1. 1 Money & Banking Week 4 Debt Instruments & Interest Rates

2. 2 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

3. 3 Bond Page of the Newspaper

4. 4 RateMaturity Mo/Yr BidAskedChgAsked Yield 13 1/4May 15143:01143:02+143.22 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

5. 5 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? 1.Calculate the PV of face value (FV=1mil, n=19, i =.02) 2.Calculate the PV of coupons using annuity table. (PMT = 66,250, n=19, i =.02) 3.Add two parts together.

6. 6 Yield to Maturity The rate of discount that equates the present value of future cash flows with the price of the credit instrument.

7. 7 Relationship Between Price and Yield to Maturity.

8. 8 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:

9. 9 Approximation for YTM: Current Yield

10. 10 Fisher Equation The nominal (actual) interest rate equals the real rate plus the expected inflation rate.

11. 11 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.

12. 12 U.S. Real and Nominal Interest Rates

13. 13 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

14. 14 Chapter Six Interest Rates: Risk Structure Term Structure

15. 15 Risk Structure of Interest Rates Bonds of same maturity will have different yields because of three factors: 1.Default risk 2.Liquidity 3.Tax considerations

16. 16 Risk Structure of Long-Term Bonds in the United States

17. 17 Rating Bonds

18. 18 Bond Ratings

19. 19 Highest Rated Corporate Bonds In the 1980s there were 32 AAA rated bonds.Today there are only six: 1.Automatic Data Processing 2.Exxon Mobil 3.General Electric 4.Johnson & Johnson 5.Pfizer 6.United Parcel Post

20. 20 History of Junk Bonds Fallen Angels Michael Milken

21. 21 yield curve last year at this time

22. 22 yield curve last week

23. 23 Theories of Term Structure (shape of yield curve) Expectations Hypothesis Segmented Markets Liquidity Premium (preferred habitat)

24. 24 Interest Rates on Different Maturity Bonds Move Together

25. 25 Relationship Between the Liquidity Premium (Preferred Habitat) and Expectations Theories