Chapter 04 - 4. Understanding Interest Rates 4.1 Measuring...

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4. Understanding Interest Rates 4.1 Measuring Interest Rates 4.2 Other Measures of Interest Rates 4.3 The Distinction between Interest Rates and Ret 4.4 The Distinction between Real and Nominal Int
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4.1 2 Different debt instruments have very different streams of payment with very different timing The concept of present ( discounted ) value is based on the commonsense notion that a dollar today is more valuable (which can be invested to earn interest) than a dollar in the future Simple loan : the lender provides the borrower with an amount of funds ( principal ) that must be repaid to the lender at the maturity date along with an additional payment for the interest Simple interest rate : the interest payment divided by the amount of the loan from a simple loan
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4.1 3 When a $100 loan continues to n years, the principal plus interest amount ( Figure 4.1 ) will be 100 x (1+ i ) n , which is the future value ( FV ) of the $100 An individual is just as happy having $100 today as having 100 x (1+ i ) n n years from now Discounting the future ( Figure 4.2 ): the process of calculating today’s value ( present value , PV ) of dollars received n years from now PV = FV /(1+ i ) n
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4.1 4 The concept of present value allows analysts to figure out today’s value (price) of a credit market instrument at a given simple interest rate ( i ) by just adding up the individual present values of all the future payments received, which can be used to compare the value of two instruments with very different timing of their payments
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4.1 5 Basic types of credit market instruments (i) simple loan – the lender provides the borrower with an amount of funds that must be repaid to the lender at the maturity date along with an additional payment for the interest (ii) fixed-payment loan ( fully amortized loan) – the lender provides the borrower with 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 such as installment loans and mortgages
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4.1 6 (iii) coupon bond – it pays the owner of the bond a fixed interest ( coupon ) payment every period until the maturity date, when a specified final amount ( face or par value ) is repaid and the coupon rate is expressed as the ratio of the dollar amount of the yearly coupon payment to the face value of the bond (iv) discount bond ( zero-coupon bond) – it is bought at a price below its face value (at a discount), and the face value is repaid at the maturity date, but it does not make any interest payments
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7 Yield to maturity – the interest rate that equates the present value of payments received from a debt instrument with its value today , which is considered by economists as the most accurate measure of interest rates For simple loans , the simple interest rate equals the yield to maturity ( Figure 4.3 ) For fixed-payment loans , with the number of years until maturity ( n ) and
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This note was uploaded on 10/05/2010 for the course ECO 349 taught by Professor H during the Fall '09 term at University of Toronto- Toronto.

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Chapter 04 - 4. Understanding Interest Rates 4.1 Measuring...

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