INTEREST RATES DETERMINATION AND STRUCTURE

For financing and investing decision making in

a dynamic financial environment of market
participants, it is crucial to understand interest
rates as one of the key aspects of the financial
environment. Several economic theories
explain determinants of the level of interest
rates. Another group of theories explain the
variety of interest rates and their term
structure, i.e. relationship between interest
rates and the maturity of debt instruments.
 Understanding Interest Rate

What is Interest Rate?

The yield to maturity is what economists mean
when they use the term interest rate. It is the
most accurate measure of interest rates.
 Measuring Interest Rates
Different debt instruments have very different
streams of payment with very different timing.
Thus we first need to understand how we can
compare the value of one kind of debt
instrument with another before we see how
interest rates are measured
 Present Value

The concept of present value (or present

discounted value) is based on the
commonsense notion that a dollar paid to you
one year from now is less valuable to you than
a dollar paid to you today:
 Cont.
Let’s look at the simplest kind of debt
instrument, which we will call a simple loan.
In this loan, the lender provides the borrower with
an amount of funds, say Rs. 100/= (called the
principal) that must be repaid to the lender at the
maturity date, (in one year) along with an additional
payment for the interest (say Rs. 10/=).
 Cont.
The simple interest rate, i, is:
i = 10/100 = 0.10 = 10%
If you make this Rs.100 loan, at the end of the
year you would have Rs.110, which can be
rewritten as:
Rs.100 * (1 + 0.10) = Rs.110
 Cont.

If you then lent out the $110, at the end of the

second year you would have:
Rs.110 * (1 + 0.10) = Rs.121
or, equivalently,
Rs.100 * (1+ 0.10) * (1 + 0.10) = Rs.100 * (1 +
0.10)2 = Rs.121
 Cont.

Continuing with the loan again, you would

have at the end of the third year:
Rs.121* (1 + 0.10) =Rs.100*(1+0.10)3 = Rs.133
Generalizing, we can see that at the end of n
years, your Rs.100 would turn into:
Rs.100 (1 + i )n
Time Line
 Cont.
The timeline tells us that we can also work
backward from future amounts to the present:
for example, Rs.133 = Rs.100 * (1 + 0.10)3
three years from now is worth Rs.100 today,
so that:
100 = 133/(1+0.10)3
The process of calculating today’s value of money
received in the future is called discounting the future.
 Ont.

We can generalize this process by writing

today’s (present) value of Rs.100 as PV, the
future value of Rs.133 as FV, and replacing
0.10 (the 10% interest rate) by i. This leads to
the following formula:
PV = FV/(1+ i)n
The concept of present value is extremely
useful, because it allows us 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.
This information allows us to compare the
value of two instruments with very different
timing of their payments.
 Example
let’s assume that you have won Rs. 20 million which
promises you a payment of Rs.1 million for the next
twenty years. If we assume an interest rate of 10%,
the first payment of Rs.1 million is clearly worth Rs.1
million today, but the next payment next year is only
worth Rs.1 million/(1 + 0.10) = Rs.909,090, The
following year the payment is worth Rs.1 million/(1 +
0.10)2 = Rs. 826,446 in today’s dollars, and so on.
When you add all these up, they come to Rs. 9.4
million.
 Four Types of Credit Market
Instruments

In terms of the timing of their payments

(i) A simple loan - the lender provides the
borrower with an amount of funds, which
must be repaid to the lender at the maturity
date along with an additional payment for the
interest. Many money market instruments are
of this type:
for example, commercial loans to businesses.
 Cont.
(ii) A fixed-payment loan - the lender
provides the borrower with an amount of
funds, which must be repaid by making the
same payment every period (such as a
month), consisting of part of the principal and
interest for a set number of years.
Installment loans (such as auto loans) and
mortgages are frequently of the fixed-
payment type.
 Cont.
(iii) A coupon bond - pays the owner of the bond a
fixed interest payment (coupon payment) every year
until the maturity date, when a specified final
amount (face value or par value) is repaid.
A coupon bond is identified by three pieces of
information. (a) the corporation or government
agency that issues the bond. (b) the maturity date of
the bond. (c) the bond’s coupon rate.
 Cont.
For example, a coupon bond with a yearly
coupon payment of $100 and a face value of
$1,000. The coupon rate is then $100/$1,000
0.10, or 10%.
Capital market instruments such as Treasury
bonds and notes and corporate bonds are
examples of coupon bonds.
 Cont.
(iv) A discount bond (also called a zero-coupon
bond) - is bought at a price below its face value (at a
discount), and the face value is repaid at the maturity
date. Unlike a coupon bond, a discount bond does
not make any interest payments; it just pays off the
face value.
For example, a discount bond with a face value of
$1,000 might be bought for $900; in a year’s time the
owner would be repaid the face value of $1,000.
 Yield to Maturity

Of the several common ways of calculating

interest rates, the most important is the yield
to maturity. It is the interest rate that equates
the present value of payments received from a
debt instrument with its value today.
 Simple Loan and Yield to Maturity .

• today’s value of a one-year loan is $100,

and the payments in one year’s time would be
$110 (the repayment of $100 plus the interest
payment of $10). Using the concept of present
value, can make today’s value of the loan
($100) equal to the present value of the $110
payment in a year, 100 = 110/(1+ i).
• i= 110-100/100 = 10/100 = 0.10 = 10%
 Fixed-Payment Loan and Yield to Maturity.

On a fixed-payment loan the borrower makes

the same payment to the bank every month
until the maturity date, when the loan will be
completely paid off.
For example, the fixed payment loan is $1,000
and the yearly payment is $126 for the next 25
years.
 Cont.
The present value is calculated as follows: At
the end of one year, there is a $126 payment
with a PV of $126/(1 + i); at the end of two
years, there is another $126 payment with a
PV of $126/(1 + i)2; and so on until at the end
of the twenty-fifth year, the last payment of
$126 with a PV of $126/(1+ i)25 is made.
Cont.
 Coupon Bond and Yield to Maturity.

To calculate the yield to maturity for a coupon bond,

we use the same strategy used for the fixed-payment
loan: Equate today’s value of the bond with its
present value. Because coupon bonds also have
more than one payment, the present value of the
bond is calculated as the sum of the present values
of all the coupon payments plus the present value of
the final payment of the face value of the bond.
 Cont.
The present value of a $1,000-face-value bond
with ten years to maturity and yearly coupon
payments of $100 (a 10% coupon rate) can be
calculated as follows:
Cont.
Cont.
 Cont.
Three interesting facts from the information in Table
1.
1. When the coupon bond is priced at its face value,
the yield to maturity equals the coupon rate.
2. The price of a coupon bond and the yield to
maturity are negatively related.
3. The yield to maturity is greater than the coupon
rate when the bond price is below its face value.
 Discount Bond and Yield to Maturity.

The yield-to-maturity calculation for a discount bond

is similar to that for the simple loan.
Consider a discount bond such as a one-year
Treasury bill, which pays off a face value of Rs.100 in
one year’s time. If the current purchase price of this
bill is Rs. 90, then equating this price to the present
value of the Rs.100 received in one year,
Rs. 90 = Rs. 100/( 1+i)
Cont.
 The Distinction Between
Interest Rates and Returns

For any security, the rate of return is defined as the

payments to the owner plus the change in its value,
expressed as a fraction of its purchase price.
for example: a $1,000-face-value coupon bond with
a coupon rate of 10% that is bought for $1,000, held
for one year, and then sold for $1,200. The payments
to the owner are the yearly coupon payments of
$100, and the change in its value is $1,200 - $1,000 =
$200.
Cont.
 Cont.

This demonstrates that the return on a bond

will not necessarily equal the interest rate on
that bond. The two may be closely related.
 Other Measures of Interest Rates

The Current yield:

The current yield is an approximation of the yield to
maturity on coupon bonds. it is easy to calculate
compared to yield to maturity. It is defined as the yearly
coupon payment divided by the price of the security.
Ic= C/P
ic = current yield
P = price of the coupon bond
C = yearly coupon
 Cont.
Yield on a Discount Basis:
• idb = F-P/F * 360/days to Maturity
Idb = Yield on discount basis
F = Face value on the discount bond
P = Purchase price of the discount bond
 Cont

On our one-year bill, which is selling for $900

and has a face value of $1,000, the yield on a
discount basis would be as follow

• I db = 1000-900/1000 * 360/365 = 0.099 =

9.9%.
 Cont.
• Real interest rate is the difference between the
nominal rate of interest and the expected rate of
inflation.
• It is a measure of the anticipated opportunity cost of
borrowing in terms of goods and services forgone.
• The dependence between the real and nominal interest
rates is expressed using the following equation:
• i =(1+ r)(1+ ie) - 1
where i is the nominal rate of interest, r is the real
rate of interest and ie is the expected rate of inflation.
 Cont.
• Example
• Assume that a bank is providing a company with a loan
of 1000 Euro for one year at a real rate of interest of 3
%. At the end of the year it expects to receive back
1030 Euro of purchasing power at current prices.
• However, if the bank expects a 10 per cent rate of
inflation over the next year, it will want 1133 Euro back
(10 per cent above 1030 Euro).
• The interest rate required by the bank would be 13.3
per cent i =(1+ 0.03)(1 + 0.1) - 1 = (1.03)(1.1) - 1 =
1.133 - 1=0.133 or 13.3 per cent