Solution Chapter 3 What Do Interest Rates Mean and What Is Their Role in Valuation?

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Part 2
Fundamentals of Financial Markets

Chapter 3
What Do Interest Rates Mean and What is Their Role in Valuation? Measuring Interest Rates Present Value Four types of Credit Market Instruments Yield to Maturity Global Box: Negative T-Bill Rates? Japan Shows the Way The Distinction Between Real and Nominal Interest Rates The Distinction Between Interest Rates and Returns Mini-Case Box: With TIPS, Real Interest Rates Have Become Observable in the United States Maturity and the Volatility of Bond Returns: Interest-Rate Risk Mini-Case Box: Helping Investors to Select Desired Interest-Rate Risk Reinvestment Risk Summary The Practicing Manager: Calculating Duration to Measure Interest-Rate Risk Calculating Duration Duration and Interest-Rate Risk

T Overview and Teaching Tips
In my years of teaching financial markets and institutions, I have found that students have trouble with what I consider to be easy material because they do not understand what an interest rate is—that it is negatively associated with the price of a bond, that it differs from the return on a bond, and that there is an important distinction between real and nominal interest rates. This chapter spends more time on these issues than does any other competing textbook. My experience has been that giving this material so much attention is well rewarded. After putting more emphasis on this material in my financial markets and institutions course, I witnessed a dramatic improvement in students’ understanding of portfolio choice and asset and liability management in financial institutions. An innovative feature of the book that first appears in this chapter is the “Study Guide,” which provides helpful hints to the student, making it easier for him or her to master the material. This section tells the students the key concept needed to master the content and suggests ways in which they can more easily grasp the concept and put it into practice. Another innovative feature of the textbook is the set of over twenty special applications called, “The Practicing Manager.” These applications introduce students to real-world problems that managers of financial institutions have to solve and make the course both more relevant and exciting to students. They are not meant to fully prepare students for jobs in financial institutions—it is up to more specialized courses such as bank or financial institutions management to do this—but these applications teach them some of the special analytical tools that they will need when they enter the business world.

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Part 2

Fundamentals of Financial Markets

This chapter contains the Practicing Manager application on “Calculating Duration to Measure InterestRate Risk.” The application shows how to quantify interest-rate risk using the duration concept and is a basic tool for managers of financial institutions. For those instructors who do not want a managerial emphasis in their financial markets and institutions course, this and other Practicing Manager applications can be skipped without loss of continuity.

T Answers to End-of-Chapter Questions
1. 2. 3. 4. $2000 = $100/(1 + i) + $100/(1 + i) + . . . + $100/(1 + i) + $1000/(1 + i) . 2 20 20

You would rather be holding long-term bonds because their price would increase more than the price of the short-term bonds, giving them a higher return. No. If interest rates rise sharply in the future, long-term bonds may suffer such a sharp fall in price that their return might be quite low, possibly even negative. People are more likely to buy houses because the real interest rate when purchasing a house has fallen from 3 percent (=5 percent –2 percent) to 1 percent (=10 percent –9 percent). The real cost of financing the house is thus lower, even though mortgage rates have risen. (If the tax deductibility of interest payments is allowed for, then it becomes even more likely that people will buy houses.)

T Quantitative Problem
1. Calculate the present value of $1,000...
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