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Lecture_09_2007

# Lecture_09_2007 - International Finance FINA 5331 Lecture 9...

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International Finance FINA 5331 Lecture 9: Interest Rates and Exchange Rates William J. Crowder Ph.D.

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Understanding Interest Rates and Exchange Rates What is the interest rate? What is its relationship to exchange rates? What useful properties can we take from this relationship?
Four Types of Credit Instruments 1. Simple loan 2. Fixed-payment loan 3. Coupon bond 4. Discount (zero coupon) bond Concept of Present Value Simple loan of \$1 at 10% interest Year 1 2 3 n \$1.10 \$1.21 \$1.33 \$1x(1 + i ) n \$FV PV of future \$1 = (1 + i ) n Present Value

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Yield to Maturity: Loans Yield to maturity = interest rate that equates today’s value with present value of all future payments 1. Simple Loan ( i = 10%) \$100 = \$110/(1 + i ) \$110 – \$100 \$10 i = = = 0.10 = 10% \$100 \$100 2. Fixed Payment Loan ( i = 12%) \$126 \$126 \$126 \$126 \$1000 = + + + ... + (1+ i ) (1+ i ) 2 (1+ i ) 3 (1+ i ) 25 FP FP FP FP LV = + + + ... + (1+ i ) (1+ i ) 2 (1+ i ) 3 (1+ i ) n
Yield to Maturity: Bonds 4. Discount Bond ( P = \$900, F = \$1000), one year \$1000 \$900 = (1+ i ) \$1000 – \$900 i = = 0.111 = 11.1% \$900 F P i = P 3. Coupon Bond (Coupon rate = 10% = C/F) \$100 \$100 \$100 \$100 \$1000 P = + + + ... + + (1+ i ) (1+ i ) 2 (1+ i ) 3 (1+ i ) 10 (1+ i ) 10 C C C C F P = + + + ... + + (1+ i ) (1+ i ) 2 (1+ i ) 3 (1+ i ) n (1+ i ) n Consol: Fixed coupon payments of \$ C forever C C P = i = i P

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Relationship Between Price and Yield to Maturity Three Interesting Facts in Table 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
Distinction Between Interest Rates and Returns Rate of Return C + P t +1 P t RET = = i c + g P t C where: i c = = current yield P t P t +1 P t g = = capital gain P t

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Key Facts about Relationship Between Interest Rates and Returns
Maturity and the Volatility of Bond Returns Key Findings from Table 2 1. Only bond whose return = yield is one with maturity = holding period 2. For bonds with maturity > holding period, i P implying capital loss 3. Longer is maturity, greater is % price change associated with interest rate change 4. Longer is maturity, more return changes with change in interest rate 5. Bond with high initial interest rate can still have negative return if i Conclusion from Table 2 Analysis 1. Prices and returns more volatile for long-term bonds because have higher interest-rate risk

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Distinction Between Real and Nominal Interest Rates Real Interest Rate Interest rate that is adjusted for expected changes in the price level i r = i π e 1. Real interest rate more accurately reflects true cost of borrowing 2. When real rate is low, greater incentives to borrow and less to lend if i = 5% and π e = 3% then: i r = 5% – 3% = 2%
U.S. Real and Nominal Interest Rates

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Interest Rate Parity Interest Rate Parity Defined Uncovered Interest Parity Covered Interest Parity Interest Rate Parity & Exchange Rate Determination Reasons for Deviations from Covered Interest Parity
Covered Interest Parity (CIP) Defined IRP is an arbitrage condition.

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Lecture_09_2007 - International Finance FINA 5331 Lecture 9...

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