Chapter 2:

Interest rate

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Main contents
1. Interest rates and Present value
2. Yield to maturity - the most
important interest rates
3. The current yield and the yield on a
discount basis - less accurate
measures of interest rates
4. The rate of return (RET)

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The content should be
understood after the lesson:
What is interest rate?
Be able to calculate PV;
Be able to distinguish and calculate:
Yield to maturity, the current yield,
the yield on a discount basis, the rate
of return.

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I. Interest rates and Present value

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1.1 Interest rate
An interest rate is the cost of
borrowing or the price paid for the
rental of funds (usually expressed as a
percentage of the rental of $100 per
year). There are many interest rates in
the economy—mortgage interest rates,
car loan rates, and interest rates on
many different types of bonds.

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1.1 Interest rate
The Distinction Between Real and Nominal Interest Rates
a. The role of Inflation:
 Inflation is proportional with the nominal interest rate,
inversely proportional with the real interest rate;
 Inflation make the different between the real and
nominal interest rates.
b. The Real and Nominal Interest Rates
 Nominal interest rate is the determined interest rate and
listed in the market;
 The real interest rates are nominal rates that eliminate
the impact of inflation.

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1.1 Interest rate
The Fisher equation is:
1 + 𝑖 = 1 + 𝑖𝑟 1 + 𝜋 = 1 + 𝑖𝑟 + 𝜋 + 𝑖𝑟 × 𝜋
=> 𝒊 = 𝒊𝒓 + 𝝅 + 𝒊𝒓 × 𝝅 ≈ 𝒊𝒓 + 𝝅
=> 𝒊𝒓 = 𝒊 − 𝝅
Where:
𝒊: Nominal Interest Rates
𝒊𝒓 : Real Interest Rates
𝝅: the expected inflation rate
Ex: You have made a one-year simple loan with a 5%
interest rate and you expect the price level to rise by 3%
over the course of the year. Calculate real interest rate in
two ways!
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Source: Mishkin, Frederic S. The economics of money, banking, and financial markets, 7th ed.

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1.2 Present value
Definition: Present value (PV) is the current value of a
future sum of money or stream of cash flows given a
specified rate of return.

𝐹𝑉
𝑃𝑉 =
(1 + 𝑖)𝑛
Ex: A computer is expected to produce in 3 years, earning 50
million dong a year. In the last year, the device can be sold
for 100 million. How much will you accept to buy that
device?

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2. Yield to maturity
Definition: The yield to maturity for an
instrument is the interest rate that equates the
present value of the future payments on that
instrument to its value today.
Calculate four types of credit market instrument:
2.1. A simple loan
2.2. A fixed-payment loan (which is also called a
fully amortized loan)
2.3. A coupon bond
2.4. A discount bond (also called a zero-coupon
bond) is bought
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2.1 Simple loan
A simple loan, in which the lender
provides the borrower with an amount of
funds, which must be repaid to the lender
at the maturity date along with an
additional payment for the interest.
Ex: Making today’s value of the loan
($100) equal to the present value of the
$110 payment in a year. Calculate YTM!

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2.2 Fixed-Payment Loan
A fixed-payment loan (which is also
called a fully amortized loan) in which
the lender provides the borrower with an
amount of funds, which must be repaid by
making the same payment every period
(such as a month), consisting of part of the
principal and interest for a set number of
years.
Ex: The loan is $1,000 and the yearly
payment is $126 for the next 25 years.
Calculate YTM! 12
2.3 Coupon Bond
A coupon bond pays the owner of the bond a fixed
interest payment (coupon payment) every year until
the maturity date, when a specified final amount (face
value or par value) is repaid.
Ex: A bond with $1,000-face-value and a 10% coupon
rate. Price of bond is $800. Calculate YTM!

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2.4 Discount bond
A discount bond (also called a zero-
coupon bond) is bought at a price below
its face value (at a discount), and the face
value is repaid at the maturity date.
Ex: Treasury bill, which pays off a face
value of $1,000 in one year’s time. If the
current purchase price of this bill is $900,
calculateYTM!

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3. The current yield and the yield
on a discount basis – less
accurate measures of interest
rates
3.1. The current yield
3.2. The yield on a discount basis

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3.1. The current yield
Definition:
 An approximation of the yield to maturity
 On coupon bonds
𝐶
Formula: 𝑖𝑐 =
𝑃
Where:
𝑖𝑐 : Current yield
C: Yearly coupon payment
P: Price of the coupon bond
Characteristics:
 The current yield to be a rather close approximation of
the yield to maturity for a long-term coupon bond.
 when the bond price equals the par value of the bond, the
yield to maturity is equal to the coupon 16 rate.
3.2. The yield on a discount basis
Definition:
 An approximation of the yield to maturity
 On discount bonds
𝑭−𝑷 𝟑𝟔𝟎
Formula: 𝒊𝒅𝒃 = 𝑭
× 𝑫𝒂𝒚𝒔 𝒕𝒐 𝒎𝒂𝒕𝒖𝒓𝒊𝒕𝒚
Where:
𝑖𝑑𝑏 : The yield on a discount basis
F: Face value of the discount bond
P: Price of the coupon bond
Characteristics:
 The current yield to be a rather close approximation of the
yield to maturity for a long-term coupon bond.
 when the discount bond price equals the par value of the bond,
the yield to maturity is equal to the coupon rate.
EX: 17
4. The rate of return (RET)
Definition:
RET is the profit earned from selling
bonds.
Formula:
𝐶 + 𝑃𝑡+1 − 𝑃𝑡 𝐶 𝑃𝑡+1 − 𝑃𝑡
𝑅𝐸𝑇 = = +
𝑃𝑡 𝑃𝑡 𝑃𝑡
= 𝑖𝑐 + 𝑔

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 Questions
1. You have just won $20 million in the state lottery, which
promises to pay you $5 million (tax free) every year for the
next 4 years. Have you really won $20 million?
2. If the interest rate is 10%, what is the present value of a
security that pays you $1,100 next year, $1,210 the year
after, and $1,331 the year after that?
3. If the security in Problem 2 sold for $3,500, is the yield to
maturity greater or less than 10%? Why?
4. Write down the formula that is used to calculate the yield
to maturity on a 20-year 10% coupon bond with $1,000
face value that sells for $2,000.
5. What is the yield to maturity on a $1,000-face-value
discount bond maturing in one year that sells for $800?
6. What is the yield to maturity on a simple loan for $1
million that requires a repayment of $2 million in five
years’ time?

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7. To pay for college, you have just taken out a $1,000
government loan that makes you pay $126 per year for 25
years. However, you don’t have to start making these
payments until you graduate from college two years from
now. Why is the yield to maturity necessarily less than
12%, the yield to maturity on a normal $1,000 fixed-
payment loan in which you pay $126 per year for 25
years?
8. Which $1,000 bond has the higher yield to maturity, a
20-year bond selling for $800 with a current yield of 15%
or a one-year bond selling for $800 with a current yield of
5%?
9. You are offered two bonds, a one-year U.S. Treasury
bond with a yield to maturity of 9% and a one-year U.S.
Treasury bill with a yield on a discount basis of 8.9%.
Which would you rather own? 20
10. If there is a decline in interest rates, which would
you rather be holding, long-term bonds or short-term
bonds? Why? Which type of bond has the greater
interest-rate risk?
11. Interest rates were lower in the mid-1980s than
they were in the late 1970s, yet many economists have
commented that real interest rates were actually much
higher in the mid-1980s than in the late 1970s. Does
this make sense? Do you think that these economists
are right?

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Thank you for your attention!
MSc. Nguyen Khanh Tin
Email: [email protected]

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