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# Financial Markets & Institutions Ch02

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• 1. 2- McGraw-Hill/Irwin Chapter Two Determination of Interest Rates
• 2. Interest Rate Fundamentals
• Nominal interest rates: the interest rates actually observed in financial markets
• affect the values (prices) of securities traded in money and capital markets
• affect the relationships between spot and forward FX rates
2- McGraw-Hill/Irwin
• 3. Time Value of Money and Interest Rates
• The time value of money is based on the notion that a dollar received today is worth more than a dollar received at some future date
• Simple interest: interest earned on an investment is not reinvested
• Compound interest: interest earned on an investment is reinvested
2- McGraw-Hill/Irwin
• 4. Present Value of a Lump Sum
• Discount future payments using current interest rates to find the present value (PV)
• PV = FV t [1/(1 + r )] t = FV t ( PVIF r,t )
• PV = present value of cash flow
• FV t = future value of cash flow (lump sum) received in t periods
• r = interest rate per period
• t = number of years in investment horizon
• PVIF r,t = present value interest factor of a lump sum
2- McGraw-Hill/Irwin
• 5. Future Value of a Lump Sum
• The future value (FV) of a lump sum received at the beginning of an investment horizon
• FV t = PV (1 + r ) t = PV ( FVIF r,t )
• FVIF r,t = future value interest factor of a lump sum
2- McGraw-Hill/Irwin
• 6. Relation between Interest Rates and Present and Future Values 2- McGraw-Hill/Irwin Present Value (PV) Interest Rate Future Value (FV) Interest Rate
• 7. Present Value of an Annuity
• The present value of a finite series of equal cash flows received on the last day of equal intervals throughout the investment horizon
• PMT = periodic annuity payment
• PVIFA r,t = present value interest factor of an annuity
2- McGraw-Hill/Irwin
• 8. Future Value of an Annuity
• The future value of a finite series of equal cash flows received on the last day of equal intervals throughout the investment horizon
• FVIFA r,t = future value interest factor of an annuity
2- McGraw-Hill/Irwin
• 9. Effective Annual Return
• Effective or equivalent annual return ( EAR ) is the return earned or paid over a 12-month period taking compounding into account
• EAR = (1 + r ) c – 1
• c = the number of compounding periods per year
2- McGraw-Hill/Irwin
• 10. Financial Calculators
• Setting up a financial calculator
• Number of digits shown after decimal point
• Number of compounding periods per year
• Key inputs/outputs (solve for one of five)
• N = number of compounding periods
• I/Y = annual interest rate
• PV = present value (i.e., current price)
• PMT = a constant payment every period
• FV = future value (i.e., future price)
2- McGraw-Hill/Irwin
• 11. Loanable Funds Theory
• Loanable funds theory explains interest rates and interest rate movements
• Views level of interest rates in financial markets as a result of the supply and demand for loanable funds
• Domestic and foreign households, businesses, and governments all supply and demand loanable funds
2- McGraw-Hill/Irwin
• 12. Supply and Demand of Loanable Funds 2- McGraw-Hill/Irwin Interest Rate Quantity of Loanable Funds Supplied and Demanded Demand Supply
• 13. Shifts in Supply and Demand Curves change Equilibrium Interest Rates 2- McGraw-Hill/Irwin Increased supply of loanable funds Quantity of Funds Supplied Interest Rate DD SS SS* E E* Q* i* Q** i** Increased demand for loanable funds Quantity of Funds Demanded DD DD* SS E E* i* i** Q* Q** Interest Rate
• 14. Determinants of Interest Rates for Individual Securities
• i j * = f(IP, RIR, DRP j , LRP j , SCP j , MP j )
• Inflation ( IP )
• IP = [( CPI t+1 ) – ( CPI t )]/( CPI t ) x (100/1)
• Real Interest Rate ( RIR ) and the Fisher effect
• RIR = i – Expected ( IP )
2- McGraw-Hill/Irwin
• 15. Determinants of Interest Rates for Individual Securities (cont’d)
• Default Risk Premium ( DRP )
• DRP j = i jt – i Tt
• i jt = interest rate on security j at time t
• i Tt = interest rate on similar maturity U.S. Treasury security at time t
• Liquidity Risk ( LRP )
• Special Provisions ( SCP )
• Term to Maturity ( MP )
2- McGraw-Hill/Irwin
• 16. Term Structure of Interest Rates: the Yield Curve 2- McGraw-Hill/Irwin Yield to Maturity Time to Maturity (a) (b) (c) (a) Upward sloping (b) Inverted or downward sloping (c) Flat
• 17. Unbiased Expectations Theory
• Long-term interest rates are geometric averages of current and expected future short-term interest rates
• 1 R N = actual N -period rate today
• N = term to maturity, N = 1, 2, …, 4, …
• 1 R 1 = actual current one-year rate today
• E( i r 1 ) = expected one-year rates for years, i = 1 to N
2- McGraw-Hill/Irwin