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1 Aufrufe61 SeitenAn introduction

Sep 06, 2018

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An introduction

© All Rights Reserved

Als PPT, PDF, TXT **herunterladen** oder online auf Scribd lesen

1 Aufrufe

An introduction

© All Rights Reserved

Als PPT, PDF, TXT **herunterladen** oder online auf Scribd lesen

- Edu 2015 Exam Fm Ques Theory
- MATHA
- Simple Interest
- Restructuring and Rescheduling
- ISHUP Guidelines
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- Math of investment
- Time value of money -Theory.docx
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Topic 1

An Understanding of

Money & Interest Rates

TEXTBOOK

1-2

What is interest rate?

1-3

investing, significantly influenced and tied together by

the interest rate.

The interest rate is the price a borrower must pay to

secure scarce loanable funds from a lender for an

agreed-upon time period.

What is interest rate?

1-4

price of credit.

Interest rates send price signals to borrowers, lender,

savers, and investors.

Whether higher interest rates increase or decrease

the savings and investment, it depends on the relative

strength of its effect on supply and demand factors.

Functions of the Interest Rate in the Economy

1-5

that promote economic growth.

Ex: Banks can attract household savings by offering

interest on deposits.

Allocates the available supply of credit to those

investment project with highest returns.

Ex: If interest rate is too high, therefore cost of

borrowing will be high and could cause profitable

project making loses.

Functions of the Interest Rate in the Economy

1-6

money into balance with demand.

Ex: If money supply exceeds demand, a decrease in

interest rate would occur and vice versa.

Act as important tool of government policy through

their influence on the volume of savings and

investments.

Ex: If economy is growing slowly and unemployment is

rising, government can use its policy tools to lower

interest rate to stimulate borrowing and investment.

Theory of Interest Rates

1-7

The Liquidity Preference or Cash Balances Theory

The Loanable Funds Theory

The Rational Expectations Theory

The Classical Theory

1-8

determined by two forces:

the supply of savings

to the market interest rates.

Demand for investment capital is negatively related to

the market interest rates.

Equilibrium achieved when supply = demand

The Classical Theory - Supply of Savings

1-9

i) Household Savings

Current household savings equal to the difference

expenditures.

Individuals prefer current over future consumption,

Higher interest rates encourage the substitution of

The Classical Theory - Supply of Savings

1-10

Relating Savings and Interest Rates

Interest

Rate

r2

r1

Current

S1 S2 Saving

The Classical Theory - Supply of Savings

1-11

Most businesses hold savings balances in the form of

retained earnings, the amount of which is determined

principally by business profits, and to a lesser

extent, by interest rates.

iii) Government

Income flows in the economy and the pacing of

government spending programs are the dominant

factors affecting government savings (budget

surplus).

The Classical Theory - Demand for

Investment Funds

1-12

replacement investment and net investment.

*Replacement investment = expenditures to replace equipment and facilities

that wearing out or technologically obsolete.

*Net investment = expenditures to acquire new equipment and facilities to

increase output.

Investment decision-making method involves the

calculation of a project’s expected internal rate of

return, and the comparison of that expected return

with the anticipated returns of alternative projects, as

well as with market interest rates.

The Classical Theory - Demand for

Investment Funds

1-13

of an investment project with the future net cash flows

(NCF) expected from that project discounted back to

their present values.

Cost of project = NCF1 NCF2 NCFn

...

1 r 1 r

1 2

1 r n

The Classical Theory - Demand for

Investment Funds

1-14

Expected

Internal A – acceptable

Rates of 15%

Return on B – acceptable

Alternative Cost of

Investment 12% C – indifferent Capital

Projects Funds

10% D = 10%

unprofitable 8% E

unprofitable 7%

The Classical Theory - Demand for

Investment Funds

1-15

In the Classical Theory of Interest Rates

Interest

Rate

r2

r1

Investment

I2 I1 Spending

The Classical Theory - Demand for

Investment Funds

1-16

Interest

Rate Investment Savings

rE

Savings &

QE Investment

Limitations of The Classical Theory

1-17

investment that affect interest rates.

The theory assumes that interest rates are the

principal determinant of the quantity of savings

available.

The theory contends that the demand for borrowed

funds comes principally from the business sector.

The Liquidity Preference (Cash Balances) Theory

1-18

interest rates is a short-term theory that was

developed for explaining near-term changes in

interest rates, and hence, is more relevant for

policymakers.

According to the theory, the rate of interest refer to

a payment to supplier of funds for the use of scarce

resource (money or cash balances) by the demander.

To classical theorist, it was irrational to hold cash as

it provides little or no return.

The Liquidity Preference (Cash Balances) Theory

1-19

the transactions motive – the purchase of goods

and services

the precautionary motive – to cope with future

emergencies and extraordinary expenses

the speculative motive – uncertainty about future

prices of bonds

The Total Demand for Money or Cash Balances &

the Equilibrium Rate of Interest

1-20

The Liquidity Preference (Cash Balances) Theory

1-21

or at least closely regulated, by the government.

The supply of money (cash balances) is often assumed

to be inelastic with respect to interest rates, since

government decisions concerning the size of the money

supply should presumably be guided by public

welfare. (not by interest rate)

The Liquidity Preference (Cash Balances) Theory

1-22

In the Liquidity Preference Theory

Interest

Rate Money

Supply

Equilibrium

interest rate Total

Demand

Quantity of

Money / Cash

QE Balances

Limitations of The Liquidity Preference

(Cash Balances) Theory

1-23

fact that over a longer term period, interest rates are

affected by changes in level of income and

inflationary expectations.

It is impossible to have a stable equilibrium interest

rate without reaching equilibrium level of income,

savings and investments in the economy.

It only considers supply and demand for money

whereas business, consumer and government demands

for financing have impact on cost of financing.

The Loanable Funds Theory

1-24

determined by the interplay of two forces:

the demand for loanable funds by domestic

businesses, consumers, and governments, as well as

foreign borrowers

the supply of loanable funds from domestic savings,

dishoarding of money balances, money creation by

the banking system, as well as foreign lending

The Loanable Funds Theory

1-25

Loanable funds?

The sum total of all the money people and entities

in an economy have decided to save and lend out

to borrowers as an investment rather than use for

personal consumption

The Loanable Funds Theory

1-26

Consumer (household) demand is relatively inelastic

with respect to the rate of interest.

Domestic business demand increases as the rate of

interest falls.

Government demand does not depend significantly

upon the level of interest rates.

Foreign demand is sensitive to the spread between

domestic and foreign interest rates.

The Loanable Funds Theory

1-27

Interest

Rate

Total Demand = Dconsumer +

Dbusiness +

Dgovernment +

Dforeign

Amount of

Loanable Funds

The Loanable Funds Theory

1-28

Domestic Savings. The net effect of income,

substitution, and wealth effects is a relatively interest-

inelastic supply of savings curve.

Dishoarding of Money Balances. When individuals and

supply of loanable funds available to others is

increased.

The Loanable Funds Theory

1-29

Commercial banks and nonbank thrift institutions

offering payments accounts can create credit by

lending and investing their excess reserves.

Foreign lending is sensitive to the spread between

domestic and foreign interest rates.

The Loanable Funds Theory

1-30

Interest

Rate Total Supply

= domestic savings +

newly created money +

foreign lending –

hoarding demand

Amount of

Loanable Funds

The Loanable Funds Theory

1-31

Interest

Rate Supply

rE

Demand

Amount of

QE Loanable Funds

The Loanable Funds Theory

1-32

At equilibrium:

Planned savings = planned investment across the

whole economic system

Money supply = money demand

Supply of loanable funds = demand for loanable

funds

Net foreign demand for loanable funds = net exports

Interest rates will be stable only when the economy, money

market, loanable funds market, and foreign currency

markets are simultaneously in equilibrium.

The Loanable Funds Theory

1-33

demand unchanged

Interest

Rate D0 S1

S2

I1

I2

Amount of

C1 C2 Loanable Funds

The Loanable Funds Theory

1-34

supply unchanged

Interest

Rate D2 S0

D1

I2

I1

Amount of

C1 C2 Loanable Funds

The Rational Expectations Theory

1-35

body of research evidence that the money and capital

markets are highly efficient in digesting new

information that affects interest rates and security

prices.

For example, when new information appears about

investment, saving or the money supply, investors

begin immediately to translate the new information

into decision to lend or to borrow funds.

The Rational Expectations Theory

1-36

about the future demand and supply of credit, and

hence interest rates.

Rate

rE

Expected Demand

Amount of

QE Loanable Funds

The Rational Expectations Theory

1-37

then interest rates will always be very near their

equilibrium levels.

Interest rates will change only if entirely new and

unexpected information appears, and the direction of

change depends on the public’s current set of

expectations.

Present Value

1-38

value) is based on the common sense notion that

“a dollar of cash flow paid to you next year is less

valuable to you than a dollar paid to you today”.

This notion is true because you could invest the dollar

in a savings account that earns interest and have more

than a dollar in one year.

The term present value (PV) can be extended to the

PV of a single cash flow or the sum of a sequence or

group of cash flows.

Present Value Concept

1-39

incorporate present value concepts:

1. Simple Loan

2. Fixed Payment Loan

3. Coupon Bond

4. Discount Bond

Present Value Concept : Simple Loan

1-40

the loan principal plus the interest.

Loan Principal: the amount of funds the lender provides to the

borrower.

Maturity Date: the date the loan must be repaid; the Loan Term is

from initiation to maturity date.

Interest Payment: the cash amount that the borrower must pay the

lender for the use of the loan principal.

Simple Interest Rate: the interest payment divided by the loan

principal; the percentage of principal that must be paid as

interest to the lender express on an annual basis.

Present Value Concept : Simple Loan

1-41

Year: 0 1 2 3 n

n

$100 $110 $121 $133 100(1+i)

$1

PV of future $1 =

1+ i n

Present Value Concept : Simple Loan

1-42

$100 today is preferable to $100 a year from now

since today’s $100 could be lent out (or deposited) at

10% interest to be worth $110 one year from now, or

$121 in two years or $133 in three years.

Present Value Concept : Simple Loan

1-43

value with present value of all future payments

$100 $110 1 i

$110 $100 $10

i .10 10%

$100 $100

**i = yield to maturity (YTM)

Present Value Concept : Fixed Payment Loans

1-44

and interest are repaid in several payments, often

monthly, in equal dollar amounts over the loan term.

Example: installment loans such as automobile loans

and home mortgages.

Present Value Concept : Fixed Payment Loans

1-45

Fixed Payment Loan (i = 12%)

$1000 2 3 ...

1 i 1 i 1 i 1 i 25

FP FP FP FP

LV 2 3 ...

1 i 1 i 1 i 1 i n

Present Value Concept : Coupon Bonds

1-46

Coupon Payment (i = 12%)

$100 $100 $100 $100 $1000

P 2 3 ... 10

1 i 1 i 1 i 1 i 1 i 10

C C C C F

P 2 3 ... n

1 i 1 i 1 i 1 i 1 i n

C C

P i

i P

Present Value Concept : Discount Bonds

1-47

$900

$1000

i F P

1 i P

$1000 $900

i .111 11.1%

$900

Relationship Between Price and Yield to Maturity

1-48

Note:

1. When bond is at par, yield equals coupon rate

2. Price and yield are negatively related

3. Yield greater than coupon rate when bond price is

below par value

Distinction Between Real & Nominal Interest Rates

1-49

1. Interest rate that is adjusted for expected

changes in the price level

ir i e

cost of borrowing

3. When real rate is low, greater incentives to

borrow and less to lend

Distinction Between Real & Nominal Interest Rates

1-50

If i = 5% and πe = 0% then

ir 5% 0% 5%

ir 10% 20% 10%

Distinction Between Interest Rates and Returns

1-51

Reinvestment Risk

1-52

long holding period

2. i at which reinvest uncertain

3. Gain from i , lose when i

Calculating Duration

i =10%, 10-Year 10% Coupon Bond

1-53

Calculating Duration

i = 20%, 10-Year 10% Coupon Bond

1-54

Formula for Duration of Bond

1-55

n n

CPt CPt

DUR t

t 1 1 i t 1 1 i

t t

1. All else equal, when the maturity of a bond

lengthens, the duration rises as well

2. All else equal, when interest rates rise, the duration

of a coupon bond fall

3. All else equal, the higher the coupon rate, the

shorter bond’s duration

Formula for Duration of Bond

1-56

i

%P DUR

1 i

From Table 3, if i 10% to 11%:

0.01

%P 6.76

1 0.10

Formula for Duration of Bond

1-57

0.01

%P 5.72

1 0.10

Formula for Duration of Bond

1-58

is the percentage change in the market value of the

security for a given change in interest rates

the greater is its interest-rate risk

Question & Application

1-59

years. Its coupon rate is 10 percent, with

interest paid to holders of record at the

conclusion of each year. This $1,000 par value

carries a current yield to maturity of 10

percent. What is its duration?

Question & Application

1-60

Question & Application

1-61

Inflation refers to a rise in the average level of prices

for all goods and services in an economy.

It is important as inflation creates distortions in the

allocation of scarce resources and definitely hurts

certain groups.

For example, it tends to discourage savings - In turn,

the decline in the savings rate tends to discourage

capital investment and hence declining in the

economy's growth.

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