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
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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
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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?
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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
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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
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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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