R. GLENN HUBBARD ANTHONY PATRICK - PowerPoint Presentation

Slide1

R. GLENN

HUBBARDANTHONY PATRICKO’BRIEN

Money,

Banking, and

the Financial SystemSlide2

Interest Rates and Rates of Return

C H A P T E R

3

3.1

3.2

3.3

Explain how the interest rate links present value with future value

LEARNING OBJECTIVES

After studying this chapter, you should be able to:

Distinguish among different debt instruments and understand how their prices are determined

Explain the relationship between the yield to maturity on a bond and its price

3.4

3.5

Understand the inverse relationship between bond prices and bond yields

Explain the difference between interest rates and rates of return

3.6

Explain the difference between nominal interest rates and real interest ratesSlide3

BANKS IN TROUBLE

During the financial crisis, the number of insolvent banks increased sharply.

With the collapse

of the housing

market, increasing

numbers of homeowners had stopped

making payments

on their mortgage loans. Banks that held these

loans saw their value drop

.Mortgage loans that were turned into mortgage-backed securities, similar

to bonds, declined by 50% or more during 2008 and 2009

.

Banks had badly misjudged both

the default risk and the interest-rate

risk on these bonds

.

An Inside Look at Policy on page 78 discusses the performance of the bond market through 2010.

Interest Rates and Rates of Return

C H A P T E R

3Slide4

Key Issue and Question

Issue

:

During the financial crisis, soaring interest rates on assets such as mortgage-backed securities caused their prices to plummet.

Question

:

Why do interest rates and the prices of financial securities move in opposite directions?Slide5

3.1

Learning Objective

Explain how the interest rate links present

value with

future value.Slide6

The Interest Rate, Present Value, and Future Value

Why Do Lenders Charge Interest on Loans?

T

he

interest rate

on a loan should cover

the opportunity cost of supplying credit, particularly, the costs associated with three factors:

Compensation for inflation: if prices rise, the payments received will buy fewer goods and services.Compensation for default risk: the borrower might default on the loan.

Compensation for the opportunity cost of waiting for the money to be paid back.Slide7

The Interest Rate, Present Value, and Future Value

Most Financial Transactions Involve Payments in the Future

The importance of the interest rate comes from the fact that

most

financial transactions involve payments in the

future

; the interest rate provides a link between the financial present and the financial future.Slide8

Compounding and Discounting

Future value The value at some future time of an investment made today.Compounding

The process of earning interest on interest as savings accumulate over time.

If:

i

= the interest rate

Principal = the amount of your investment (your original $1,000)FV = the future value (what your $1,000 will have grown to in one year)then we can rewrite the expression as:

Compounding for More Than One Period

If you invest $1,000 for

n

years, where

n can be any number of years, at an interest rate of 5%, then at the end of n years, you will have:

The Interest Rate, Present Value, and Future ValueSlide9

Solved Problem

3.1A

Comparing Investments

The Interest Rate, Present Value, and Future Value

Suppose you are considering investing $1,000 in one

of the

following bank CDs

:

First

CD, which will pay an interest rate of 4%

per year

for three

years

Second

CD, which will pay an interest rate of

10% the

first year, 1% the second year, and 1% the third yearWhich CD should you choose?Slide10

Solved Problem

3.1A

Comparing Investments

Solving the Problem

Step 1

Review the chapter material.

Step 2

Calculate the future value of your investment with the first CD.

Step 3 Calculate the future value of your investment with the second CD and decide which CD you should choose.

Principal = $1,000, i

= 4%, n = 3 yearsFV = $1,000 x (1 + 0.04)3

= $1,124.86Principal =

$1,000, i1 = 10%, i2

= 1%, i3 = 1%, n = 3 years

FV = $1,000 x (1 + 0.10) x (1 + 0.01) x (1 + 0.01) = $1,122.11

Decision: You should choose the investment with the highest future value, so you should choose the first CD.

The Interest Rate, Present Value, and Future ValueSlide11

Present value The value today of funds that will be received in the future.

Time value of money The way that the value of a payment changes depending on when the payment is received.Discounting

The process of finding the present value of funds that will be received in the future.

An Example of Discounting

Funds in the future are worth less than funds in the present, so

they

have to be reduced, or discounted, to find their present value.

The Interest Rate, Present Value, and Future ValueSlide12

Some Important Points about Discounting

1. Present value is sometimes referred to as “present discounted value.”2. The further in the future a payment is to be received, the smaller its present value (See Table 3.1).

3.

The higher the interest rate used to discount future payments, the smaller the present value of the payments

(See Table 3.1).

4.

The present value of a series of future payment is simply the sum of the

discounted value of each individual payment.

The Interest Rate, Present Value, and Future ValueSlide13

Solved Problem

3.1B

Valuing a Contract

Jason

Bay played the 2009

baseball season

with the Boston Red Sox.

When he

became a free agent,

the Red Sox offered him a contract for $15 million per year for four years. The New York Mets offered him a contract that would pay him a total

of $66 million.According to sportswriter Buster Olney: “The Mets’

offer to Jason Bay is heavily backloaded, to the point that the true value of the four-year [contract] falls to within the range of the offer he turned down from the Red Sox.”

What does Olney mean by the payments in the Mets’ contract being “backloaded”? What does he mean by the “true value” of

the contract?How would backloading the payments affect the true value of the contract?

The Interest Rate, Present Value, and Future ValueSlide14

Valuing a Contract

Solving the ProblemStep 1 Review the chapter material.Step 2

Explain what Olney means by “backloaded” and “true value.”

A “backloaded” contract means that the

Mets offered Jason

Bay lower

salaries in the first years and higher salaries in the later years of the

contract. The “true value” probably refers to the present value of the contract.

Step 3 Explain how backloading affects the value of the contract.We know that the present value of payments is lower the further away in time those payments

are made. So, if the Mets’ contract pays Bay most of the $66 million in the third and fourth years of the contract, it could have a present value similar to the Red Sox contract that paid $60 million spread out as four annual $15

million payments.

The Interest Rate, Present Value, and Future Value

Solved Problem

3.1BSlide15

A Brief Word on Notation This book will always

enter interest rates in numerical calculations as decimals. For instance, 5% will be 0.05, not 5.Discounting and the Prices of Financial Assets

Discounting

gives us a way of determining the prices of financial assets. By adding up the present values of all the payments, we have

the dollar

amount that a buyer will pay for the asset. In other words, we have

determined the

asset’s price.

The Interest Rate, Present Value, and Future ValueSlide16

3.2

Learning Objective

Distinguish among different debt instruments and understand how their prices are determined.Slide17

Debt instruments

(also known as credit market instruments or fixed income assets) Methods of financing debt, including simple loans, discount bonds, coupon bonds, and fixed payment loans.Equity A claim to part ownership of a firm; common stock issued by a corporation.

The

price of a financial asset is equal to the present value of the

payments to

be received from owning it.

Debt Instruments and Their PricesSlide18

Loans, Bonds, and the Timing of Payments

In this section, we discuss four basic categories of debt instruments:Simple loansDiscount bonds

Coupon bonds

4. Fixed-payment loans

Debt Instruments and Their PricesSlide19

Simple loan

A debt instrument in which the borrower receives from the lender an amount called the principal and agrees to repay the lender the principal plus interest on a specific date when the loan matures.Simple LoanAfter one year, Nate’s would repay the principal plus interest: $10,000 + ($10,000 × 0.10), or $11,000.

Debt Instruments and Their PricesSlide20

Discount Bond

The lender receives interest of $10,000 - $9,091 = $909 for the year. Therefore, the interest rate is $909/$9,091 = 0.10, or 10%. Discount bond A debt instrument in which the borrower repays the amount of the loan in a single payment at maturity but receives less than the face value of the bond initially.

Debt Instruments and Their PricesSlide21

Coupon Bonds

Terminology of coupon bonds:Face value, or par value, is the amount to be repaid by the bond issuer (the borrower) at

maturity.

The

coupon

is the

annual fixed dollar amount of interest paid by the issuer

of the bond to the buyer.The coupon rate is the

value of the coupon expressed as a percentage of the par value of the bond.

The current yield is the value of the coupon expressed as a percentage of the current price.

Coupon bond A debt instrument that requires multiple payments of interest on a regular basis, such as semiannually or annually, and a payment of the face value at maturity.

Debt Instruments and Their PricesSlide22

Coupon Bonds

For example, if IBM issued a $1,000 30-year bond with a coupon rate of 10%, it would pay $100 per year for 30 years and a final payment of $1,000 at the end of 30 years. The timeline on the IBM coupon bond is:

Maturity

is

the length of time before the bond expires and the

issuer makes

the face value payment to the buyer

.

Debt Instruments and Their PricesSlide23

Fixed-Payment Loan

For example, if you are repaying a $10,000 10-year student loan with a 9% interest rate, your monthly payment is approximately $127. The time line of payments is:

Fixed-payment loan

A debt instrument

that requires

the borrower

to make regular periodic

payments of principal and interest to the lender.

Debt Instruments and Their PricesSlide24

Making the Connection

Do You Want the Principal or Do You Want the Interest?

Creating New Financial Instruments

Back when the U.S. Treasury offered only short-term discount bonds, investors were seeking to benefit

from

longer terms knowing

the exact return if they held the bonds to

maturity.

In 1982, Merrill Lynch created the

TIGR (Treasure Investment Growth Receipt), which is a discount bond that works like a Treasury Bill.

Two years later, the Treasury introduced its own version called STRIPS (Separate Trading of Registered Interest and Principal Securities). These bonds allowed investors to buy each interest payment and the face value of the bond.

Individuals can obtain long-term discount bonds as well as the regular Treasury coupon bonds, thereby increasing their options for investment.

Debt Instruments and Their PricesSlide25

3.3

Learning Objective

Explain the

relationship between

the yield

to maturity

on a bond

and its

price.Slide26

Bond Prices

Consider a coupon bond with i = 6%, FV = $1,000, n = 5 years. The expression for the price, P, of the bond is the sum of the present values of the six

payments:

Below is a

general expression for a bond that

makes coupon

payments,

C

, has a face value,

FV

, and matures in

n

years:

Bond Prices and Yield to MaturitySlide27

Yield to Maturity

Yield to maturity The interest rate that makes the present value of the payments from an asset equal to the asset’s price today.Whenever

participants in

financial markets

refer to the interest rate on a financial asset, the interest rate is the yield

to maturity

.Yields to Maturity on Other Debt Instruments

Simple Loans

Consider a $10,000 loan required to pay $11,000 in one year.

Value today = Present value of future payments Solving for i:

Bond Prices and Yield to MaturitySlide28

Discount Bonds

Consider a $10,000 one-year discount bond with a value today of $9,200. Value today = Present value of future payments Solving for i:

A

general equation for a

one-year

discount bond

that sells

for price,

P, with face value, FV

. The yield to maturity is:

Bond Prices and Yield to MaturitySlide29

Fixed-Payment Loans

Consider a $100,000 loan with annual payments of $12,731. Value today = Present value of future payments

In general, for a fixed-payment

loan with

fixed payments,

FP, and a maturity of n

years, the equation is: 

Perpetuities

A perpetuity does not mature. The price of a couponbond that pays an infinite number of coupons equals:

So, a perpetuity with a coupon of $25 and a price of $500 has a yield to maturity of i = $25/$500 = 0.05, or 5%.

Bond Prices and Yield to MaturitySlide30

Solved Problem

3.3

Yield to Maturity for Different Types of Debt

Instruments

For each of the following situations, write the

equation that

you would use to calculate the yield to

maturity. You

do not have to solve the equations for

i; just write the appropriate equation.a) A simple loan for $500,000 that requires a payment of

$700,000 in four years.b) A discount bond with a price of $9,000, which has a

face value of $10,000 and matures in one year.c) A corporate bond with a face value of $1,000, a price of $975, a coupon rate

of 10%, and a maturity of five years.d) A student loan of $2,500, which requires payments of $315 per year for 25

years. The payments start in two years.

Bond Prices and Yield to MaturitySlide31

Solved Problem

3.3

Yield to Maturity for Different Types of Debt

Instruments

Solving the Problem

Step 1

Review the chapter material.

Step

2 Write an equation for the yield to maturity for each of the following debt instruments.

A simple loan for $500,000 that requires a

payment of $700,000 in four years.

A discount bond with a price of $9,000, which has a face value of $10,000 and matures in one year.

Bond Prices and Yield to MaturitySlide32

Solved Problem

3.3

Yield to Maturity for Different Types of Debt

Instruments

Solving the Problem

Step 1

Review the chapter material.

Step

2 Write an equation for the yield to maturity for each of the following debt instruments.

A corporate bond with a face value of $1,000, a price of $975, a coupon rate of 10%, and a maturity of five years

.

A student loan of $2,500, which requires payments of $315 per year for 25 years. The payments start in two years.

Bond Prices and Yield to Maturity

(continued)Slide33

3.4

Learning Objective

Understand the

inverse relationship between bond

prices and

bond yields

.Slide34

The Inverse Relationship between Bond Prices and Bond Yields

What Happens to Bond Prices When Interest Rates Change?If the price of an asset increases, it is called a

capital gain

. If the price of the asset declines, it is called a

capital loss

.

Coupon bonds may be sold many times in a

secondary market.The issuer of the bond is no longer involved in these transactions.

If new bonds are issued at a higher interest rate, holders of bonds that pay lower rates would have to adjust the price at which they are willing to sell their bonds.

To calculate the new price, we need to use the same yield to maturity of the newly issued bonds.

Because the yield to maturity is higher, the bond’s market price will fall below its face value.

As interest rates rise, bond prices fall.Slide35

Making the Connection

Banks Take a Bath on Mortgage-Backed Bonds

Many mortgage-backed

securities are similar to long-term bonds in that they pay regular

interest based

on the payments borrowers make on the underlying mortgages

.

In the secondary market for mortgage-backed securities, as borrowers began to default on their payments, buyers required much

higher yields to compensate for the higher levels

of default risk.Higher yields on these securities meant lower prices. By 2008, the prices of many

mortgage-backed securities had declined by 50% or more.By early 2009, U.S. commercial banks had suffered losses on their investments

of about $1 trillion.Banks had relearned the lesson that soaring interest rates can have

a devastating effect on investors holding existing debt instruments.

The Inverse Relationship between Bond Prices and Bond YieldsSlide36

Bond Prices and Yields to Maturity Move in Opposite Directions

If interest rates on newly issued bonds rise, the prices of existing bonds will fall.If interest rates on newly issued bonds fall, the prices of existing bonds will rise.

In other words,

yields to maturity and bond prices move in opposite directions

.

The reason, as

noted earlier,

is that if interest rates rise, existing bonds issued when interest rates were lower become less desirable to investors, and their prices fall. If interest rates fall, existing bonds become more desirable, and their prices rise

.This relationship should also hold for other debt instruments.

The Inverse Relationship between Bond Prices and Bond YieldsSlide37

Secondary Markets, Arbitrage, and the Law of One Price

Financial arbitrage The process of buying and selling securities to profit from price changes over a brief period of time.An investor in a financial market buys securities to earn a return.

A trader

buys and sells securities to profit from small differences in

prices.

During the period before bond prices fully adjust to changes in interest rates, there is an opportunity for

arbitrage.

The prices of financial securities at any given moment allow little or no opportunity for arbitrage profits

.The prices of securities should adjust so that investors receive the same yields on comparable securities.

For example, bonds with 8% coupon rates will have the same yield as bonds with 6% coupon rates.This rationale follows the principle called the

law of one price, which states that identical products should sell for the same price everywhere.

The Inverse Relationship between Bond Prices and Bond YieldsSlide38

Making the Connection

Reading the Bond Tables in the Wall Street Journal

Bond A matures on August

15, 2015, and

has a

coupon rate of 4.250%, so

it pays

$42.50 each year on its $1,000 face value

.

Prices are reported per $100 of face value. For Bond A, 112:08 means

“112 and 08/32,” or a price of $1,122.50 for this $1,000 face value bond.

The bid price is the sell price; the asked price is the price to buy the bond.

For Bond A, the bid price rose by 8/32 from the previous day.

Treasury Bonds and Notes

The Inverse Relationship between Bond Prices and Bond YieldsSlide39

The current

yield equals the coupon divided by the price: $42.50/$1,122.50, or 3.79% for Bond A.The current yield of Bond A is well above the yield to maturity

of 1.7066%.

This

illustrates that the current yield is not a good substitute for the yield

to maturity

for instruments with a short time to maturity because it ignores the effect of expected

capital gains or losses.

The Inverse Relationship between Bond Prices and Bond Yields

Making the Connection

Reading the Bond Tables in the Wall Street Journal

Treasury Bonds and NotesSlide40

Making the Connection

Reading the Bond Tables in the Wall Street Journal

Treasury bills are discount bonds,

not coupon

bonds

.

Treasury notes and bonds quote prices, while

Treasury

bills quote yields.

The bid yield is the discount yield for sellers. The asked yield is for buyers.

The dealers’ profit margin is the difference between the asked bid yields.

The yield to maturity, in the last column, is useful for comparing investments.

Treasury Bills

The Inverse Relationship between Bond Prices and Bond YieldsSlide41

A bond’s rating shows the likelihood that the firm will default on the bond.

Prices are quoted in decimals.The last time this Goldman Sachs bond was traded that day, it sold for a price of $1,048.68.

New York Stock Exchange Corporation Bonds

The Inverse Relationship between Bond Prices and Bond Yields

Making the Connection

Reading the Bond Tables in the Wall Street JournalSlide42

3.5

Learning Objective

Explain the

difference between

interest

rates and

rates of return.Slide43

Interest Rates and Rates of Return

Return The total earnings from a security; for a bond, the coupon payment plus the change in the price of the bond.Rate of return,

R

The return on a security as a percentage of the initial price; for a bond, the coupon payment plus the change in the price of a bond divided by the initial price.

For example,

for a bond with a $1,000 face value

and a coupon rate of 8%:If the end-of-year price was $1,271.81, then,

the rate of return for the year was:

If the end-of-year price was $812.61, then

,

the rate of return

for the year was:

 Slide44

A general equation for the rate of return

on a bond for a holding period of one year is:

A General Equation for the Rate of Return

Three

important points to

note:

1.

For

the current

yield, the calculation uses the initial price.

2.

If

you sell the bond, you have a

realized capital gain or loss

. If

you do not sell the bond, your gain or loss is unrealized

.3. Neither the current yield nor the yield to maturity may be a good indicator of the rate of return because they ignore your capital gain or capital loss.

Interest Rates and Rates of ReturnSlide45

Interest-Rate Risk and Maturity

Interest-rate risk The risk that the price of a financial asset will fluctuate in response to changes in market interest rates.Bonds with fewer years to maturity will be less affected by a change in market interest

rates.

At

the end of

one year

, the yield to maturity

on similar bonds has risen to 10%. The table shows that the longer the maturity of your bond, the lower (more negative) your

return after one year of holding the bond. With a maturity of 50 years, your rate of return for the first year of owning your bond will be -33.7%.

Interest Rates and Rates of ReturnSlide46

3.6

Learning Objective

Explain the

difference between nominal interest

rates and

real interest

rates.Slide47

Nominal interest rate

An interest rate that is not adjusted for changes in purchasing power.Nominal Interest Rates versus Real Interest Rates

Real interest rate

An interest rate that is adjusted for changes in purchasing power.

Inflation causes the purchasing power of both the interest income and the principal to decline.

Because lenders and borrowers don’t know what the

actual

real interest rate will

be during

the period of a loan, they must estimate an expected real interest rate.

The expected real interest rate, r, equals the nominal interest rate, i, minus the expected rate of inflation,

e.Therefore, the nominal interest rate equals the real interest rate

plus the expected inflation rate: i = r + e.

p

p

 Slide48

Nominal Interest Rates

versus Real Interest RatesSlide49

Figure 3.1

Nominal and

Real Interest Rates, 1981–2010

In this figure, the nominal

interest rate

is the interest rate

on three-month

U.S. Treasury bills

.The actual real interest rate is the nominal interest minus the

actual inflation rate, as measured by changes in the consumer price index.The expected real interest rate is the nominal interest

rate minus the expected rate of inflation as measured by a survey of professional forecasters. When the U.S. economy

experienced deflation during 2009, the real interest rate was greater than the nominal interest rate.•

Nominal Interest Rates

versus Real

Interest RatesSlide50

It is

possible for the nominal interest rate to be lower than the real interest rate. For this outcome to occur, the inflation rate has to be negative, meaning that the price level is decreasing rather than increasing.Deflation A sustained decline in the price level.

In January 1997, the U.S. Treasury started issuing indexed bonds to

address investors

’ concerns about the effects of inflation on real interest rates

. With

these

bonds, called TIPS (Treasury Inflation Protection Securities), the Treasury increases the principal as the price level increases.

Nominal Interest Rates versus Real

Interest RatesSlide51

Figure 3.2

TIPS as a Percentage

of All

Treasury Securities

TIPS (Treasury

Inflation Protection

Securities) were

an increasing

percentage of all U.S. Treasury securities until 2009.•

Nominal Interest Rates

versus Real

Interest RatesSlide52

Answering the Key Question

At the beginning of this chapter, we asked the question

:

“Why do interest rates and the prices of financial securities move in opposite directions

?”

We have seen in this chapter that the price of a financial security equals the present value of

the payments

an investor will receive from owning the security

. When

interest rates rise, present values fall, and when interest rates fall, present values rise.

Therefore, interest rates and the prices of financial securities

should move in opposite directions.Slide53

AN

INSIDE LOOK AT POLICY

Higher Interest Rates Increase Coupons, Decrease Capital Gains

Wall Street Journal,

Coupon

Clipping: Playing

a

Calmer Corporate-Bond Market

As this chapter explained, as interest rates rise, bond prices fall. The table

below illustrates why this is so.

The

price of Treasury bills paid in December 1998 was $4.353 less than the face value of the bills. This represented an interest rate of 4.6%.

The price paid in April 2010 was about only $0.49 less than

the face value, which represented an interest rate of only 0.5%.

Investors expected increases in interest rates in the latter part of 2010. Higher interest rates would mean higher coupon payments on new bonds, but lower bond prices would reduce the opportunity for

capital gains.