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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 Bond Page of the Newspaper

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## 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

### Bond Page of the Newspaper

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)

### 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