ECON 311 1nd Edition Lecture 3 Outline of Last Lecture I. Role of Financial SystemII. Structure of Financial MarketsIII. Money Market InstrumentsOutline of Current Lecture I. Interest and Interest RatesII. Calculating Interest RatesIII. Four Credit Market InstrumentsCurrent LectureChapter 3: Understanding Interest RatesI. Interest and Interest Rates- Interest – the amount lenders receive for extending credit or the amount borrowers payfor 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 consumptionTwo – Period Intertemporal Consumption ModelThese 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 2 ConsumptionPeriod 1 ConsumptionSlope = (1 + r)Income x (1+r)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 capitalEX: If you buy a bulldozer your losing the interest you could have accumulated if you lent out the moveII. Calculating Interest Rates- Concepts:o Present Valueo Yield to Maturity1. Present Value – of $1 n years in the future is 1/(1+i)r, where i is the interest ratePV =FV(1+i)rWhere PV = present value, FV = future value, i = interest rate, r = number of periods- Some methods of calculating interest rates ignore the “time value” of money2. 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 assetEX: Bond to pay $100 a year for 3 years with the current price at $200Current Price 2015 Payment 2016 Payment 2017 Payment$200 $100 $100 $100$200¿100(1+i)1+100(1+i)2+100(1+i)3Current Price PV of future payments- The interest rate (i) that makes both sides of the equation equal is called the YIELD TO MATURITYIII. Four Credit Market Instruments1. 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 lenderFV =PV (1+i)nFV =10000(1+0.04)5FV =12166.53- $10,000 of this is principal and $2,166.53 of the Future Value is interestTo find Yield to Maturity take current price of 10,000 and put it in the formula$ 10,000=$ 12,166.53(1+i)5YTM=0.04=iThe YTM on a simple loan is a simple interest rate2. Discount Bond- Borrower repays face value of the bond at maturity but initially receives less than face valueThe 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 valueYield to Maturity:Current Price=PV of future payments8219.71=10000(1+i)58219.71(1+i)5=10000i=4 %EX: Yield to Maturity on 1 period discount bondWhere p = bond price and F = face valueP=F(1+i)P(1+i)=F(1+i)=FPi=FP−1∨i=F−PP3. 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 maturityEX: F = face value = $10,000, n = 5 years, C = coupon payment = $400The 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 debtYield to MaturityCurrent Price $ 10,000=400(1+i)+400(1+i)2+400(1+i)3+400(1+i)4+10400(1+i)5Solve for i=4 %- 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 periodIV. Fixed Payment Loan- Borrower makes regular period payments of equal size each payment includes both principal AND interestEX: Car payment is $614.37 per month for 4 years- Portion of interest to principal paid changes over time from more interest to more