UNIVERSITI TUNKU ABDUL RAHMAN (UTAR)

Financial Markets and Regulations (UKFB 3053)

Tutorial 3: Determination of interest rate
Questions and answer:

1. The one-year real rate of interest is currently estimated to be 4 percent. The current annual
rate of inflation is 6 percent, and market forecasts expect the annual rate of inflation to be 8
percent. What is the current one-year nominal rate of interest?
The approximate one-year nominal interest rate i = r + e = 4% + 8% = 12%. The exact oneyear nominal interest rate i = (1 + r) (1 + e) - 1 = (1.04) (1.08) - 1 = 12.32.

2. The following annual inflation rates have been forecast for the next 5 years:
Year 1
Year 2
Year 3
Year 4
Year 5

3%
4%
5%
5%
4%

Use the average annual inflation rate and a 3% real rate to calculate the appropriate contract
rate for a one-year and a five-year loan. How would your contract rates change if the year 1
inflation forecast increases to 5%? Discuss the difference in the impact on the contract rates
from the change in inflation.
A lender would want to be compensated for both the real rate and any expected loss of
purchasing power. The sum of the real rate 3% plus the expected rate of inflation, 3%, would
be roughly 6% and accurately, (1.03) (1.03) -1 = 6.09%. The five-year loan rate would be the
sum of the real rate plus the average inflation rate expected or:
The sum of the real interest rate, 3%, plus the geometric average expected inflation rate of
4.197% is (1.03) (1.04197) - 1 = 7.32%. If the one-year expected inflation rate were 5%, the
geometric average expected rate of inflation would be 4.6% and the contract rate would be
(1.03) (1.046) -1 = 7.73%. Nominal rates include the real rate plus the expected inflation rate
3. Write the equation which expresses the present value (or price) of a bond that has an 8%
coupon (annual payments), a 4-year maturity, and a principal of $1,000, if yields on
similar securities are 10%.
P = 80/(1.10)1 + 80/(1.10)2 + 80/(1.10)3 + 1,080/(1.10)4 = $936,60
4. Find the price of a corporate bond maturing in 5 years that has a 5% coupon (annual
payments), a $1,000 face value, and is rated Aa. A local newspaper's financial section reports
that the yields on 5 year bonds are: Aaa = 6%, Aa = 7%, and A = 8%.
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P = 50/(1.07)1 + 50/(1.07)2 + 50/(1.07)3 + 50/(1.07)4 + 1,050/(1.07)5 = $918

5. Explain why yields and prices of debt-instruments are inversely related.
The coupon and principal amount are fixed at time of issue. The only way to adjust the yield
on the bond to the current market interest rate is to adjust the price
6. Carol Chastain purchases a one-year discount bond with a face value of $1,000 for $862.07.
What is the yield of the bond?
$862.07 = $1,000/(1 + i) (1 + i) = $1,000/$862.07 = 1.16 i = 0.16 or 16%.

Additional questions:
1.

Define interest rate risk. Explain the two types of interest rate risk. How can an investor with a
given holding period use duration to reduce interest rate risk?

Interest rate risk is the potential variability in the realized yield relative to the expected
yield (yield-to-maturity) because of changes in market interest rates. Two offsetting risks
- price risk and reinvestment risk - create this expected/realized yield differential. Price
risk is the variability in the realized yield caused by changing interest rates if the bond is
sold before maturity (capital gains/losses), while reinvestment risk is the variability in the
realized yield caused by changing interest rates when coupons are reinvestment.
Selecting an investment with duration equal to the investor's holding period locks in the
yield-to-maturity (eliminates interest rate risk), the impact of varying market interest rates
on the investor's yield.
2.

If actual inflation turns out to be less than expected inflation, would you rather have been a
borrower or a lender? Why?

You would rather have been lender. When inflation is less than expected, the nominal
interest rate over compensates lenders for inflation. Thus, lower-than-anticipated inflation
transfers wealth from borrowers to lenders
3.

Sam has just lent Mary $1000 for 1 year 6%. Sam and Mary expect inflation to be 3% over the
next year. If inflation turns out to have been only 2%, what is the impact upon Sam and Mary?
Sam benefits at Marys expense. She paid 6% on a loan that should only have yield 5% if
inflation had been correctly forecast.

4.

Explain why interest rates move with changes in inflation.

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Interest rates change in response to changes in inflation because inflation is a primary

component of nominal interest rates. Short-term rates respond more to monthly changes
in inflation than long-term rates because the inflation component of a contract rate is for
the rate of inflation expected across the life of the contract and accordingly, a monthly
change has a larger effect on expectations across a short-term contract than a long-term
contract.
5.
Consider a bond with a 7% annual coupon and a face value of $1,000.
Complete the following
table:
Years to Maturity
Discount Rate
Current Price
3
5
3
7
6
7
9
7
9
9
What relationship do you observe between yield to maturity and the current
market value?

When yield to maturity is above the coupon rate, the bonds current price is below its face
value. The opposite holds true when yield to maturity is below the coupon rate. For a
given maturity, the bonds current price falls as yield to maturity rises. For a given yield
to maturity, a bonds value rises as its maturity increases. When yield to maturity equals
the coupon rate, a bonds current price equals its face value regardless of years to
maturity

6.
A 10-year, 7% coupon bond with a face value of $1,000 is currently selling for
$871.65. Compute
your rate of return if you sell the bond next year for $880.10.
C Pt 1 Pt 70 880.10 871.65
R

0.09, or 9%.
Pt
871.65

7.
Calculate the duration of a $1,000 6% coupon bond with three years to
maturity. Assume that all
market interest rates are 7%.
Year
Payments
PV of Payments
Time Weighted PV of Payments
Time Weighted PV of Payments
Divided by Price

1
60.00
56.07
56.07
0.06

2
60.00
52.41
104.81
0.11

3
1060.00
865.28
2595.83
2.67

Sum
973.76
2.83

This bond has a duration of 2.83 years. Note that the current price of the bond is $973.76,
which is the sum of the individual PV of payments.

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8.
Consider the bond in the previous question. Calculate the expected price
change if interest rates drop to 6.75% using the duration approximation. Calculate
the actual price change using
discounted cash
flow.
Usingthedurationapproximation,thepricechangewouldbe:

P DUR

i
0.0025
P 2.83
973.76 6.44.
1 i
1.07

Thenewpricewouldbe$980.20.Usingadiscountedcashflowapproach,thepriceis
980.23only$.03different.
Year
Payments
PVofpayments

9.

1
60.00
56.21

2
60.00
52.65

3
1060.00
871.37

Sum
980.23

Calculate the duration of a $1,000 4-year bond with an 8% coupon (annual payments)
that is currently selling at par.
Duration (D) = Summation of Time-Weighted PVs of CFs/Price
D = [80 (1)/(1.08)1 + 80 (2)/(1.08)2 + 1,080 (3)/(1.08)3]/1,000 = $3,577.10/$1,000 = 3.577
years
Early cash flows (high reinvestment risk) will be weighted at a low value, thus lowering the
duration. If the bond is held 3.577 years, the investor will earn the yield-to-maturity of 8%.
If bond is held to maturity, price risk is eliminated, but the realized yield will be higher/lower
than 8%, depending upon reinvestment rates.

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