Chapter 6

Measuring and Calculating

Some Interest Rates and
Financial Asset Prices

McGraw-Hill/Irwin Copyright 2008 by The McGraw-Hill Companies, Inc. All Rights Reserved.
 Learning Objectives
To learn how money market interest rates are
determined, and how those interest rates are
used by dealers when trading money market
assets.

To explore the important relationships

between the interest rates on bonds and
other financial instruments and their market
value or price.

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 Learning Objectives

To look at the many different ways lending

institutions calculate interest rates they
charge borrowers for loans.

To determine how interest rates or yields

on deposits in banks, credit unions, and
other depository institutions are figured.

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 Introduction

Many different interest-rate measures

attached to different types of financial assets
have been developed, leading to considerable
confusion, especially for small borrowers and
savers.

We will examine the methods most frequently

used to measure interest rates and the prices
of financial assets in the money and capital
markets.
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 Units of Measurement
For Interest Rates
The Interest rate is the price charged to a
borrower for the loan of money

Interest Fee required by the lender for

rate on = the borrower to obtain credit 100
loanable Amount of credit made
funds available to the borrower

Interest rates usually expressed as

annualized percentages
360-day and 365-day years are common
Compounding terms may also differ
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 Units of Measurement
For Interest Rates

A basis point equals 1/100 of a

percentage point.
Example
10.5% = 10% + 50 basis points, or 1050 basis
points

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 Interest Rates in the
Wholesale Money Markets
Wholesale money market
Lending for short period of time
Large sums of money
Here we are concerned with
How interest rates are computed on these
money market assets
How are interest rates reported in the
financial press

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 Computing Interest Rates on
Money Market Assets
Most money market assets have similar
characteristics

Short-term
Receives no income until asset matures
At maturity receive par value (face value)
Must pay less than par to purchase security
Return is price appreciation
Assets sold at a discount to par value

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 Computing Interest Rates on
Money Market Assets
Rate of return on money market instrument
Coupon-equivalent (or bond-equivalent of
investment rate) rate of return

Need three pieces to estimate

Par value
Number of days to maturity
Purchase price

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 Computing Interest Rates on
Money Market Assets
The formula for the actual annualized rate of
return for a single year:

Investment rate(IR)
= Par value Purchase price 365 .

Purchase price Days to maturity

This rate of return is referred to as coupon-

equivalent or bond-equivalent.

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 Problem

Suppose you have purchased a 90-

dayTreasure Bill of $100,000 for
$99,000 and hold until maturity. What
is the annualized IR?

Page# 149.
 Computing Interest Rates on
Money Market Assets
In the money market a different rate is
quoted
Bank discount rate (DR)
Not the actual annualized rate of return
Used as trading standard
Easier to estimate than IR
Use face value in denominator
instead of price
Use 360 rather than 365 days

6-13
 Computing Interest Rates on
Money Market Assets
The formula for the bank discount
rate(DR):

= Par value Purchase price 360 .

Par Value/Face value Days to maturity

Problem: What if the DR of the Previous

example?

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 Holding-Period Yield on
Money Market Assets
Financial assets sold at a discount

Price tends to rise over time

Price exactly equal to part at maturity
Prices do not rise at a steady, uniform rate
Price changes will be impacted by continuous
changes in the market interest rates
If you hold to maturity, you lock in a nominal
return
If you sell early, then price fluctuations impact
your investment return

6-15
 Holding-Period Yield on
Money Market Assets
The holding period yield (HPY) on assets sold at a
discount is:
HPY = DR at purchase +/- Change in DR over holding period

Change in DR over holding period=

(Initial days to maturity-Days held)x Difference in DR
Days Held
Difference in DR is the change in the CR between when the
asset is purchased and when it is sold

Example: Suppose the investor sold the T-bill after 30 days for a price of
$95,000 at DR rate of 3 %. What is the HPY for the Investor?

6-16
 Interest Rate Quotations on
US Treasury Bills
Treasury bills are money market assets
Issued by the U.S. government
Various maturities
4 weeks
3 months
6 months
Daily report of information on the bills
Various financial sources
For each maturity

6-17
 Interest Rate Quotations on
US Treasury Bills

Security dealers who act as market

makers usually quote two prices
The higher ask price is the dealers selling
price
The lower bid price is the dealers buying
price
The difference between the bid and ask
prices is the spread the dealers
return for creating a market
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 Interest Rates on Bonds and Other
Long-Term Debt Securities
Yield to maturity (YTM) of a financial asset
The rate of interest that the market is currently
prepared to pay for the financial asset
It is the rate that equates the purchase price
(P) with the present value the stream of
coupon payments (C) by the asset

6-19
 Interest Rates on Bonds and
Other Long-Term Debt Securities

Adjustments for non-annual rates

Include a parameter k, the number of
times during the year that the interest
income is paid to the investor

6-20
 Measures of the Rate of Return
(Yield) On a Financial Asset
The holding-period yield is an investment
rate of return
Over its actual or planned holding period
It is the discount rate (h) equalizing the
purchase price (P) of a financial asset with all
the discounted annual payments (C) received
until the asset is sold at time m for price Pm

6-21
 Understanding Yield to Maturity

Example
A 5-year corporate bond has a face value of
$1,000. Its promised a annual coupon rate is
10% and it pays $50 in interest every 6 months.
The bond is currently selling for $900

6-22
 Price Quotations on
U.S. Treasury Notes and Bonds
U.S. Treasury notes (T-notes) and U.S.
Treasury bond (T-bonds)
Original maturities of 2 years to 30 years
Most are fixed payments
Typically semi-annually
Need to know
Price and maturity
Date coupons paid
Amount of coupon payments
Current yield to maturity
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 Price Quotations on
U.S. Treasury Notes and Bonds
The current yield of a financial asset is
the ratio of the annual income
(dividends or interest) generated by the
asset to its market value.
Example
The current yield of a share of common
stock selling for $30 in the market and
paying an annual dividend of $3 to the
shareholder is $3/$30 = 0.10, or 10%

6-24
 Rates of Return on Perpetual
Financial Instruments
Some financial instruments never
mature
Perpetuity financial instruments
May be fixed-income
Equal payments to its holder every year
Ad infinitum
May be variable-return
Corporate stock
Future payments may change over time
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 Rates of Return on Perpetual
Financial Instruments
Perpetuity rate
Annual rate of return on a perpetual financial
instrument =

Annual cash flow promised .

current price or present value

Or
Current Price =Annual cash flow promised .

Annual rate of return

A more usable formula is:
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 Rates of Return on Perpetual
Financial Instruments

Key points to consider

An infinite stream of cash flows has a
finite value
There is an inverse relationship between
the current price and the rate of return
This can be weaker than for bonds
It does not always hold for common
stock

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 Rates of Return on Perpetual
Financial Instruments
Stock pricing formula
D0 is current dividend
EDi is expected future dividend at time I
R is the minimum rate of return required
by a companys shareholders
SP is the companys stock price

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 Rates of Return on Perpetual
Financial Instruments
This simplifies to

If the growth rate in dividends is constant

Then the formula becomes =

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 Yield-Asset Price Relationships

demand for loanable funds supply of securities

Interest-Rate Determination Asset Price Determination
Interest D Price
Rate
D S D S
S

Loanable Assets
Funds

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 Yield-Asset Price Relationships

supply of loanable funds demand for securities

Interest-Rate Determination Asset Price Determination
Interest Price D
Rate
D S D S
S

Loanable Assets
Funds

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Interest Rates Charged or Paid by
Institutional Lenders
Simple interest method
Assesses interest charges on a loan only
for the period of time that the borrower has
actual use of the borrowed funds

Interest = principal rate term

The more frequently a borrower makes

repayments on a loan, the less the total
interest
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 Interest Rates Charged or Paid by
Institutional Lenders
Add-on interest method
Interest is calculated on the full loan principal
The sum of interest and principal payments is
divided by the number of payments to determine the
dollar amount of each payment
In a single payment loan, the simple interest and add-
on methods give the same interest rate
As the number of installment payments increases,
the borrower pays a higher effective rate under the
add-on method

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Interest Rates Charged or Paid by
Institutional Lenders
Discount loan method
Determines the total interest charged to
the customer on the basis of the amount to
be repaid
Loan proceeds are only the difference
between the total amount owed and the
interest bill
Hence, the effective interest rate is
Interest paid 100
Net loan proceeds
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Interest Rates Charged or Paid by
Institutional Lenders
Monthly payments of a home mortgage
loan
First covers in full the monthly interest on
the outstanding principal
The remainder is then applied to the
principal of the loan
t 12 where
r r
1 L = total amount owed
12 12
L t 12
r = annual loan interest rate
r t = number of years of the loan
1 1
12
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 Compound Interest

The compounding of interest means that the

lender or depositor earns interest income on
both the principal and accumulated interest
The formula for calculating the future value of
a financial asset earning compound interest
is:

tm FV = future value of the asset

r
FV P 1 P = principal value of the asset
m r = annual interest rate
m = annual compounding frequency
t = term of the asset in years
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 APY on Deposits

The U.S. Truth in Savings Act of 1991

Requires depository institutions to use the daily
average balance in a customers deposit
Over each interest-crediting period
To determine the customers annual percentage
yield (APY) for that deposit account

365
where
i

APY 1 1 100
d
i = interest earned
b b = daily average balance
d = term in days

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 Markets on the Net

Bankrate.com at www.bankrate.com
CNN Money at
money.cnn.com/pf/banking
Compare Interest Rates at
www.compareinterestrates.com
Credit Card Analyzer at
www.creditcardanalyzer.com
Federal Reserve System at
www.federalreserve.gov
6-38
 Markets on the Net

FinAid at www.finaid.org
Financial Power Tools at
www.financialpowertools.com
Interest Rate Calculator at
www.interestratecalculator.com
Investopedia at
www.investopedia.com/calculator
LendersCompete.com at
lenderscompete.com
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 Markets on the Net

Local Bank Rates on Loans and

Savings at www.digitalcity.com
Mortgage Professors Web Site at
mtgprofessor.com

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 Chapter Review

Introduction
Units of measurement for interest rates
and asset prices
Calculating and quoting interest rates
Basis points
Prices of stocks and bonds

6-41
 Chapter Review

Measures of the rate of return, or yield, on

a loan, security, or other financial asset
Rate of return on a perpetual financial
instrument
Coupon rate
Current yield
Yield to maturity
Holding-period yield
Bank discount rate

6-42
 Chapter Review

Yield-asset price relationships

Interest rates and the prices of debt
securities
Interest rates and stock prices

6-43
 Chapter Review

Interest rates charged by institutional

lenders
Simple interest rate
Add-on rate of interest
Discount loan method
Home mortgage interest rate
Annual Percentage Rate (APR)
Compound interest
Annual Percentage Yield (APY) on
deposits
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