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Understanding Interest Rates.docx

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Brock University
Zisimos Koustas

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) (1+i)=$1(1+i)^2, similarly, 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
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