Topic 2.pptx - Understanding Interest Rates Credit Market...

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Understanding Interest Rates
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Credit Market Instruments In terms of the timing of cash flow payments, there are four basic types of credit market instruments: Simple loans Fixed payment or fully amortized loans Coupon Bonds Discount Bonds
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Present Value/Present Discounted Value It is the discounted value of future cash flows or income Computed using the formula Where PV : Present value CF: Cash flows i = interest rate/yield to maturity n = maturity period n i CF PV ) 1 (
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Example Rs 100 is lent out with a maturity period of 1 year and interest rate of 10 percent. After one year the total payment would be Rs 110. If this money is further lent out then after one year total payment would be 110 (1+0.10) = 121. Alternatively, with compound interest rate of 10 percent Rs 100 would become Rs 121 following the formula 100 (1+0.10) (1+0.10) = 100 (1+0.10) 2 = 121 Generalising, we obtain that after n years the payment would be 100 (1+0.10) n . Now working backward, the present value of a future payment, say 121, can be calculated as where CF is the final cash flow (=Rs 121) and i is the interest rate (=10 percent). n i CF ) 1 ( 100
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Yield to Maturity The most accurate measure of interest rate Equates the present value of cash flows from a debt instrument with its value today
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PV for Credit Market Instruments In terms of the timing of cash flow payments, there are four basic types of credit market instruments: 1. Simple loan - a sum is lent with a maturity date at which the borrower must pay the principal amount with additional simple or compound interest payment P is principal amount, I is interest payment, n is the maturity period and i is interest rate n i I P PV ) 1 (
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