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EC223 (81)
Chapter 4

# Chapter 4 EC223.docx

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Department
Economics
Course
EC223
Professor
Angela Trimarchi
Semester
Winter

Description
EC223 Chapter 4 – Understanding Interest Rates Week 4 Measuring Interest Rates -Different debt instruments have very different streams of cash payments to the holder – known as cash flows – with very different timing Present Value -Based on the fact that a dollar paid to you one year from now is less valuable to you than a dollar paid to you today -Simple loan – the lender provides the borrower with an amount of funds that must be repaid to the lender at the maturity date, along with an additional payment for interest PV = Current value n (1 + i) -The concept of present value allows us to figure out today’s value (price) of a credit market instrument at a given simple interest rate, I, by just adding up to the individual present values of all the future payments received Four Types of Credit Market Instruments 1. A simple loan – the lender provides the borrower with an amount of funds that must be repaid to the lender at the maturity date along with an additional payment for the interest 2. A fixed-payment loan – the lender provides the borrower with an amount of funds, which must be repaid by making the same payment every period consisting of part o the principal and interest for a set number of years 3. A coupon bond – pays the owner of the bond a fixed interest payment every year until the maturity date, when a specified final amount (face value) is repaid. The bond’s coupon rate is the dollar amount of the early coupon payment expressed as a percentage of the face value of the bond 4. A discount bond – bought at a price below its face value and the face value is repaid at the maturity date Yield to Maturity -The interest rate that equates the present value of cash flow payments received froma debt instrument with its value today Simple Loan PV = Cash flow in one year n (1 + i) -The simple interest rate equals the yield to maturity Fixed-Payment Loan -The borrower makes the same payment to the bank every month until the maturity date, when the loan will be completely paid off -We equate today’s value of the loan with its present value LV = Fixed payment + Fixed payment + Fixed payment + ….. + Fixed payment 2 3 n (1 + i) (1 + i) (1 + i) (1 + i) Coupon Bond -Same strategy used for the fixed-payment loan: equate today’s value of the bond with its present value P = Coupon payment + Coupon payment + Coupon payment + ….. + Coupon payment (1 + i) (1 + i)2 (1 + i) (1 + i) EC223 Chapter 4 – Understanding Interest Rates Week 4 -Three facts emerge: -When the coupon bond is priced at its face value, the yield to maturity equals the coupon rate -The price of a coupon bond and the yield to maturity are negatively related; that is, as the yield to maturity rises, the price of the bon falls. As the yield to maturity Falls, the price of the bond rises -The yield to maturity is greater than the coupon rate when the bond price is below its face value -These three facts are true for any coupon bond -Bond price and the yield to maturity are negatively related -When the yield to maturity equals the coupon rate, the bo
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