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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 l.jpg

Money & Banking

Week 4

Debt Instruments & Interest Rates


Draw cash flow diagrams for the four types of credit instruments l.jpg
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



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Semi annual coupon on $1 mil of face value? instruments.

$66,250.00

Number of coupons remaining?

M06 … M15 19

Asked price of $1 mil of face value?

$1,430,625


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Pricing a coupon bond instruments.

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)

  • Add two parts together.


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Yield to Maturity instruments.

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


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Relationship Between Price instruments.and Yield to Maturity

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Calculate the yield to maturity on a consol that pays 100 a year and is priced at 2 500 l.jpg
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:


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Approximation for YTM: Current Yield year and is priced at $2,500.


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Fisher Equation year and is priced at $2,500.

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


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TIPS (Treasury Inflation Protection Securities) year and is priced at $2,500.

  • 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.


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U.S. Real and Nominal Interest Rates year and is priced at $2,500.


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Money Market Instruments year and is priced at $2,500.

  • 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


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Chapter Six year and is priced at $2,500.

Interest Rates:

  • Risk Structure

  • Term Structure


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Risk Structure of Interest Rates year and is priced at $2,500.

Bonds of same maturity will have different yields because of three factors:

  • Default risk

  • Liquidity

  • Tax considerations


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Risk Structure of Long-Term Bonds year and is priced at $2,500.in the United States


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Rating Bonds year and is priced at $2,500.


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Bond Ratings year and is priced at $2,500.


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Highest Rated Corporate Bonds year and is priced at $2,500.

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


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History of Junk Bonds year and is priced at $2,500.

  • Fallen Angels

  • Michael Milken


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yield curve last year at this time year and is priced at $2,500.


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yield curve last week year and is priced at $2,500.


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Theories of Term Structure year and is priced at $2,500.(shape of yield curve)

  • Expectations Hypothesis

  • Segmented Markets

  • Liquidity Premium (preferred habitat)



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


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