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Lec4303_CH3-4

Lec4303_CH3-4 - Financial Markets and Institutions Chapter...

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Financial Markets and Institutions Chapter 3 What Do Interest Rates Mean and What Is Their Role in Valuation?

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Lecture Objectives Measuring Interest Rates The Distinction Between Real and Nominal Interest Rates The Distinction Between Interest Rates and Returns
Present Value The concept of present value (or present discounted value ) is based on the commonsense notion that a dollar of cash flow paid to you one year from now is less valuable to you than a dollar paid to you today. The term present value (PV) can be extended to mean the PV of a single cash flow or the sum of a sequence or group of cash flows.

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Present Value Applications There are four basic types of credit instruments which incorporate present value concepts: 1. Simple Loan 2. Fixed Payment Loan 3. Coupon Bond 4. Discount Bond
Simple loan of \$100 Year: 0 1 2 3 n \$100 \$110 \$121 \$133 100 × (1+ i ) n \$100 today is worth \$110 one year from now, or \$100 × (1+i) n in year n. PV of future \$1 = \$1 1+ i ( 29 n Present Value Concept: Simple Loan

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Quick Quiz Suppose you invest \$500 at 4 percent for six years. How much money will you have at the end of six years? Now suppose you will be getting \$800 in four years. What is an equivalent amount today if you discount at 3.7 percent?
Yield to Maturity Yield to maturity (YTM) = interest rate that equates a security’s price with the present value of its future cash flows. 1 Year Simple Loan ( 29 1 \$100 \$110 1 i = + .10 10% i = =

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YTM: Fixed Payment Loans Fixed Payment Loan \$1000 = \$126 1 + i ( 29 + \$126 1 + i ( 29 2 + \$126 1 + i ( 29 3 + ... + \$126 1 + i ( 29 25 LV = FP 1 + i ( 29 + FP 1 + i ( 29 2 + FP 1 + i ( 29 3 + ... + FP 1 + i ( 29 n If the loan is \$1,000, and the yearly cash flow payment is \$126 for the next 25 years
YTM: Coupon Bonds Coupon Bond (Coupon rate = 10% = C / F ) P = \$100 1 + i ( 29 + \$100 1 + i ( 29 2 + \$100 1 + i ( 29 3 + ... + \$100 1 + i ( 29 10 + \$1000 1 + i ( 29 10 P = C 1 + i ( 29 + C 1 + i ( 29 2 + C 1 + i ( 29 3 + ... + C 1 + i ( 29 n + F 1 + i ( 29 n Perpetuity: Fixed coupon payments of \$C forever P = C i i = C P

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Relationship Between Price and Yield to Maturity Three interesting facts in Table 3-1 1. When bond is at par, yield equals coupon rate 2. Price and yield are negatively related 3. Yield greater than coupon rate when bond price is below par value
Premium and Discount Bonds There are three types of bonds: Premium bonds Discount bonds Par bonds

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Lec4303_CH3-4 - Financial Markets and Institutions Chapter...

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