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Chapter 4

# Chapter 4 - Chapter 4-Understanding Interest Rates Present...

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Chapter 4 - Understanding Interest Rates Present Value •A dollar paid to you one year from now is less valuable than a dollar paid to you today •Why? –A dollar deposited today can earn interest and become \$1 x (1+i) one year from today. Discounting the Future Simple Present Value Four Types of Credit Market Instruments •Simple Loan •Fixed Payment Loan •Coupon Bond •Discount Bond Yield to Maturity 2 3 Let = .10 In one year \$100 X (1+ 0.10) = \$110 In two years \$110 X (1 + 0.10) = \$121 or 100 X (1 + 0.10) In three years \$121 X (1 + 0.10) = \$133 or 100 X (1 + 0.10) In years \$100 X (1 + ) n i n i n PV = today's (present) value CF = future cash flow (payment) = the interest rate CF PV = (1 + ) i i

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•The interest rate that equates the present value of cash flow payments received from a debt instrument with its value today Simple Loan Fixed Payment Loan Coupon Bond 1 PV = amount borrowed = \$100 CF = cash flow in one year = \$110 = number of years = 1 \$110 \$100 = (1 + ) (1 + ) \$100 = \$110 \$110 (1 + ) = \$100 = 0.10 = 10% For simple loans, the simple interest rate equ n i i i i als the yield to maturity 2 3
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Chapter 4 - Chapter 4-Understanding Interest Rates Present...

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