ECON 311 1nd Edition Lecture 3 Outline of Last Lecture I Role of Financial System II Structure of Financial Markets III Money Market Instruments Outline of Current Lecture I Interest and Interest Rates II Calculating Interest Rates III Four Credit Market Instruments Current Lecture Chapter 3 Understanding Interest Rates I Interest and Interest Rates Interest the amount lenders receive for extending credit or the amount borrowers pay for obtaining credit Interest rate reflects the amount of interest paid in relation to the amount lent or borrowed Economic Definition of Interest rates reflect the trade off between present and future consumption Two Period Intertemporal Consumption Model Period 2 Consumption Income x 1 r Slope 1 r These notes represent a detailed interpretation of the professor s lecture GradeBuddy is best used as a supplement to your own notes not as a substitute Period 1 Consumption Income When you spend income today you lose income and the interest it would have accumulated like opportunity cost Interest rates reflect the price or capital EX If you buy a bulldozer your losing the interest you could have accumulated if you lent out the move II Calculating Interest Rates Concepts o Present Value o Yield to Maturity 1 Present Value of 1 n years in the future is 1 1 i r where i is the interest rate PV FV 1 i r Where PV present value FV future value i interest rate r number of periods Some methods of calculating interest rates ignore the time value of money 2 Yield to Maturity YTM does not ignore the time value of money The interest rate that equates the price of an asset today with the present value of all future payments associated with that asset EX Bond to pay 100 a year for 3 years with the current price at 200 Current Price 2015 Payment 2016 Payment 2017 Payment 200 100 100 100 200 Current Price 100 100 100 1 2 1 i 1 i 1 i 3 PV of future payments The interest rate i that makes both sides of the equation equal is called the YIELD TO MATURITY III Four Credit Market Instruments 1 Simple Loan Borrower receives principal and repays principal plus interest at maturity end of loan EX 10 000 loan for 5 n 5 years simple interest rate 4 In 9 14 the borrower receives 10 000 and then in 5 years on 9 19 the borrower repays 12 166 53 to the lender FV PV 1 i n FV 10000 1 0 04 5 FV 12166 53 10 000 of this is principal and 2 166 53 of the Future Value is interest To find Yield to Maturity take current price of 10 000 and put it in the formula 10 000 12 166 53 1 i 5 YTM 0 04 i The YTM on a simple loan is a simple interest rate 2 Discount Bond Borrower repays face value of the bond at maturity but initially receives less than face value The borrower receives 8 219 71 on 9 14 On 9 19 the borrower repays 10 000 This amount includes 8 2119 71 for Principal and 1 780 29 of interest Selling bond at a discounted value from the face value Yield to Maturity Current Price PV of future payments 8219 71 10000 1 i 5 8219 71 1 i 5 10000 i 4 EX Yield to Maturity on 1 period discount bond Where p bond price and F face value P F 1 i P 1 i F 1 i F P F F P i 1 i P P 3 Coupon Bonds Borrower initially receives the face value of the bond then makes payments of interest at regular intervals and repays the face value at maturity EX F face value 10 000 n 5 years C coupon payment 400 The borrower receives 10 000 on 9 14 and then pays 400 on 9 16 9 17 and 9 18 Finally on 9 19 the borrower repays 10 400 to pay off the debt Yield to Maturity Current Price 10 000 400 400 400 400 10400 2 3 1 i 1 i 1 i 1 i 4 1 i 5 Solve for i 4 IV Coupon rate C F or the coupon payment divided by the face value Coupon payments accrue less interest because they pay off the interest from period to period Fixed Payment Loan Borrower makes regular period payments of equal size each payment includes both principal AND interest EX Car payment is 614 37 per month for 4 years Portion of interest to principal paid changes over time from more interest to more principal