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