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Chapter 10 Interst Rates.docx

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Ryerson University
FIN 501
Edward Blinder

FIN501 investment analysis I CHAPTER 10 INTEREST RATES INTEREST RATE HISTORY AND MONEY MARKET RATES  Prime rate: the basic interest rate on short-term loans that the largest commercial banks charge to their most creditworthy corporate customers o Rates are quoted as prime plus or minus a spread  Bellwether rate: interest rate that serves as a leader or as a leading indicator of future trends; interest rates as a bellwether of inflation  Bank rate: interest rate that the Bank of Canada offers to commercial banks for overnight-reserve loans o Discount rate is the interest rate that the bank offers to commercial banks for overnight reserve loans  Increasing discount rate means bank may be signalling that it intends to pursue a tight-money policy, most likely to control budding inflationary pressures  Decreasing discount rate means bank may be signalling an intent to pursue a loose-money policy to stimulate economic activity  Call money rate: interest rate brokerage firms pay for call money loans, which are bank loans to brokerage firms o This rate is used as a basis for customer rates on margin loans  Commercial paper: short-term, unsecured debt issued by the largest corporations  Certificates of deposit (CDs): large-denomination deposits of $100,000 or more at commercial banks for a specific term o Interest rate paid on CDs varies according to the term of the deposit; the longer the term, the lower the interest rate  Bankers acceptance: a postdated cheque on which a bank has guaranteed payment; commonly used to finance international trade transactions o They are short-term, marketable securities and they are guaranteed by both the borrower and the bank  Eurodollars: certificates of deposit denominated in US dollars at commercial banks outside the USA  London interbank offered rate (LIBOR): interest rate that international banks charge one another for overnight Eurodollar loans  Treasury bills (T-bills): a short-term government debt instrument MONEY MARKET PRICES AND RATES  Pure discount security: an interest-bearing asset that makes a single payment of face value at maturity with no payments before maturity o Yield on an interest-bearing asset is simply a measure of the interest rate being offered by the asset  Basis point: with regard to interest rates or bond yields, one basis point is 1 percent of 1 percent (0.01%)  Bank discount basis: a method for quoting interest rates on money market instruments CURRENT PRICE = FACE VALUE x (1 – [DAYS TO MATURITY/360] x DISCOUNT YIELD) EX. Suppose a banker’s acceptance has a face value of $1 million that will be paid in 90 days. If the interest rate, quoted on a discount basis, is 5%, what is the current price of the acceptance? $1,000,000 x [1 – (90/360) x 0.5] = $987,500 The “discount” is the difference between the face value and the price $1,000,000 - $987,500 = $12,500  Bond equivalent yield: a method for quoting Canadian treasury bills BOND EQUIVALENT YIELD = [($1000 – PRICE)/PRICE] x [365/DAYS TILL MATURITY] EX. Consider the bill issue with 155 days to maturity, with a bid discount of 3.52% and an asked discount rate of 3.51%. For a $1 million face value T-bill, the corresponding bid and asked prices can be calculated using the discounts shown along with our bank discount basis pricing formula. $1,000,000 x [1 – (155/360) x 0.0352] = $984,844.44  Bank discount yield is converted to a bond equivalent yield using the following formula o This conversion formula is correct for maturities of six months or less o Must use 366 days if February 29 (leap year) occurs within the next 12 months BOND EQUILALENT YIELD = (365 x DISCOUNT YIELD) / (360 – DAYS TO MATURITY x DISCOUNT YIELD) EX. Suppose the asked discount rate on a T-bill with 170 days to maturity is 3.22%. What is the bond equivalent yield? (365 x 0.0322) / (360 – 170 x 0.0322) = 3.315% FIN501 investment analysis I  Can calculate a T-bill asked price using the asked yield, which is a bond equivalent yield BILL PRICE = FACE VALUE / (1 + BOND EQUIVALENT YIELD x DAYS TO MATURITY/365) EX. Above calculated 3.315% bond equivalent yield on a T-bill with 170 days to maturity and a 3.22% asked discount rate. $1,000,000 / (1 + 0.03315 x 170/365) = $984,795  Bond equivalent yield on a T-bill with less than 6 months to maturity and money market rates not quoted on a discount basis are generally quoted on a “simple” interest basis like the annual percentage rate (APR) APR = INTEREST RATE ER PERIOD x NUMBER OF PERIODS IN A YEAR  Effective annual rate: the true interest rate that is really going to pay m 1 + EAR = (1 + APR/m) EX. To see the bond equivalent yield on a T-bill is just an APR, we can calculate the price of the bill: face value $1 million, 3.22% asked discount, and 170 days to maturity. Asked price = $984,794 = $1,000,000 x [1 – (170/360) x 0.0322) Discount is $15,206, thus you earned this in interest on the investment of $984,794 1.544% = $15,206 / $984,794 In a 365-day year, there are 365/170 = 2.147 periods of 170-day lengths. This is the bond equivalent yield 3.315% = 2.147 x 1.544% Calculating the EAR using the 3.315% 1 + EAR = 1.03344 = (1 + 0.03315/2.147)= 3.344% RATES AND YIELDS ON FIXED-INCOME SECURITIES  Ca
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