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Understanding interest rates

Understanding interest rates. EK3301 Lecture 2. Introduction. Interest rate. Definition: the yield to maturity Measuring interest rates:

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Understanding interest rates

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  1. Understanding interest rates EK3301 Lecture 2 EK 3301 monetary economics

  2. Introduction • Interest rate. • Definition: the yield to maturity • Measuring interest rates: • Simple loan; provides the borrower with an AMOUNT of funds that must be rapid to lender at the MATURITY DATE along with an ADDITIONAL AMOUNT known as interest payment • Fixed-payment loan; provides a borrower with an amount of funds that is to be repaid by making the SAME MONTHLY PAYMENT • Coupon bond; pays the owner of the bond a YEARLY FIXED interest payment until the maturity date , when a specified final amount (FACE VALUE) is repaid • Discount bond; is BOUGHT at a price BELOW its FACE VALUE and the face value is repaid at the maturity date EK 3301 monetary economics

  3. Present Value • A dollar paid to a person one year from now IS LESS VALUABLE to that person than a dollar today • In the case of simple loan, cost of borrowing funds is the simple interest rate • Simple interest rate: • Proceeds from simple loan: EK 3301 monetary economics

  4. Discounting the future • Calculating what dollars received in the future are worth today • Example to calculate the present discounted value of the future $1 : EK 3301 monetary economics

  5. Yield to Maturity • Most common way of calculating interest rates. • YTM; the interest rate that equates the present value of payment received from a debt instrument with its value today • Methods of calculating YTM on the four types of credit market instruments EK 3301 monetary economics

  6. Simple loan E.g: 1-year loan and loan amount of $100 and payment in 1 yr’s time would be $110 Hence ***For simple loans, the simple interest rate = YTM**** EK 3301 monetary economics

  7. ii. Fixed-payment loan E.g: Loan is $1000, Yearly pmt $126 for the next 25 years. Hence, ***In FPL, the YTM is not known*** EK 3301 monetary economics

  8. iii. Coupon bond Way of calculating its YTM is the same as FPL: EK 3301 monetary economics

  9. iv. Discount bond The YTM calculation for a discount bond is similar to that for the simple loan. E.g: 1-yr treasury bill which pays off a face value of $1000 in 1 yr’s time. Current purchase price is $900, the PV of $900 in one year is EK 3301 monetary economics

  10. Real Vs. Nominal Interest Rates • Real interest rate is the interest rate that is adjusted for expected changes in the price level so that it more accurately reflects the true cost of borrowing • Defined by the Fisher Equation: • **when the RIR is low, greater incentives to borrow and lower incentives to lend.** EK 3301 monetary economics

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