Slides_Fundamentals of Investments - Chapter 9 pot

9
9
C h a p t e r
Interest RatesInterest Rates
second edition
Fundamentals
of
Investments
Valuation & Management
Charles J. Corrado Bradford D.Jordan
McGraw Hill / Irwin Slides by Yee-Tien

(Ted) Fu
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Time is Money
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Interest Rates
Our goal in this chapter is to discuss
the many different interest rates that
are commonly reported in the
financial press, as well as their basic
determinants and separable
components.
Goal
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Interest Rate History
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Work the Web
 For a look at interest rates from 3000
B.C., visit the historical research
section at:

Money Market Rates
9 -

6
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Hill Companies Inc.All rights reserved.
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Money Market Rates
 Prime rate - The basic interest rate on short-
term loans that the largest commercial banks
charge to their most creditworthy corporate
customers.
 Bellwether rate - Interest rate that serves as a
leader or as a leading indicator of future
trends, e.g. inflation.
 Federal funds rate - Interest rate that banks
charge each other for overnight loans of $1

million or more.
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Money Market Rates
 Discount rate - The interest rate that the Fed
offers to commercial banks for overnight
reserve loans.
 Call money rate - The interest rate brokerage
firms pay for call money loans from banks.
This rate is used as the basis for customer rates
on margin loans.
 Commercial paper - Short-term, unsecured
debt issued by the largest corporations.
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Money Market Rates
 Certificate of deposit (CD) - Large-
denomination deposits of $100,000 or more at
commercial banks for a specified term.
 Banker’s acceptance - A postdated check on
which a bank has guaranteed payment.
Commonly used to finance international trade
transactions.
 London Eurodollars - Certificates of deposit
denominated in U.S. dollars at commercial
banks in London.
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Money Market Rates
 London Interbank Offered Rate (LIBOR) -
Interest rate that international banks charge
one another for overnight Eurodollar loans.
 U.S. Treasury bill (T-bill) - A short-term U.S.
government debt instrument issued by the U.S.
Treasury.
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Work the Web
 For the latest on money market rates,
visit:

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Money Market Prices and Rates
 There are several different ways market
participants quote interest rates.
Pure discount security
An interest-bearing asset that makes a single
payment of face value at maturity with no
payments before maturity.
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Money Market Prices and Rates
 Bank discount basis - A method for quoting

interest rates on money market instruments.
Used for T-bills, banker’s acceptances, etc.
Current price =
⎟
⎠
⎞
⎜
⎝
⎛
×−× yieldDiscount
360
maturitytoDays
1ValueFace
Money Market
Prices and Rates
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14
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Work the Web
 For price and yield data on U.S.
Treasury securities, visit:

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Money Market Prices and Rates

 A bank discount yield can be converted to a
bond equivalent yield.
Bond equivalent yield =
yieldDiscountmaturitytoDays360
yieldDiscount365
×−
×
Note that this formula is correct only for maturities of
six months or less. Moreover, if February 29 occurs
within the next 12 months, 366 days must be used.
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Money Market Prices and Rates
 We can calculate a treasury bill asked price
using the asked yield, which is a bond
equivalent yield.
Current price =
65maturity/3 toDaysyield equivalent Bond1
ValueFace
×+
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Money Market Prices and Rates
 “Simple” interest basis - Another method for
quoting interest rates. Calculated just like
annual percentage rates (APRs). Used for
CDs, etc.
 The bond equivalent yield on a T-bill with less

than six months to maturity is also an APR.
 An APR understates the true interest rate,
which is usually called the effective annual
rate (EAR).
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Money Market Prices and Rates
 In general, if we let m be the number of
periods in a year, an APR can be converted to
an EAR as follows:
m
m
⎟
⎠
⎞
⎜
⎝
⎛
+=+
APR
1EAR1
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Money Market Prices and Rates
Example: Prices and Rates
 Suppose a T-bill with 170 days to maturity has a
asked discount of 3.22%.
 For $1 million in face value, asked price =

 So, on this 170-day investment, you earn $15,206 in
interest on an investment of $984,794, or 1.544%.
 365/170 = 2.147. So APR = 2.147×1.544% = 3.315%
794,984$0322.
360
170
1000,000,1$ =
⎟
⎠
⎞
⎜
⎝
⎛
×−×
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Money Market Prices and Rates
Example: Prices and Rates …continued
 Bond equivalent yield
APR
%315.3
0322.701360
0322.365
=
=
×−
×
=


03344.1
147.2
03315.
1EAR1
147.2
=
⎟
⎠
⎞
⎜
⎝
⎛
+=+
So EAR = 3.344%
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Rates and Yields on Fixed-Income Securities
 Fixed-income securities include long-term debt
contracts from a wide variety of issuers:
Î the U.S. government,
Î real estate purchases (mortgage debt),
Î corporations, and
Î municipal governments.
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Rates and Yields on Fixed-Income Securities
 The Treasury yield curve is a plot of Treasury
yields against maturities.

 It is fundamental to bond market analysis
because it represents the interest rates for
default-free lending across the maturity
spectrum.
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Rates and Yields on Fixed-Income Securities
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Rates and Yields on Fixed-Income Securities