FIN 4520 - INTEREST RATES
Three kinds of interest rates:
Yield to maturity
Current yield
Discount yield
Yield to maturity:
Defined as the interest rate that equates present value with market price.
The most accurate measure of interest rates.
Greater than a bond's coupon rate if the bond price is less than face value.
Current yield:
Defined as annual coupon payment divided by market price.
Easy to calculate.
Worse measure for short-term bonds than for long-term bonds.
Discount yield:
Defined as [(face value - price) / face value] x [360 / days to maturity].
Understates the yield to maturity, especially for long-term bonds.
Present value:
PV = FV/(1 + i)T for a discount (zero-coupon) bond maturing in T years.
PV = CP/(1 + i) + CP/(1 + i)2 + ... + CP/(1 + i)T + FV/(1 + i)T for a coupon bond.
Total return:
Yield + capital gains or losses.
Used to evaluate investment alternatives.
Real versus nominal interest rates:
inom = ireal + expected inflation rate.
Used to evaluate borrowing and lending opportunities.