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Money & Banking

Week 4

Debt Instruments & Interest Rates

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Draw cash flow diagrams for the four types of credit instruments.

Take the perspective of the lender.

Simple loanAnnuity/Amortized loanCoupon bondZero coupon bond

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Bond Page of the

Newspaper

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Rate Maturity

Mo/Yr

Bid Asked Chg Asked

Yield13 1/4 May 15 143:01 143:02 +14 3.22

Semi annual coupon on $1 mil of face value?$66,250.00Number of coupons remaining?M06 … M15 19Asked price of $1 mil of face value?$1,430,625

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Pricing a coupon bond

Suppose I need a 4% rate of return.

How much would I be willing to pay for $1 million of face value of the bond on the previous slide?

1. Calculate the PV of face value (FV=1mil, n=19, i = .02)

2. Calculate the PV of coupons using annuity table. (PMT = 66,250, n=19, i = .02)

3. Add two parts together.

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Yield to Maturity

The rate of discount that equates the present value of future cash flows with the price of the credit instrument.

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Relationship Between Price and Yield to Maturity

.

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Calculate the yield to maturity on a consol that pays $100 a year and is

priced at $2,500.

Recall formula for present value of a consol:

i

couponPV

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Approximation for YTM: Current Yield

P

Cic

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Fisher Equation

The nominal (actual) interest rate equals the real rate plus the expected inflation rate.

e

rii

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TIPS (Treasury Inflation Protection Securities)

• Originally issued in 1997.

• Interest and principal payments are adjusted for inflation.

• In times of high inflation the $ amount paid to investors rises.

• Return on TIPS provides information on expected inflation.

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U.S. Real and Nominal Interest Rates

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Money Market Instruments

• Debt instruments• Short-term (year or less)• Low risk• High denomination• Also known as “cash”• Examples: Treasury bills, commercial

paper, bankers acceptances, repurchase agreements, CD’s

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Chapter Six

Interest Rates:

• Risk Structure

• Term Structure

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Risk Structure of Interest Rates

Bonds of same maturity will have different yields because of three factors:

1. Default risk

2. Liquidity

3. Tax considerations

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Risk Structure of Long-Term Bonds in the United States

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Rating Bonds

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Bond Ratings

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Highest Rated Corporate Bonds

In the 1980s there were 32 AAA rated bonds.Today there are only six:

1. Automatic Data Processing

2. Exxon Mobil

3. General Electric

4. Johnson & Johnson

5. Pfizer

6. United Parcel Post

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History of Junk Bonds

• Fallen Angels

• Michael Milken

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yield curve last year at this time

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yield curve last week

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Theories of Term Structure (shape of yield curve)

• Expectations Hypothesis

• Segmented Markets

• Liquidity Premium (preferred habitat)

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Interest Rates on Different Maturity Bonds Move Together

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Relationship Between the Liquidity Premium (Preferred Habitat) and

Expectations Theories