Chapter 2 - Understanding interest rates

# Chapter 2 - Understanding interest rates - Chapter 2...

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Chapter 2 Understanding interest rates Interest rates are among the most closely watched variables in the economy. Before we can go on with the study of money, banking, and financial markets, we must understand exactly what the phrase interest rates means. A. Four types of credit market instruments In terms of the timing of their payments, there are four basic types of credit market instruments: Types of credit market instruments Explanation 1. A simple loan The lender provides the borrower with an amount of funds, which must be repaid to the lender at the maturity date along with an additional payment for the interest. Example: commercial loans to business. 2. A fixed-payment loan (also called a fully amortized 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 of the principal and interest for a set number of years. 3. A coupon bond Pays the owner of the bond a fixed interest payment (coupon payment) every year until the maturity date, when a specified final amount (face value or par value) is repaid. The coupon payment is so named because the bondholder used to obtain payment by clipping a coupon off the bond and sending it to the bond issuer, who then sent the payment to the holder. A coupon bond is identified by three pieces of information. First is the corporation or government agency that issues the bond. Second is the maturity 2-1

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date of the bond. Third is the bond’s coupon rate. 4. A discount bond A bond that is bought at a price below its face value (at a discount), and the face value is repaid at the maturity date. These four types of instruments require payments at different times: simple loans and discount bonds make payment only at their maturity dates, whereas fixed-payment loans and coupon bonds have payments periodically until maturity. B. Yield to maturity (YTM) The most important way of calculating interest rates is the yield to maturity. It is the interest rate that equates the present value of payments received from a debt instrument with its value today. Because the procedure for calculating the yield to maturity is based on sound economic principles, this is the measure that economists think most accurately describes the interest rate. Types of credit market
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Chapter 2 - Understanding interest rates - Chapter 2...

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