CHAPTER%204

CHAPTER%204 - Measuring Interest Rates Yield on a Discount...

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Measuring Interest Rates Yield on a Discount Basis Interest Rates and Returns Real and Nominal Interest Rates Last Lecture: Money is everything generally accepted as payment Medium of exchange, unit of account, store of value Evolution of the payments system Monetary aggregates Money measures are linked to economic activity, inﬂation and interest rates

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Measuring Interest Rates Yield on a Discount Basis Interest Rates and Returns Real and Nominal Interest Rates CHAPTER 4 Understanding Interest Rates
Measuring Interest Rates Yield on a Discount Basis Interest Rates and Returns Real and Nominal Interest Rates Present (Discounted) Value A dollar paid to you one year from now is less valuable than a dollar paid to you today. You can invest a dollar today and earn an interest rate in one year. Diﬀerent debt instruments have very diﬀerent streams of cash payments ( cash ﬂows ). We can compare the value of these instruments by looking at their present value .

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Measuring Interest Rates Yield on a Discount Basis Interest Rates and Returns Real and Nominal Interest Rates Discounting the Future Consider a simple loan : lender provides the borrower with a amount of funds X (= principal ). The borrower repays (1 + i ) X at the maturity date . simple interest rate = interest payment principal = iX X = i Example: Suppose the annual simple interest rate is 10% and you lend out \$100: Today 0 year 1 year 2 year n \$100 (1 + 0 . 10) × \$100 (1 + 0 . 10) × \$110 ... (1 + 0 . 10) n × \$100 = \$110 = \$121
Measuring Interest Rates Yield on a Discount Basis Interest Rates and Returns Real and Nominal Interest Rates Simple Present Value Discounting the future : In the example, \$121 after 2 years is worth \$100 today. The present value ( PV ) is \$100. PV = Cash Flow in year n (1 + i ) n = (1 + i ) n X (1 + i ) n = X The opportunity cost of holding \$100 as cash rather than making the loan is: PV loan - PV cash = X - X (1 + i ) n = (1 + i ) n - 1 (1 + i ) n X

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Yield on a Discount Basis Interest Rates and Returns Real and Nominal Interest Rates Suppose you win a lottery paying you \$1000 monthly for the next 20 years. The annual interest rate is 10%.
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This note was uploaded on 10/08/2008 for the course ECON 3310 taught by Professor Davis during the Fall '07 term at Cornell.

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CHAPTER%204 - Measuring Interest Rates Yield on a Discount...

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