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## Money & Banking

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**Money & Banking**Week 4 Debt Instruments & Interest Rates**Draw cash flow diagrams for the four types of credit**instruments. Take the perspective of the lender. Simple loan Annuity/Amortized loan Coupon bond Zero coupon bond**Semi annual coupon on $1 mil of face value?**$66,250.00 Number of coupons remaining? M06 … M15 19 Asked price of $1 mil of face value? $1,430,625**Pricing a coupon bond**Suppose I need a 4% rate of return. How much would I be willing to pay for $1 million of face value of the bond on the previous slide? • Calculate the PV of face value (FV=1mil, n=19, i = .02) • Calculate the PV of coupons using annuity table. (PMT = 66,250, n=19, i = .02) • Add two parts together.**Yield to Maturity**The rate of discount that equates the present value of future cash flows with the price of the credit instrument.**Calculate the yield to maturity on a consol that pays $100 a**year and is priced at $2,500. Recall formula for present value of a consol:**Fisher Equation**The nominal (actual) interest rate equals the real rate plus the expected inflation rate.**TIPS (Treasury Inflation Protection Securities)**• Originally issued in 1997. • Interest and principal payments are adjusted for inflation. • In times of high inflation the $ amount paid to investors rises. • Return on TIPS provides information on expected inflation.**Money Market Instruments**• Debt instruments • Short-term (year or less) • Low risk • High denomination • Also known as “cash” • Examples: Treasury bills, commercial paper, bankers acceptances, repurchase agreements, CD’s**Chapter Six**Interest Rates: • Risk Structure • Term Structure**Risk Structure of Interest Rates**Bonds of same maturity will have different yields because of three factors: • Default risk • Liquidity • Tax considerations**Highest Rated Corporate Bonds**In the 1980s there were 32 AAA rated bonds.Today there are only six: • Automatic Data Processing • Exxon Mobil • General Electric • Johnson & Johnson • Pfizer • United Parcel Post**History of Junk Bonds**• Fallen Angels • Michael Milken**Theories of Term Structure (shape of yield curve)**• Expectations Hypothesis • Segmented Markets • Liquidity Premium (preferred habitat)**Relationship Between the Liquidity Premium (Preferred**Habitat) and Expectations Theories