FIN 1302

Basic Finance
Interest Rates (part 01)

Ms.Udeshika Pathirana
Department of Finance
Faculty of Management and Finance

1
 Learning Outcomes
At the end of this lesson students should be able
to;
- Explain the difference between Yield and Yield to
Maturity
- Identify types of bonds based on Yield
- Calculate the Yield and Yield to Maturity

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 What is Yield?
• Yield, describes the annual return on an investment and
could be in the forms of interests, dividends or any other
form of a return.
• The yield on a bond is based on both the purchase price
of the bond and the interest, or coupon, payments
received.
• Although a bond’s coupon interest rate is usually fixed,
the price of the bond fluctuates continuously in response
to changes in interest rates, as well as the supply and
demand, time to maturity, and credit quality of that
particular bond.
• Because yield is a function of price, changes in price cause
bond yields to move in the opposite direction.
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Bond Yield can be described as a function of Price
which can be categorized as follows;
1. Premium bond
When a bond's market price is above par and its
current yield is lower than its coupon rate.
2. Discount Bond
When a bond sells for less than par and its current
yield is higher than the coupon rate.
3. Par value Bond
When a bond sells for its exact par value, the current
yield and the coupon rate are exactly the same.

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There are two ways of looking at bond yields;
Current Yield
• This is the annual return earned on the price paid
for a bond.

Current Yield = Bond’s Annual Coupon Interest Payments

Bond’s Purchase Price
Example:
• If an investor bought a bond with a coupon rate of
6% at par, and full face value of Rs.1000, the
interest payment over a year would be Rs.60. That
would yield a current yield of 6%. (60/1000)
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• When a bond is purchased at full face value,
the current yield is the same as the coupon
rate. However, if the same bond were
purchased at less than face value, or at a
discount price, of Rs.900., the current yield
would be higher at 6.6% (60/900). Likewise, if
the same bond were purchased at more than
face value, or at a premium price of Rs.1100,
the current yield would be lower at 5.4%
(60/1100).

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Yield to Maturity
• This reflects the total return an investor receives by
holding the bond until it matures. A bond’s yield to
maturity reflects all of the interest payments from
the time of purchase until maturity, including interest
on interest. Equally important, it also includes any
appreciation or depreciation in the price of the bond.
• Because the YTM reflects the total return on a bond
from purchase to maturity, it is generally more
meaningful for investors than current yield.
• By examining YTM, investors can compare bonds
with varying characteristics, such as different
maturities, coupon rates or credit quality.
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Yield to Maturity

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Yield to Maturity
• Can be calculated when the current price and
the cash flows are known.
• Suppose a bond traded at Rs. 883.4 at the
market which has the face value of Rs. 1000
paying 6% per annum per 5 years.
– Calculate YTM using interpolation.

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 What is the Yield Curve?
• The Yield curve is a line graph that plots the
relationship between yields to maturity and time to
maturity for bonds of the same asset class and credit
quality. The plotted line begins with the spot interest
rate, which is the rate for the shortest maturity, and
extends out in time.
• A yield curve depicts yield differences, or yield
spreads, that are due solely to differences in
maturity. It therefore conveys the overall relationship
that prevails at a given time in the marketplace
between bond interest rates and maturities. This
relationship between yields and maturities is known
as the term structure of interest rates.
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 Yield to Maturity(%)

0
Term to Maturity

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 What determines the shape of the
Yield Curve?
Most economists agree that two major factors affect the
slope of the yield curve:
• Investors’ expectations for future interest rates:
Investors who are willing to lock their money now need
to be compensated for the anticipated rise in rates,
thus the higher interest rate on long-term investments.
• Certain “risk premiums” that investors require to hold
long-term bonds: Longer maturities entail greater risks
for the investor. Hence a risk premium is required by
the market because at longer durations there is more
uncertainty and a greater chance of shattering events
to have an impact on the investment.
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Three widely followed theories have evolved that
attempt to explain these factors in detail:

1. The Pure Expectations Theory

This holds that the slope of the yield curve reflects only
investor’s expectations for future short-term interest
rates. Much of the time, investors expect interest rates
to rise in the future, which accounts for the usual
upward slope of the yield curve.

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2. The Liquidity Preference Theory
This asserts that long term interest rates not only reflect
investor’s assumptions about future interest rates but
also include a premium for holding long-term bonds,
called the term premium or the liquidity premium.

The premium compensates investors for the added risk of

having their money tied up for a longer period, including
the greater price uncertainty. Because of the term
premium, long-term bond yields tend to be higher than
short-term yields, and the yield curve slopes upward.

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3. Segmented market theory
Assumes that the debt market is divided into several
segments based on the maturity of the debt. In each
segment the yield of the debt depend on the demand
and supply. The theory assumes that investor do not
shift from one maturity to another in their borrowings-
lending activities and therefore, the shift in the yield
are caused by changes in the demand and supply for
the bonds of different maturities.

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 Normal/Upward sloping/Steep Yield Curve

Upward

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• A sharply upward sloping, or steep yield curve,
has often preceded an economic upturn. The
assumption behind a steep yield curve is
interest rates will begin to rise significantly in
the future. Investors demand more yield as
maturity extends if they expect rapid
economic growth because of the associated
risks of higher inflation and higher interest
rates, which can both hurt bond returns.
• When inflation is rising, the CBSL will often
raise interest rates to fight inflation.
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Inverted / Downward sloping Yield curve

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• This curve can be a signal of recession. When
yields on short term bonds are higher than
those on long term bonds, it suggest that
investors expect interest rates to decline in the
future, usually in conjunction with a slowing
economy and lower inflation.

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Flat/Humped Yield Curve

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 Importance of Yield Curve

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 Additional Questions
1. Suppose you could buy a 91-day T-bill which has a
face value of Rs.100 at an asked price of Rs. 98.
Calculate the yield of the T-bill?

2. Explain different uses of yield curve?

Thank
You
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