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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