Face Value
CUSIP number Committee on Uniform
Security Identification Procedures.
All securities have a CUSIP number, but a
stock is typically identified by its ticker
symbol (E.g., Trustmarks is TRMK)
Everything other than stocks are identified
by their CUSIP number.

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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

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Coupon Bond
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.

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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.

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Figure 1 Real and Nominal Interest Rates


(Three-Month Treasury Bill), 19532014

Sources: Nominal rates from Federal Reserve Bank of St. Louis FRED database: http://research.stlouisfed.org/fred2/. The real rate is
constructed using the procedure outlined in Frederic S. Mishkin, The Real Interest Rate: An Empirical Investigation, CarnegieRochester Conference Series on Public Policy 15 (1981): 151200. 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.

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