Class 5

# Class 5 - Econ 350 U.S Financial Systems Markets and...

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Econ 350 U.S. Financial Systems, Markets and Institutions Class 5 Econ 350 U.S. Financial Systems, Markets, and Institutions Class 5: Interest rates – measurement In today’s class we examine interest rates and how they are measured. We have discussed the importance of interest rates both at a personal level and at a macroeconomic level. We now look in much more detail at how interest rates are defined and measured. First we look at the different types of loans and bonds. Next, we will discuss the idea of the yield to maturity and how it applies to different types of bonds. Of all of the measures of interest rates, the yield to maturity is viewed as the most accurate. Finally, we will explore other measures of the return earned on a bond or loan, and discuss the difference between real and nominal interest rates. Course Objectives After today’s class, you should: -- be able to describe the four types of loans and bonds. -- understand the ideas of yield to maturity and present value. -- know the relationship between the yield to maturity and coupon rate for coupon bonds. -- understand other measures of interest and the return on a bond. -- know Fisher’s equations Types of Loans Fundamentally, there are four types of loans: simple loans, fixed-payment loans, coupon bonds, and discount bonds. You should recognize that a bond is just a type of loan where the bond itself is used as a security. There are many different forms of transferring funds from borrower to lender. Simple loans A simple loan is, as it says, the simplest form of a loan. I lend you money this year, and you pay me back a larger sum next year to encourage me to make the loan to begin with. This is the whole idea of interest, and that interest rates adjust so that the supply of loanable funds is in line with the demand for loanable funds. For example, say if I lend you \$100 this year, and then you pay me back \$110 next year. That would be a simple loan. Simple loan: provides the borrowers with funds that are paid back at maturity, plus interest. Examples include commercial loans and loans from one person to another. Fixed-payment loans Fixed payment loans are very common in residential and consumer lending. As the name says, the borrower makes fixed payments over fixed intervals until the loan is paid off. An example would be if I borrow \$1000 and then pay \$126 per year for the next 25 years. Fixed-payment loan: The borrower makes the same payment each month, consisting of an interest payment plus a payment toward the principal, until the loan is paid off. 31

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Econ 350 U.S. Financial Systems, Markets and Institutions Class 5 Examples include mortgages, automobile loans, and consumer loans. Coupon bonds
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Class 5 - Econ 350 U.S Financial Systems Markets and...

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