R. GLENN HUBBARD ANTHONY PATRICK O’BRIEN Money,

Transcript:R. GLENN HUBBARD ANTHONY PATRICK O’BRIEN Money,:
R. GLENN HUBBARD ANTHONY PATRICK O’BRIEN Money, Banking, and the Financial System 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 rates 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 3 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? 3.1 Learning Objective Explain how the interest rate links present value with future value. The Interest Rate, Present Value, and Future Value Why Do Lenders Charge Interest on Loans? The 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. 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. Compounding and Discounting Future