Session 3 - The Meaning of Interest Rate

The Economics of Money, Banking, and Financial Markets
Thirteenth Edition
Chapter 4
The Meaning of Interest Rates
Copyright © 2022, 2019, 2016 Pearson Education, Inc. All Rights Reserved
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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.
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 $1 (1 + i) 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 one year: $100  (1 + 0.10 ) = $110
In two years: $110  (1 + 0.10 ) = $121
or $100  (1 + 0.10 )
2
In three years: $121 (1 + 0.10 ) = $133
or $100  (1 + 0.10 )
3
In n years
$100  (1 + i )
n
Simple Present Value (1 of 2)
PV = today’s (present) value
CF = future cash flow (payment)
i = the interest rate
CF
PV =
(1 + i )n
Simple Present Value (2 of 2)
• Cannot directly compare payments scheduled in different points in the time line
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.
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
PV = amount borrowed = $ 100
CF = cash flow in one year = $ 110
n = number of years = 1
$110
$100 =
(1 + i )1
(1 + i ) $100 = $110
$110
(1 + i ) =
$100
i = 0.10 = 10%
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
FP FP FP FP
LV = + 2
+ 3
+ ... +
1 + i (1 + i ) (1 + i ) (1 + i )n
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
C C C C F
P= + 2
+ 3
+. . . + +
1+ i (1+ i ) (1+ i ) n
(1+ i ) (1+ i )n
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
• 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.
• Consol or perpetuity: a bond with no maturity date that does not repay
principal but pays fixed coupon payments forever
𝑃 = 𝐶/𝑖𝑐
Pc = price of the consol
C = yearly interest payment
Ic = yield to maturity of the consol
can rewrite above equation as this: i c = C / Pc
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−𝐏
𝒊=
𝐏
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
C Pt +1 − Pt
RET = +
Pt Pt
RET = return from holding the bond from time t to time t + 1

Pt = price of bond at time t
Pt +1 = price of the bond at time t + 1
C = coupon payment
C Pt +1 − Pt
= current yield = i c = rate of capital gain = g
Pt Pt
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 −49.7
negative 49.7
−39.7
negative 39.7
20 10 1,000 516 −48.4

negative 48.4
−38.4
negative 38.4
10 10 1,000 597 −40.3

negative 40.3
−30.3
negative 30.3
5 10 1,000 741 −25.9

negative 25.9
−15.9
negative 15.9
2 10 1,000 917 −8.3

negative 8.3
+1.7
1 10 1,000 1,000 0.0 +10.0
*Calculated with a financial calculator, using Equation 3.
• 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.
• 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.
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 = 𝑖𝑟 + 𝜋 𝑒
i = nominal interest rate
i r = real interest rate
 e = expected inflation 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 FRED 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.

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The Economics of Money, Banking, and Financial Markets

– To understand the importance of this notion, consider the value of a $20

In three years: $121 (1 + 0.10 ) = $133

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

P = Current price of the discount bond

As with a coupon bond, the yield to maturity is negatively related to the

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

20 10 1,000 516 −48.4

10 10 1,000 597 −40.3

5 10 1,000 741 −25.9

2 10 1,000 917 −8.3

*Calculated with a financial calculator, using Equation 3.

• Real interest rate is adjusted for changes in price level so it more

– Ex ante real interest rate is adjusted for expected changes in the

– Ex post real interest rate is adjusted for actual changes in the

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