Chapter 4
Interest Rates and Rates of Return
Overview
Interest rates tend to be mysterious to many students. Students who fail at the beginning of the semester to
understand the basics of calculating interest rates end up experiencing considerable difficulty later in the
semester. This is true both in courses that stress financial institutions—because students have difficulty
understanding the rudiments of bank asset management or the roots of the savingsandloan and banking
crises—and in courses that stress policy—because students have great difficulty in understanding the
impact of Federal Reserve policy. Hence, carefully going over the material in this chapter should pay large
dividends later in the semester.
The concept of present value is fundamental to interest rate calculations, but many students find it difficult
to grasp when it is first presented. Working through several examples—such as those presented in the text
—is a worthwhile use of class time. Students also often have difficulty grasping the distinction between
the yield to maturity and the rate of return for holding a financial asset that is sold before maturity. Several
important points made later in the course turn on this distinction. Students often find going over the
interpretation of the bond price and bond yield listings from
The Wall Street Journal
to be one of the more
interesting and useful exercises in the course. Most students, if they had ever looked at these listings at all,
consider them to be a cryptic jumble. Once students have a basic understanding of bond prices and bond
yields, they’ll generally find it rewarding to read the “Markets” column, which appears each day on the
first page of
The Wall Street Journal’s
“C” Section. Finally, the distinction between nominal and real
interest rates is worth stressing. An interesting class discussion can be centered on the question of how to
decide whether a nominal interest rate of, say, 10% is high.
Outline
I.
Comparing Debt Instruments
A)
Debt instruments (also called
credit market instruments
) are IOUs or promises by the
borrower to pay interest and repay principal to a lender.
1. Debt instruments take different forms because lenders and borrowers have different needs.
2. Four general categories of debt instruments are: simple loans, discount bonds, coupon bonds,
and fixed payment loans.
B)
The timing of payments that bond issuers make to lenders varies across the categories of bonds.
1. With a
simple loan
the borrower receives from the lender an amount of funds called the
principal and agrees to repay the lender the principal plus an additional amount called interest.
2. With a
discount bond
the borrower pays the lender the amount of the loan, called the face
value or par value, at maturity, but receives less than the face value initially.
3. Borrowers issuing a
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 Fall '11
 Sanchez
 Inflation, Interest Rates

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