Course Notes for Seminar 3

Chapter 5: Time Value of Money

Part B

Instructor: Dr. LAU Sie Ting

 Coverage

• Types of Interest rates

• Practical Examples: Housing Loan and Car
Loan
• Different ways to structure a loan
• More Applications of TVM
• Nominal, Effective, and Complication in
Calculating Periodic Interest Rate
• Compound Annual Growth Rate
• Advanced topic: growing annuity
• The 4 TVM equations
• Questions on TVM (to be provided in class)
 (bonds) fixed income
securities

Types of Interest Rates

• Loan interest rate can be fixed or floating adjusted by the market
• Floating IR: pegged to SIBOR or Singapore Interbank Offered Rate;
Example, 1% over 3-month SIBOR.
• Prime Lending Rate; SWAP Offer Rate (SOR).
• Housing loans are almost always based on floating interest rate (because
of the long tenure). Maybe fixed for the first 2 to 3 years.
• SIBOR is the interest rate at which bank can borrow from other banks; set
by ABS and used in Asia; 1m, 3m, 6m, 12m. China – SHIBOR. Worldwide,
use LIBOR.
• SIBOR is an interbank money market interest rate.
• In China, floating rate for mortgage loan is Loan Prime Rate (set by PBOC)
+ x% basis point. There is also Provident Fund Loan to supplement the
commercial bank mortgage loan. And instead of same PMT for the tenure
of the loan, can have higher PMT in the beginning than in the end.
 continued
• SOR reflects the cost of borrowing S$ synthetically by borrowing
US$ and then swap to S$ using a forex swap. It is as if you are
borrowing in US$.
• SOR tends to be more volatile (can end up paying more interest
(if US$ appreciates); sometimes less interest) – not popular and
now only available for commercial property loans.
• Singapore Overnight Rate Average (SORA) – is a volume-
weighted average rate of unsecured overnight interbank SGD
transactions brokered in Singapore.
• Prime lending rate = each bank has one and is the best rate to
best customers. This rate is much higher than SIBOR rate. Pay a
spread if you are not their best customers.
• Many criteria for obtaining a loan; for example, Total debt
servicing ratio = your total debt/your gross monthly income.
 continued
• EasiCredit is a standby line of credit with the
flexibility to choose the repayment amount and
tenure of the outstanding balance. It is a fast
approval short term loan with very high
interest cost. For example, OCBC EasiCredit rate
(Oct 2020) is about 1.75% per month).
• Besides loan rate, there is interest rate for
savings account (differ from bank to bank).
• Time deposit rate (also called fixed deposit).
 More on Interest Rate
• Internationally, U.S. Federal Funds rate and discount rate are
most important interest rates.
• The federal funds rate is the rate at which banks lend reserve 准备⾦余额
balances to other banks on an overnight basis. Reserves are
excess balances held at the Federal Reserve to maintain reserve
requirements. Set by Fed Reserve’s FOMC 8 times a year. This
rate controls the short-term interest rate.
• The discount rate is the minimum interest rate set by the US
Federal Reserve for lending to other banks. This rate determines
the money supply – lower this rate in order to increase money
supply. This is slightly higher than Fed Funds rate.
• SIBOR and SOR are directly affected by US Fed Funds rate.
 Practical Example: Housing Loan
in Singapore
• Loan = $1m; Duration = 25 years (25*12=300
monthly payments); IR = 2% or monthly = 2/12 =
0.1667%. =periodic rate,assume compounding and cash flow same,
• What is monthly installment? PMT = $4,239
• If IR increases to 3%: PMT = $4,743 or $504 more. IR
was 5.5% in 1999 (PMT = $6,141).
• Can use Excel to do up the schedule of payment or
amortization schedule.
• Critical thinking: Impact of interest rate risk on
homeowners.
 Different ways to structure a loan
• #1: Option Reset Adjustable Rate Mortgages (ARMs)
• Borrower has the choice of initial monthly payment.
For example, allowing borrower to make a monthly
payment equal to only half of the interest due in the
first month. The borrower then pay this fixed amount
of PMT every month.
• Because the monthly payment is less than the interest
charged, the loan balance grew every month. When
the loan balance grew to 110% of the original principal,
the monthly payment is reset to fully amortize the now
larger loan at the prevailing market interest rates.
 ARMs (continued)
• Can find out how long it takes to reset the ARM.
• For example, loan amount = $1m (PV) to be paid over
30 years; FV = 10% more or $1.1m; let interest = 6%
per year or 0.5% per month = $5,000 in the first month.
Therefore, PMT = $2,500. Solve for n, n = 36.72
months.
• Typically, bank will try give the borrower a lower-than-
market “teaser” rate, so now the borrower will
probably have to pay a higher-than-market rate for the
remaining months (360 – 36.72 or 37 months).
• What are the advantages and disadvantages (risk) to
the homeowner? Because the house is pledged as
collateral, the bank will force-sell the house in a loan
default.
 #2: Balloon Payment Mortgage
• In this mortgage, there is a balance due at
maturity. For example, the loan amount is
$1m, to be paid over 120 months. The FV is
not $0, but let’s say is $200,000.
• At the end of 120 months, the bank may allow
a new mortgage, if the borrower cannot come
up with the $200,000 payment.
 Many ways to structure a loan
• ARMs, balloon payment mortgage
• Bullet loan = no amortizing of principal; borrow $1m and
pay $1m at the end of the loan. Only pay interest every
month. This is how a regular bond works.
• It is also possible to have a loan with higher PMT in earlier
years and lower PMT in later years.
• Could have all kinds of combination. For example, no
principal payment for first 5 years, partial amortization for
the remainder of the loan period, and finally a balloon
payment at the end of the loan. Creative financing.
• Banking regulations in some countries may prohibit some
of these loan structure, especially if it deals with residential
properties.
Summary of Amortization Methods
• Straight line or linear amortization – total interest
amount is distributed equally over the life of a loan.
Principal repayment is also constant. Therefore, fixed
periodic total payment; PMT is the same every period.
• Declining balance – this is the regular amortizing loan -
interest payment declines over time whereas principal
payment increases over time. PMT is the same every
period. The annuity can be due or ordinary.
• Bullet – periodic payment is on the interest only. Loan
paid upon maturity.
 continued
• Balloon – just like bullet, except that some
principal amount is repaid every period and a
big chunk of principal amount is paid at the
end of the loan.
• Negative amortization – total payment per
period is not enough to cover interest. At
maturity, loan and left-over interest are paid
in one lump sum.
 Difference between straight line and
declining
• In both cases, nominal interest rate, number of
payments, and monthly payment amount are the
same.
• But loan provider could calculate monthly interest
charges using a different predefined percentage each
month (usually interest portion payment is higher in
earlier years and lower in later years). The catch is that
if the borrower repay the loan early, he/she will end up
with a bigger loan repayment than a regular amortizing
loan. It won’t be a problem if the borrower does not
repay the loan early.
• Used in auto loans in some countries as different
finance companies try to offer competitive rate (with
hidden clause).
 Practical Example: Auto Loan in
Singapore
• Calculation is different from textbook example
• Car loan = $50,000; total installments = 48 months;
Terms Charges or Applied IR = 1.88%.
• Total IR = $50,000 X 1.88% X 4 years = $3,760.
• Monthly payment = $53,760/48 = -$1,120. First payment
due on agreement date.
• What is Effective IR? IR=3.82%
• Note: set calculator to BGN mode; PMT=-1,120;
PV=50,000; N=48; FV=0; find Interest = 0.313%/month.
Using EAR equation, effective = 3.82% per year.
• Penalty for early settlement. (1+i/n)N-1
 Other TVM Applications
• Valuing bonds (chapter 9): 10 years to maturity, Par (FV) =
$1,000, Coupon (PMT) = 5% a year = $50 a year, need to know IR
(known as Yield-to-Maturity, YTM) and then we can find PV or
price.
• Valuing stocks (chapter 10): expected to pay dividends of $1 at
the end of the year, dividend to grow at 5% per year, with IR
(known as cost of equity), we can find PV or price.
• Project valuation (chapter 12): Invest $1m in a project, expected
to receive $250,000 per year for 8 years, with IR (known as Cost
of Capital, COC = chapter 11), we can find out from the NPV
whether the project is acceptable.
 Recap: Classification of
Interest Rates
• Nominal rate (INOM): also called the quoted or stated rate.
An annual rate that ignores compounding effects.
– INOM is stated in contracts. Periods must also be given,
e.g. 4% quarterly (i.e., 1% per 3 months) or 4% daily
interest.
• Periodic rate (IPER): amount of interest charged each
period, e.g. monthly or quarterly.
– IPER = INOM/M, where M is the number of compounding
periods per year. M = 4 for quarterly and M = 12 for
monthly compounding.
 Classification of Interest Rates
(continued)
• Effective (or equivalent) annual rate (EAR = EFF%): the annual
rate of interest actually being earned, considering compounding.
– EFF% for 4% semiannual interest
EFF% = (1 + INOM/M)M – 1
= (1 + 0.04/2)2 – 1 = 4.04%
– Should be indifferent between receiving 4.04% annual
interest and receiving 4% interest (meaning 2% interest per 6
months), compounded semiannually.
– Note that INOM per year = M[(1 + EFF%)1/M -1]. Using this
equation, if we remove M, then we get the periodic interest
rate. Iperiodic = [(1 + EFF%)1/M -1].
 When is each rate used?
• INOM: Written into contracts, quoted by banks
and brokers. Not used in calculations or shown
on time lines.
• IPER: Used in calculations and shown on time
lines. If M = 1, INOM = IPER = EAR.
• EAR: Used to compare returns on investments
with different payments per year. Used in
calculations when annuity payments don’t
match compounding periods.
 Quoted versus Actual Interest
Rate
• What is quoted versus what is actually
paid/received can be very different. Always use
the effective interest rate as comparison.
• For example, a finance company quoted a very
low 1.11% interest rate with the following PMT:
• $10k X 60 months = $185
• $50k X 60 months = $925
• $100k X 60 months = $1,850
• If you do the calculation, eff = 4.185%.
 Note on Periodic interest
calculation
• Scenario 1A where compounding is more frequent than cash flow: if
compounding is once a month and cash flow occurs once a quarter,
then need to use 2 steps to get periodic interest rate. See FM Fitness
Club question.
• In the earlier example (Scenario 1B), compounding is once every 6
months, but cash flow is once a year, there is no need for a 2-step
approach to get periodic interest rate. Just find EFF% or effective
annual rate and that is the periodic rate.
• Scenario 2: If compounding is once a quarter and cash flow occurs
once a quarter, periodic interest rate is just = nominal per year divide
by 4. Easy.
• Scenario 3: If compounding is once every 6 months and cash flow
occurs once a quarter, which is unrealistic, it is not possible to find
periodic interest rate.
 Complication in calculating
periodic rate
• Scenario 1A where compounding is more
frequent than cash flow: if compounding is
once a month and cash flow occurs once a
quarter, then need to use 2 steps to get
periodic interest rate.
• See FM Fitness Club question.
 Question (Scenario 1A)
You plan to enroll in FM Fitness Club for the next 10 years. The club
offers you two ways to pay for the membership fee. You can choose
to pay an immediate amount of $X or you can choose to pay $200
every quarter for the next 10 years, with the first payment payable
immediately. Assuming you can earn a nominal rate of 24%,
compounded monthly from your bank, what is the closest value of
$X that would make you indifferent between the two payment
plans?

Compounding frequency is once a month, but cash flow frequency

is once a quarter. Periodic interest rate always follows the
frequency of cash flows.
 Answer
• Beg annuity; PMT=200; n=10*4=40; FV=0; we want to find PV,
but we need to first find interest, the periodic interest per
quarter.
• Step 1: Using EFF% equation, effective = (1.02)12 -1 = 26.8242%
per year.
• Step 2: Using iNOM equation, iNOM per quarter or per-quarter
periodic rate = (1.268242)1/4 -1 = 6.12%.
• With interest known, we can solve for PV = $3,145.70.
• Instead of 2-step approach, alternatively:
• Use EFF per quarter equation to find periodic interest; = (1 + iNOM
per quarter/3mths in one quarter)3 -1 = (1 + 0.06/3)3 -1 =
0.061208 = 6.12%.
 Scenario 1A (another example)
• Interest is compounded quarterly, and cash flows occur
semi-annually.
• Nominal interest rate = 6%.
• Step 1: Using EFF% equation, effective = (1+0.06/4)4 -1 =
0.061364
• Step 2: Using iNOM equation, iNOM per 6-month or semi-
annual periodic rate = (1.061364)1/2 -1 = 0.030225 =
3.0225%.
• Alternatively, effective per 6 months = (1 +
3%/2Qper6mths)2 -1 (will give you the same answer).
 Compound Annual Growth Rate
(CAGR)
• It is the return on investment over a certain time period.
• It is the same as IRR except that IRR can handle more
complicated cash flows.
• It is similar to effective annual rate (in both cases, it is return
when compounding is taken into consideration) but different
usage.
If $1 increases to $1.50 in 3 years, then:
• CAGR = (end value/beg value)1/N -1
• = (1.50/1)1/3 -1
• = 0.1447 or 14.47% per year.
Note that this is just rearranging FV = PV(1+i)N, where i is the CAGR.
 continued
• Note that we cannot use Return = (1.50-1)/1
= 50%. This is return per 3 years and there is
no compounding (no TVM).
• We also cannot use 50%/3 = 16.67% per
year (again, no compounding).
• These are examples of simple return
calculation, which is also widely used.
 Advanced topic: Growing annuity
• An annuity is a series of constant amounts to be
received or paid over a specified number of
periods.
• A growing annuity is a series of amounts either
received or paid that grow at a constant rate.
• Useful in financial planning. For example, a
retiree wishing to withdraw a constant real
amount (meaning inflation-adjusted) every year
in order to maintain a constant standard of living.
 How to find a growing annuity
• A person with $1m in retirement wishing to withdraw a
constant real amount annually over the next 20 years.
Let’s assume interest earning is 6% and inflation is 3% a
year over the 20 years. This is typically an annuity due
problem, since you will need to withdraw the money
for spending at the beginning of every year.
• The formula to find the payment of a growing annuity
due (PVIFGAdue)
• = {1-[(1+g)/(1+r)]N}[(1+r)/(r-g)].
• Now, PMT = PV/PVIFGAdue
• You can use this formula (which is tedious), or the
spreadsheet (there is an Excel’s Goal Seek feature), or
the financial calculator.
Calculation using a financial calculator
• First, find the real rate of return, rreal =
[(1+rnominal)/(1+Inflation)] – 1.
• Real rate = [1.06/1.03] – 1 = 0.029126214 =
2.9126214%
• Using financial calculator, set to BEGIN mode,
N=20, I/YR=2.9126214, PV=-1m, FV=0, solve
for PMT=$64,786.88. This PMT is the
withdrawal today. Future withdrawals will
increase by 3% (the inflation rate) per year.
 What if the withdrawals were at the
end of the year
• Use the END model, enter all the numbers,
PMT = $66,673.87. This amount is beginning-
of-year terms, while inflation occurs during
the year. Hence, initial end-of-year withdrawal
= $66,673.87 (1+Inflation) = $68,674.09. This
is the amount of first withdrawal. Subsequent
withdrawals will increase by 3% (inflation rate)
a year. At the end of the 20 years, the balance
(FV) will = 0.
Another example of a growing annuity
• Suppose you need to accumulate $100,000 in 10
years. You want to make 10 deposits, the first one
starting today. The bank pays 6% interest and
inflation is expected to be 2% a year. You want to
increase your annual deposits at the inflation
rate.
• Real rate = 1.06/1.02 – 1 = 3.9215686%.
• At 2% inflation, the future $100,000 will have a
real value = $100,000/(1+0.02)10 = $82,034.83
 continued
• Using BEG mode, N=10, I/YR=3.9215686,
PV=0, FV=82034.83, solve for PMT=-6,598.87
• This is the deposit at t=0. Subsequent deposits
will increase by the inflation rate of 2% to give
us a FV of $100,000.
• The key here is to express I/YR, FV, and PMT in
real instead of nominal terms.
 The 4 TVM Equations
• PV = FVN /(1 + I)N
• FVN = PV(1 + I)N

PVAdue = PVAord(1 + I); FVAdue= FVAord(1 + I)