FIB2101 - E

Economics of Money and Banking

Instructor:
Economics of Money and Banking

Chapter 2
Interest Rates

Instructor:

4
 Learning Objectives

• Calculate the present value of future cash flows and the yield to maturity
• Recognize the distinctions among yield to maturity, current yield, rate of return, and rate of capital gain.
• Interpret the distinction between real and nominal interest rates
• Identify the factors that affect the demand for assets.
• List and describe the factors that affect the equilibrium interest rate in the bond market
• Describe the connection between the bond market and the money market through the liquidity
preference framework.
• List and describe the factors that affect the money market

Economics of Money and Banking 1 5

OUTLINE

1 Understanding interest rates

2 The behavior of interest rates

Economics of Money and Banking

2

5
1. Understanding Interest rate

1.1 Present value concept and types of interest rate

1.2 Measuring interest rate
1.3 The distinction between interest rate and return

Economics of Money and Banking 3

 1. Understanding interest rates
1.1 Present value concept and types of interest rate

WHAT IS INTEREST RATE?

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 1. Understanding interest rates
1.1 Present value concept and types of interest rate

v Present value concept

• The concept of present value (or present discounted value) is based on the commonsense notion that
a dollar paid to you one year from now is less valuable than a dollar paid to you today.

Ø Why: a dollar deposited today can earn interest and become $1 x (1+i) one year from today.

• The concept of present value is extremely useful, because it allows us to figure out today’s value (price)
of a credit/ debt market instrument at a given simple interest rate.

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 1. Understanding interest rates
1.1 Present value concept and types of interest rate

v Present value concept

• Example: if Anna made Jane, a simple loan of $100 for one year. Anna requires Jane to repay the
principal of $100 in one year’s time, along with an additional payment for interest , $10.

Calculate the interest rate

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 1. Understanding interest rates
1.1 Present value concept and types of interest rate

v Present value concept

• Example: if Anna made Jane, a simple loan of $100 for one year. Anna requires Jane to repay the
principal of $100 in one year’s time, along with an additional payment for interest , $10.
• Answer: Interest rate of this loan
10
𝑖= = 0.1 = 10%
100

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 1. Understanding interest rates
1.1 Present value concept and types of interest rate

v Present value concept

• Example (cont): if Anna made Jane, a simple loan of $100 for one year. Anna requires Jane to repay the
principal of $100 in one year’s time, along with an additional payment for interest , $10

What is the total amount Anna will receive at the end of year 1

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 1. Understanding interest rates
1.1 Present value concept and types of interest rate

v Present value concept

• Example (cont): If Anna made Jane, a simple loan of $100 for one year. Anna requires Jane to repay
the principal of $100 in one year’s time, along with an additional payment for interest , $10
• Answer: At the end of year 1, Anna will receive:
$100 × 1 + 0.1 = $110

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 1. Understanding interest rates
1.1 Present value concept and types of interest rate

v Present value concept

§ Example (cont): If Anna then lent out the $110 at the same interest rate, at the end of the second year
Anna would have:
$110 × 1 + 0.1 = $121

!
Or $100 × 1 + 0.1 1 + 0.1 = $100 × 1 + 0.1 = $121

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 1. Understanding interest rates
1.1 Present value concept and types of interest rate

v Present value concept

• Example (cont): Generlizing, at the end of n years, $100 would turn into

!
$100 × 1 + 0.1

Or 𝐶𝐹 = 𝑃𝑉 (1 + 𝑖)"

In which: CF= Future cash flow (payment)

PV = Today’s value
i = interest rate
n = number of years

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 1. Understanding interest rates
1.1 Present value concept and types of interest rate

v Present value concept

• Example (cont):

The process of calculating today’s value of amount received in the future is called Discounting the future

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 1. Understanding interest rates
1.1 Present value concept and types of interest rate

v Present value concept

Simple Present Value

𝐶𝐹
𝑃𝑉 = (
1+𝑖

In which: CF= Future cash flow (payment)

PV = Today’s value
i = interest rate
n = number of years

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 1. Understanding interest rates
1.1 Present value concept and types of interest rate

v Types of interest rate

Nominal Interest rate Real Interest rate

• Nominal interest rate makes no • Real interest rate is adjusted for

allowance for inflation changes in price level so it more
accurately reflects the cost of
borrowing.

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 1. Understanding interest rates
1.1 Present value concept and types of interest rate

v Types of interest rate – Fisher Equation

ir = i - pe

In which: ir = Real Interest rate

i = Nominal Interest rate
pe = Expected Inflation rate

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 1. Understanding interest rates
1.1 Present value concept and types of interest rate

v Types of interest rate – Fisher Equation

• Example: What is the real interest rate if the nominal interest rate is 8% and the expected inflation
rate is 10% over the course of a year?

• Answer: The real interest rate is -2%. Although you will be receiving 8% more dollars at the end
of the year, you will be paying 10% more for goods. The result is that you will be able to buy 2%
fewer goods at the end of the year, and you will be 2% worse off in real terms. Mathematically,

ir = i - pe

r = 0.08 - 0.10 = -0.02 = -2%

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 1. Understanding interest rates

1.2 Measuring Interest rates

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 1. Understanding interest rates
1.2 Measuring Interest rates

v Yield to maturity:
• Yield to maturity: the interest rate that equates the present value of cash flow payments received
from a debt instrument with its value today

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 1. Understanding interest rates
1.2 Measuring Interest rates

v Yield to maturity:

4 types of credit market instruments

1 2 3 4

Simple Loan Fixed Payment Loan Coupon Bond Discount Bond

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 1. Understanding interest rates
1.2 Measuring Interest rates

v Yield to maturity - Simple Loan

• Example: For one-year loan, today’s value is $100. The payment in one year’s time would
be $110.

Calculate the yield to maturity (YTM) i of this simple loan

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 1. Understanding interest rates
1.2 Measuring Interest rates

v Yield to maturity - Simple Loan

• Example: For one-year loan, today’s value is $100. The payment in one year’s time would be $110.

𝐶𝐹
• Answer: 𝑃𝑉 =
1+𝑖 "

11O
→ 100 =
1+𝑖

110 − 100
→𝑖= = 0,1 = 10%
1

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 1. Understanding interest rates
1.2 Measuring Interest rates

v Yield to maturity – Fixed Payment Loan

• Fixed payment loan has the same cash flow payment every period throughout the life of the loan
• Since the fixed payment loan involves more than one cash flow payment, the present value of the
fixed-payment loan is calculated as the sum of the present values of all cash flow payments.

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 1. Understanding interest rates
1.2 Measuring Interest rates

v Yield to maturity – Fixed Payment Loan

• Example: The loan is $1000. Yearly payment is $85.81 for the next 25 years.

Calculate YTM of the loan.

Using the formula:

𝐶𝐹
𝑃𝑉 = "
1+𝑖

PV = PV1 + PV2 +…+ PV25

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 1. Understanding interest rates
1.2 Measuring Interest rates

v Yield to maturity – Fixed Payment Loan

• Example: The loan is $1000. Yearly payment is $85.81 for the next 25 years.

• Answer: YTM of the loan:

85.81 85.81 85.81

1000 = + !
+. . +
1+𝑖 1+𝑖 1 + 𝑖 !"

→ 𝑖 = 7%

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 1. Understanding interest rates
1.2 Measuring Interest rates

v Yield to maturity – Fixed Payment Loan

• Formula:

𝑭𝑷 𝑭𝑷 𝑭𝑷
𝑳𝑽 = + 𝟐 +. . +
(𝟏3𝒊) (𝟏3𝒊) (𝟏3𝒊)𝒏

in which: LV = Loan value

FP = Fixed yearly payment
n = Number of years until maturity

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 1. Understanding interest rates
1.2 Measuring Interest rates

v Yield to maturity – Coupon Bond

• To calculate the yield to maturity for a coupon bond, equate today’s value of the bond with its
present value

• Formula:
𝑪 𝑪 𝑪 𝑭
𝑷= + 𝟐
+ ⋯+ 𝒏
+ 𝒏
𝟏+𝒊 𝟏+𝒊 𝟏+𝒊 𝟏+𝒊

in which: P = Price of coupon bond

C = yearly coupon payment
F = face value of the bond
n = years to maturity date

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 1. Understanding interest rates
1.2 Measuring Interest rates

v Yield to maturity – Coupon Bond

• Example: Find the price of a 10% coupon bond with a face value of $1000, a 12.25% YTM, and 8
years to maturity

• Answer: § 𝐶 = $1000 × 10% = $100

#$$ #$$ #$$ #$$$
§ 𝑃= + + ⋯+ +
#%#&.&(% #%#&.&(% # #%#&.&(% $ #%#&.&(% $

→ P = $ 889.20

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 1. Understanding interest rates
1.2 Measuring Interest rates

v Yield to maturity – Coupon Bond

• When the coupon bond = its face value, the yield to maturity = the coupon rate.

• The price of a coupon bond and YTM are negatively related.

• YTM > coupon rate when the bond price < its face value.

(Source: Mishkin, 2022)

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 1. Understanding interest rates
1.2 Measuring Interest rates

v Yield to maturity – Coupon Bond

• Consol or perpetuity: a bond with no maturity date that does not repay principal but pays fixed
coupon payments forever.
• Formula:
𝑪
𝑷𝒄 =
𝒊𝒄

in which: Pc = Price of the consol

C = Yearly interest payment
ic = YTM of the consol

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 1. Understanding interest rates
1.2 Measuring Interest rates

v Yield to maturity – Discount Bond

• Discount bond (also called a zero-coupon bond) is bought at a price < its face value, and the
face value is repaid at the maturity date.
• A discount bond does NOT make any interest payments.

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 1. Understanding interest rates
1.2 Measuring Interest rates

v Yield to maturity – Discount Bond

• Using the present value formula, to calculate YTM of a discount bond.

• Formula: 𝐶𝐹
𝑃𝑉 = (
1+𝑖

In which: CF= Future cash flow (payment)

PV = Today’s value
i = interest rate
n = number of years

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 1. Understanding interest rates
1.2 Measuring Interest rates

v Yield to maturity – Discount Bond

• Example: A current price of $1000 Treasury bill is $900. Maturity is 1 year.

What is the YTM?

1000
• Answer: 900 =
1+𝑖 %

→ i = 0.111 = 11.1 %

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 1. Understanding interest rates
1.2 Measuring Interest rates

v Yield to maturity – Discount Bond

• Generally, for any one-year discount bond, the YTM can be written as:

!" #;
i=
#;

in which: i = YTM of a one-year discount bond

F = Face value
Pd = Current price

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 1. Understanding interest rates

1.3 The distinction between interest rates and return

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 1. Understanding interest rates
1.3 The distinction between interest rates and return

• For any security, the rate of return (or return) is defined as:

“The amount of each payment to the owner + the change in the security’s value, expressed as a

fraction of its purchase price”

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 1. Understanding interest rates
1.3 The distinction between interest rates and return

• Example: There is a $1,000-face-value coupon bond with a coupon rate of 10% that is bought

for $1,000, held for one year, and then sold for $1,200.

What is the return of this bond?

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 1. Understanding interest rates
1.3 The distinction between interest rates and return

• Example: There is a $1,000-face-value coupon bond with a coupon rate of 10% that is bought
for $1,000, held for one year, and then sold for $1,200.

• Answer:

Ø The yearly coupon payments: $1,000 x 10% = $100

Ø The change in the bond’s value: $1,200 - $1,000 = $200

$100 + $200
Ø The return of this bond: 𝑅= = 0.3 = 30%
$1,000

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 1. Understanding interest rates
1.3 The distinction between interest rates and return

• Generally, the return on a one- year bond held from time t to time t + 1 can be written as:

𝑪 𝑷𝒕&𝟏 − 𝑷𝒕
𝑹 = +
𝑷𝒕 𝑷𝒕

→ 𝑹 = 𝒊𝑪 + 𝒈

in which: R = Return of holding bond ic = Current yield

C = Coupon payment g = Rate of capital gain
Pt = Price of the bond at time t
Pt+1 = Price of the bond at time t+1

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 1. Understanding interest rates
1.3 The distinction between interest rates and return

• The return = the YTM only if the holding period = the time to maturity.

• A rise in interest rates is associated with a fall in bond prices, resulting in a capital loss if time
to maturity is longer than the holding period.

• Prices and returns for long-term bonds are more volatile than those for shorter-term bonds.
• There is no interest-rate risk for any bond whose time to maturity matches the holding
period.

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 2. The behavior of interest rates

2.1 Determinants of Asset Demand

2.2 Supply and Demand in the Bond Market
2.3 Supply and Demand in the Market for Money

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 2. The behavior of interest rates
2.1 Determinants of asset demand

Expected Return
Wealth
Theory of
Portfolio Choice

Liquidity
Risk

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 2. The behavior of interest rates
2.1 Determinants of asset demand - Theory of Portfolio Choice

1 Wealth

→
• Holding all other factors constant, wealth

→
→ Quantity demanded of an asset
→ The quantity demanded of an asset is positively related to wealth

2 Expected return

→
• Holding all other factors constant, expected return of an asset relative to alternative assets
→ Quantity demanded of an asset →
→ The quantity demanded of an asset is positively related to its expected return of an asset relative to
alternative assets.

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 2. The behavior of interest rates
2.1 Determinants of asset demand - Theory of Portfolio Choice

3 Risk
Holding all other factors constant, an asset’s risk relative to that of alternative assets

→
•

→
→ Quantity demanded of an asset
→ The quantity demanded of an asset is negatively related to risk of its returns relative to
alternative assets

4 Liquidity
• Holding all other factors constant, the more liquid an assets is relative to alternative assets
→ The greater the quantity demanded will be
→ The quantity demanded of an asset is positively related to its liquidity relative to alternative assets

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 2. The behavior of interest rates
2.1 Determinants of asset demand - Theory of Portfolio Choice

(Source: Mishkin, 2022)

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 2. The behavior of interest rates

2.2 Supply and Demand in the Bond Market

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 2. The behavior of interest rates
2.2 Supply and demand in the Bond market

v Market Equilibrium Figure 1: Supply and Demand for Bonds

Price of Bonds, P ($)

• Equilibrium is when Bd = Bs 1,000

(i = 0%) Bs
With excess supply, the
bond price falls to P *
• When Bd > Bs , there is excess demand, price will rise 950
(i = 5.3%) A I

and interest rate will fall

900
(i = 11.1%) B H
C

P * = 850

• When Bd < Bs , there is excess supply, price will fall and

(i * = 17.6%)

800 G D
(i = 25.0%)
interest rate will rise With excess demand, the
750
F E bond price rises to P *
(i = 33.0%)
Bd

100 200 300 400 500

Quantity of Bonds, B
($ billions)

(Source: Mishkin, 2022)

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 2. The behavior of interest rates
2.2 Supply and demand in the Bond market

v Changes in Equilibrium interest rates

Wealth Expected Return

Demand for Bond

Risk Liquidity

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 2. The behavior of interest rates
2.2 Supply and demand in the Bond market

v Changes in Equilibrium interest rates – Shift in the Demand for bonds

Demand

→
1 à

→
Wealth
for bonds

P I • In a business cycle expansion with

→ growing income and wealth, the demand
for bonds rises and the demand curve for
bonds shifts to the right.
• In a recession, when income and wealth
are falling, the demand for bonds falls,
𝐁)* 𝐁!* and the demand curve shifts to the left.

B
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 2. The behavior of interest rates
2.2 Supply and demand in the Bond market

v Changes in Equilibrium interest rates – Shift in the Demand for bonds

Expected Return for Demand

→
2

→
à
Long-Term bonds for bonds

• Higher expected future interest rates lower the

P → I expected return for long- term bonds, decrease the
demand, and shift the demand curve to the left.
• An increase in expected return on alternative assets
lowers the demand for bonds and shifts the demand
curve to the left.
• An increase in the expected rate of inflation lowers
the expected return on bonds, causing their demand
𝐁!* 𝐁)* to decline and the demand curve to shift to the left.

B
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 2. The behavior of interest rates
2.2 Supply and demand in the Bond market

v Changes in Equilibrium interest rates – Shift in the Demand for bonds

Riskiness Demand

→
3

→
à
of bonds for bonds

P → I • An increase in the riskiness of bonds causes

the demand for bonds to fall and the
demand curve to shift to the left.
• An increase in the riskiness of alternative
assets causes the demand for bonds to rise
and the demand curve to shift to the right
𝐁!* 𝐁)*

B
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 2. The behavior of interest rates
2.2 Supply and demand in the Bond market

v Changes in Equilibrium interest rates – Shift in the Demand for bonds

Liquidity Demand

→
4

→
à
of bonds for bonds

P I • Increased liquidity of bonds results in an

→ increased demand for bonds, and the
demand curve shifts to the right.
• Increased liquidity of alternative assets
lowers the demand for bonds and shifts the
demand curve to the left.
𝐁)* 𝐁!*

B
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 2. The behavior of interest rates
2.2 Supply and demand in the Bond market

v Changes in Equilibrium interest rates

Expected profitability of
investment opportunities

Supply of Bond
Expected Inflation

Government Budget Deficits

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 2. The behavior of interest rates
2.2 Supply and demand in the Bond market

v Changes in Equilibrium interest rates – Shift in the Supply of bonds

Expected
Supply

→
1

→
Profitability à
of Investment of bonds

P I
𝐁)+ 𝐁!+

B
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 2. The behavior of interest rates
2.2 Supply and demand in the Bond market

v Changes in Equilibrium interest rates – Shift in the Supply of bonds

Expected Supply

→
2

→
à
Inflation of bonds

P I
𝐁)+ 𝐁!+

B
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 2. The behavior of interest rates
2.2 Supply and demand in the Bond market

v Changes in Equilibrium interest rates – Shift in the Supply of bonds

Government Supply

→
3

→
à
Budget Deficits of bonds

P I
𝐁)+ 𝐁!+

B
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 2. The behavior of interest rates
2.2 Supply and demand in the Bond market

v Changes in Expected Inflation

Figure 2: Response to a Change in Expected Inflation
Price of Bonds, P
B1s
• Step 1. A rise in expected inflation shifts the
B2s
bond demand curve leftward . . .

1
P1 • Step 2. and shifts the bond supply curve
rightward . . .
2

• Step 3. causing the price of bonds to fall and

P2

d B1d the equilibrium interest rate to rise.

B
2

Quantity of Bonds, B

(Source: Mishkin, 2022)

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 2. The behavior of interest rates

2.3 Supply and Demand in the Market for Money

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 2. The behavior of interest rates
2.3 Supply and demand in the market for money

v Liquidity preference framework

• Keynesian model that determines the equilibrium interest in terms of supply and demand for
money

• Keynes’s assumption: people use 2 main categories of assets to store their wealth: money and
bonds.

• Total wealth in the economy = Bs + Ms = Bd + Md

. Bs - Bd = M d - M s

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 2. The behavior of interest rates
2.3 Supply and demand in the market for money

v Liquidity preference framework

Figure 3: Equilibrium in the Market for Money
• Equilibrium is when Interest Rate, i
(%)

Md = Ms 30 Ms

A With excess supply, the interest

25
rate falls to i *.

• If the market for money is in equilibrium, the bond 20

B

market is also in equilibrium. i * =15

C

10 D

E With excess demand,

5 the interest rate rises
to i *.
Md

0 100 200 300 400 500 600

Quantity of Money, M
($ billions)
(Source: Mishkin, 2022)

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 2. The behavior of interest rates
2.3 Supply and demand in the market for money

v Changes in equilibrium interest rates

Income Effect

• Shifts in Demand for money

Price – level Effect

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 2. The behavior of interest rates
2.3 Supply and demand in the market for money

v Changes in equilibrium interest rates - Shifts in Demand for money

Higher level Demand for money at each

→
→
1 of income à interest rate

I M+
i"

i!
→
M)* M!*
0

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 2. The behavior of interest rates
2.3 Supply and demand in the market for money

v Changes in equilibrium interest rates - Shifts in Demand for money

Demand for money at each

→
→
2 Price level à interest rate

I M+
i"

i!
→
M)* M!*
0

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 2. The behavior of interest rates
2.3 Supply and demand in the market for money

v Changes in equilibrium interest rates - Shifts in Supply of money

Money supply Supply curve

→
→
which is controlled by à
central bank

M)+ M!+
I →
i!

i"

M,
0

M
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 2. The behavior of interest rates
2.3 Supply and demand in the market for money

• Liquidity preference framework leads to the conclusion that an increase in the money supply will
lower interest rates: the liquidity effect.

• Income effect finds interest rates rising because increasing the money supply is an expansionary
influence on the economy.

• Price-Level effect predicts an increase in the money supply leads to a rise in interest rates in response
to the rise in the price level

• Expected-Inflation effect shows an increase in interest rates because an increase in the money supply
may lead people to expect a higher price level in the future

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 2. The behavior of interest rates
2.3 Supply and demand in the market for money

Figure 4 Response over Time to an Increase in Money Supply Growth

Interest Rate, i Interest Rate, i

Interest Rate, i

i2
i2
i1 i1
i2 i1

T T
T
Time Time
Liquidity Income, Price-Level, Liquidity Income, Price-Level,
Effect and Expected- Effect and Expected-
inflation Effects inflation Effects

(a) Liquidity effect larger than (b) Liquidity effect smaller than (c) Liquidity effect smaller than
other effects other effects and slow adjustment expected-inflation effect and fast
of expected inflation adjustment of expected inflation

(Source: Mishkin, 2022)

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 Q&A
Thank you

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