Understanding Interest Rates
Four types of credit instruments
1. Simple loan: the principal amount of the loan must be repaid to the lender at maturity with an additional
amount as interest.
2. Fixed payment loan: is to be repaid by making the same payment every month, consisting of part of the
principal and interest for a set number of years (i.e. mortgage loan)
3. Coupon bond: pays the owner of the bond a fixed interest payment (coupon payment) every year until the
maturity date when a specified final amount (face value) is repaid.
4. Discount Bond: is bought at a price below its face value (at a discount), and the face value is repaid at the
maturity date (i.e. treasury Bills)
Concept of present value: allows comparisons of the value of the above types of debt instruments.
Consider a simple loan of $1 with annual interest rate I=10%. The accumulated principal plus interest
after one year is $1+i$1=$1(1+i ). After two years $1(1+i)+i $1(1+i), which is equal to $1(1+i)
year 1 2 3 n
$1(1+i) $1(1+i)^2 $1(1+i)^3 $1(1+i)^n
$1.10 $1.21 $1.33 $1(1+i)^n
Thus, a dollar will have accumulated to $1(1+i)^n after n years. By analogy the value of a dollar pay able
n years into the future at present (present value) is PV of future $1=$1/$1(1+i)^n (1)
Yield to maturity: loans
Yield to maturity = interest rate that equates today’s value of an asset with the present value of all future
payments flowing from the asset.
1. simple o