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Understanding Interest Rates »... Wasn’t it Ben Franklin who said that???? A fool and his Money are soon Partying!!!! 1 Copyright © 2014 Diane Scott Docking

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2 Learning Objectives Understand the different names for interest rates Understand and compute the different ways interest rates are quoted Use quoted rates to calculate loan payments and balances, future values, annuities

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Copyright © 2014 Diane Scott Docking 3 What are Interest Rates? To understand interest rates, it’s important to think of interest rates as a price—the price of using money. When you borrow money to buy a car, you are using the bank’s money now to get the car and paying the money back over time. The interest rate on your loan is the price you pay to be able to convert your future loan payments into a car today.

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Copyri ght © 2014 Diane Scott Docki ng 4

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5 Various Types of Interest Rates 1. Coupon Rate, Nominal Rate, or Stated Rate 2. Simple Interest Rate 3. Yield to Maturity (YTM) 4. Current Yield (CY) 5. Internal Rate of Return (IRR) 6. Discount Rate (DR) 7. Effective Annual Return or Yield (EAR) or (EAY) 8. Annual Equivalent Rate (AER) 9. Annual Percentage Yield (APY) 10. Average Annual Percentage Yield (APY) 11. Annual Percentage Rate (APR)

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Coupon Rate (aka: Stated rate, Nominal rate) A 2-year, $1,000 face value bond has a coupon of 5%. Interest is paid semi-annually. How much interest will you receive every 6 months? A: Face x (coupon/# payments per year) = Interest payment. $1,000 x (.05/2) = $1,000 x.025 = $25. Copyright © 2014 Diane Scott Docking 6

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Coupon Rate (aka: Stated rate, Nominal rate) A 2-year, $1,000 face value bond pays interest semi-annually. The current price of the bond is $1, The current market yield is 4%. What is the coupon rate on this bond? A: Copyright © 2014 Diane Scott Docking 7 FV=1,000 PV= -1, n=2 x 2 = 4 i/y = 4%/2 = 2% Pmt = $25 semiannual x 2 = $50/year Coupon rate = 50/1,000 = 5%

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Copyright © 2014 Diane Scott Docking 8 Simple Interest Rate Simple Interest Rate: the interest payment divided by the loan principal; the percentage of principal that must be paid as interest to the lender. Convention is to express the interest rate on an annual basis, irrespective of the loan term. Example: Mary has a $10,000 3-year loan with a simple interest rate of 6%. Mary will pay $10,000 x 6% = $600 in interest every year for 3 years. At the end of the third year she will repay the $10,000 principal balance.

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Yield to Maturity (YTM) YTM most commonly refers to savings accounts Bonds In some in instances YTM is same as the internal rate of return (IRR) and the discount rate (DR). Depends on the context in which the term is used. Example: You invest $ in a savings account today. In 2 years you withdraw $250. What is your YTM assuming annual compounding? Copyright © 2014 Diane Scott Docking 9 FV = 250 PV = N = 2 Pmt = 0 Cpt i/y = 15%

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Copyright © 2014 Diane Scott Docking 10 Current Yield (CY) Current yield (CY) is just an approximation for YTM – easier to calculate. It is usually used with bonds. However, we should be aware of its properties: 1. If a bond’s price is near par and has a long maturity, then CY is a good approximation of YTM. 2. A change in the current yield always signals change in same direction as yield to maturity.

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Example: Current Yield A 2-year corporate bond, par value $1,000, is selling for $980. Its annual coupon rate is 6%. What is the bond’s current yield? What is the bond’s YTM assuming annual interest payments? Semi-annual payments? Copyright © 2014 Diane Scott Docking 11

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Solution to Example: Current Yield What is the bond’s current yield? What is the bond’s YTM assuming annual interest payments? Semi-annual payments? Copyright © 2014 Diane Scott Docking 12 FV=1000 PV=980 N=2 Pmt=60 therefor i/y = % FV=1000 PV=980 N=2 x 2 = 4 Pmt=60/2 = 30 therefore i/y = x 2 = 7.090%

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Copyright © 2014 Diane Scott Docking 13 Internal Rate of Return (IRR) In Bonds: The IRR is the rate that forces the PV of expected future cash flows of interest and principal to equal the initial cost of the bond. In Corporate: The IRR is the rate that forces the PV of a project’s expected cash flows to equal its initial cost. IRR is the same as YTM in many instances.

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Copyright © 2014 Diane Scott Docking 14 Discount Rate (DR) The Discount Rate can mean many things: In Bonds: the discount rate can be the YTM In Corporate: the discount rate can be the IRR In Banking: the discount rate is the rate that the Federal reserve loans money to commercial banks. In the Treasury Bill market: the discount rate is the rate used to calculate the price of the T-Bill.

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Copyright © 2014 Diane Scott Docking 15 Effective Annual Rate, Return or Yield (EAR) or (EAY) The EAR or EAY is the return earned or paid over a 12-month period taking any within-year compounding of interest into account. EAR or EAY = (1 + r) c – 1 where c = the number of compounding periods per year, and r = the periodic rate. That is the nominal rate divided by the number of compounding periods in the year. Recall from Time Value of Money Lecture: where m = the number of compounding periods per year

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Copyright © 2014 Diane Scott Docking 16 Example 1: EAR or EAY Suppose your savings account pays interest at 6% (stated rate), compounded monthly. What is the Effective Annual Yield that you are earning on your account?

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Copyright © 2014 Diane Scott Docking 17 Example 2: EAR or EAY Suppose your bank account pays interest monthly with an effective annual rate of 6%. What is the “stated” or nominal interest rate your bank is offering?

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Copyright © 2014 Diane Scott Docking 18 Solution to Example 2: EAR or EAY What is the “stated” or nominal interest rate your bank is offering?

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Copyright © 2014 Diane Scott Docking 19 Annual Equivalent Rate (AER) The AER is a way of quoting the actual interest earned each compounding period: where: r = stated annual interest rate m = number of compounding periods per year AER is same as EAR

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Copyright © 2014 Diane Scott Docking 20 Annual Percentage Yield (APY) or Average Annual Percentage Yield (APY) APY can mean two things. Annual Percentage Yield APY is a way of quoting the actual interest earned each compounding period: where: r = stated annual interest rate m = number of compounding periods per year In this case Annual Percentage Yield (APY) is same as Effective Annual Yield (EAY)

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Copyright © 2014 Diane Scott Docking 21 APY can also mean Average Annual Percentage Yield If investment or loan is for more than 1 year then you calculate the Average Annual Percentage Yield: where: r = annual interest rate m = number of times interest is compounded per year n = number of years Continuous compounding: APY can also mean Average Annual Percentage Yield If investment or loan is for more than 1 year then you calculate the Average Annual Percentage Yield: where: r = annual interest rate m = number of times interest is compounded per year n = number of years Continuous compounding: Annual Percentage Yield (APY) or Average Annual Percentage Yield (APY)

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Copyright © 2014 Diane Scott Docking 22 Example 1: APY Mary has invested $10,000 in a savings account that is paying interest at a 6% (stated rate), compounded quarterly. What is the Annual Percentage Yield (APY) that Mary is earning on her investment? If rates remain constant, how much will Mary have in her account at the end of 3 years? What is the Average Annual Percentage Yield (APY) that Mary earned on her initial investment over the 3 year period?

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Copyright © 2014 Diane Scott Docking 23 Solution to Example 1: APY What is the Annual Percentage Yield that Mary is earning on her investment?

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Copyright © 2014 Diane Scott Docking 24 Solution to Example 1: APY If rates remain constant, how much will Mary have in her account at the end of 3 years? PV = -$10,000 N = 3 x 4 = 12 I/Y = 6%/4 = 1.5 Pmt = 0 Cpt FV = $11,956.18

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Copyright © 2014 Diane Scott Docking 25 Solution to Example 1: APY What is the Average Annual Percentage Yield (APY) that Mary earned on her initial investment over the 3 year period?

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Copyright © 2014 Diane Scott Docking 26 Annual Percentage Rate (APR) The Annual Percentage Rate (APR) is a way of quoting the actual interest cost of funds over the term, INCLUDING any closing costs and fees.

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Copyright © 2014 Diane Scott Docking 27 Example: Computing a Loan APR with and without upfront closing costs 1)Mary agrees to a 15-year, $200,000 mortgage loan, with a rate of 5%. Her upfront closing costs are estimated to be $0. What are Mary’s monthly loan payments? What is the APR on this loan? 2)Assume Mary agrees to a 15-year, $200,000 mortgage loan, with a rate of 5% with estimated upfront closing costs to be $2,000. What are Mary’s monthly loan payments? What is the APR on this loan?

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Copyright © 2014 Diane Scott Docking 28 1)Mary agrees to a 15-year, $200,000 mortgage loan, with a rate of 5%. Her upfront closing costs are estimated to be $0. What are Mary’s monthly loan payments? What is the APR on this loan? 5% FV= 0 PV=200,000 N=15 x 12 = 180 I/Y = 5%/12 = % therefore Pmt = $1, Example: Computing a Loan APR with and without upfront closing costs

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Copyright © 2014 Diane Scott Docking 29 2)Mary agrees to a 15-year, $200,000 mortgage loan, with a rate of 5%. Her upfront closing costs are estimated to be $2,000. What are Mary’s monthly loan payments? What is the APR on this loan? FV= 0 PV=200,000 N=15 x 12 = 180 I/Y = 5%/12 = % therefore Pmt = $1, Example: Computing a Loan APR with and without upfront closing costs FV= 0 PV=200,000 - $2,000 closing costs = $198,000 N=15 x 12 = 180 Pmt = $1, CPT I/Y = APR = x 12 = 5.153%

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