ear/apr time value of money. returns and compounding returns are often stated in annual terms...
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![Page 1: EAR/APR Time Value of Money. Returns and Compounding Returns are often stated in annual terms Interest is paid (accrues) within the year Example: Savings](https://reader035.vdocument.in/reader035/viewer/2022062318/55176e585503463e368b4b69/html5/thumbnails/1.jpg)
EAR/APRTime Value of Money
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Returns and Compounding
Returns are often stated in annual terms Interest is paid (accrues) within the year
Example: Savings accounts: interest accrues every month
How do Banks report “interest rates”? Unfortunately, they do not report annual growth rates
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APR
Banks report “Annual Percentage Yields” or “APRs”
Let N be the number of times a bank pays interest per year Example: if the bank pays interest annually N=12
Let rm be the effective monthly interest rate
Then the APR is simply rm*12
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APR
Example: A bank pays 5% semi-annually. What is APR?
APR=0.05*2 = 10%
What is the annual growth rate on the account? 1.052 -1=10.25%
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Effective Annual Rates
The effective annual rate or EAR, is simply the annual growth rate. For the example above, the effective
annual growth rate is 10.25%
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NrNAPR /
1)1( Nr
1)1( /1 NEAR
You can’t move directly fromEAR to APR or vice-versawithout finding r first.
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Effective Annual Rate Effective Annual Rate: The effective return on
an investment assuming all interest payments are reinvested at the same rate.
Example: Account pays 1% per month In 1 year, a $1 investment has grown to
Effective annual return is 13%
13.101.11 12
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Effective Annual Rates
What is EAR on UCCU savings account if APR is 12%? Assume interest accrues monthly.
%67.12
1267.112
12.11
12
EAR
EAR
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Effective Monthly Rates
The EAR is 15% What is effective 1-month rate? What
is the APR? Assume interest accrues monthly.
04.1412*17.1
%17.1
115.1
115.112/1
12
APR
EMR
EMR
EMR
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APR and EAR
APRs are always defined for 1 year
But we could have Effective 6 month rates Effective 3 year rates Effective 2-month rates
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Effective rates
If the effective annual rate is 12%, what is the effective 6-month rate? 3 year rate?
We just need to find the 6-month and 3-month growth rates.
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Effective Rates
Effective 6-month rate is given by
Effective 3-year rates is given by
%8.5
)1()12.1(
6
26
m
m
r
r
%49.40
)1()12.1(
3
33
y
y
r
r
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Pricing Bonds Zero-Coupon Bond
Assume an investment of similar risk pays 8% per year.
Face Value of Bond =1000 Bond Matures in 10 years
Price? Just find present value
19.46308.1/1000 10 Price
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Pricing Bonds
How about a coupon paying bond? Assume an investment of similar risk pays 8%
per year. Face Value of Bond =1000 Bond Matures in 3 years Bond pays a coupon of 50 at end of each year
(5% of face value)
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Pricing Bonds
Cash flows from bond 50 at end of year 1 50 at end of year 2 1050 at end of year 3
We can “split up” each of these cash flows and think of each of them as a separate zero-coupon bond.
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Pricing Bonds
Cash Flow 1: 50 at end of year 1 Price of this cash flow: 50/1.08=46.30
Cash flow 2: 50 at end of year 2 Price of this cash flow: 50/1.082 = 42.87
Cash flow at end of year 3 Price of this cash flow: 1050/1.083=900.21
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Pricing Bonds
The price of this bond is just the sum of the PV’s of each of the pieces
Price= 46.3 + 42.87 + 900.21=989.38
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Pricing Semi-Annual Bonds
Most Bonds pay coupons every six months Example:
Face value: 1000 Coupon: 30 every six months Matures: 1.5 years Investment of similar risk: pays 2% every six
months
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Pricing Semi-Annual Bonds
Cash flows 30 at end of first 6 months 30 at end of first year 1030 when bond matures
PV of cash flows 30/1.02 = 29.41 30/1.022 = 28.84 1030/1.023 = 970.59
Price of bond = 1028.84
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Yield-to-Maturity Suppose we know bond price, and cash flows.
Yield-to-Maturity comes from the interest rate that makes the price equal to the sum of the PV of all cash flows.
Notation: y: the rate that makes the price equal to the sum of
discounted cash flows YTM: yield to maturity
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Yield-to-Maturity
Example: Zero coupon bond Face value=1000 Price=600 Matures in 5 years
For a zero-coupon bond, YTM=y
%76.101600
1000
600
1000)1(
)1(
1000600
5/15
5
yy
y
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Yield-to-Maturity
Economic Interpretation: For a zero-coupon bond, YTM is the
effective annual return. From example above:
5-year return: 1000/600-1=0.67
%76.10167.1
67.1)1(
5/1
5
y
y
y
r
r
r
return annual effective
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Yield-to-Maturity
Coupon paying bonds Example:
Bond matures in 3 years Pays 4% coupon annually FV=1000 Price=$987
32 )1(
1040
)1(
40
1
40987
yyy
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Yield-to-Maturity
In this case, it is too difficult to solve for y algebraically
Use Financial Calculator N=3 pmt=40 Price=-987 FV=1000 Rate=?
For an annual coupon paying bond, YTM = y
%47.4y
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Yield-to-Maturity
Economic Interpretation For annual coupon paying bonds, YTM is
the effective annual return assuming all coupons are reinvested at the same rate.
From previous example Suppose we invest all coupons at 4.473% What do we get in 3 years?
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Yield-to-Maturity
Future value of first coupon: 40(1.0473)2=43.66
Future value of second coupon 40(1.0473)=41.79
Future value of last cash flow 1040
Total future value =43.66+ 41.79+1040 = 1125.45
Total 3-yr return = 1125.45/987-1=14.027%
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Yield-to-Maturity
Effective Annual Return:
yr
r
r
y
y
y
%47.4114027.1
14027.1)1(
3/1
3
return annual effective
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Yield-to-Maturity
Semi-Annual Coupon paying bonds Example:
Bond matures in 1 year Pays $20 coupon semi-annually FV=1000 Price=$990
2)1(
1020
1
20990
yy
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Yield-to-Maturity
Again, in this case, it is too difficult to solve for y algebraically
Use Financial Calculator N=2 pmt=20 Price=-990 FV=1000 Rate=? %519.2y
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Yield-to-Maturity
Economic Interpretation For semiannual coupon paying bonds, y is
the effective six-month return assuming all coupons are reinvested at the same rate.
From previous example Suppose we invest all coupons at 2.519% What do we get in 1 year?
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Yield-to-Maturity
Future value of first coupon: 20(1.02519)=20.50
Future value of last cashflow 1020
Total future value =20.50 + 1020 = 1040.50
Total 1-yr return = 1040.50/990-1=5.10%
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Yield-to-Maturity
Effective six-month return
yr
r
r
m
m
m
%519.210510.1
0510.1)1(
2/16
6
26
return month-six effective
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Yield-to-Maturity
For semi-annual bonds, the YTM is always quoted as an APR:
For semi-annual bonds, the coupon paid is always quoted as a percentage of face value times two.
2yYTM
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Example
Semi annual bond Matures in 2 years Coupon rate=8% Face=1000 Price=955
What is y? What is YTM?
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Example
Finding y: N=4 pmt =40 FV=1000 PV=-955 Rate?
%55.10
%277.5
YTM
y
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Example
Find bond price Semi annual bond YTM=6% Coupon rate=9% Matures 3 years FV=1000
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Example
Finding Price: N=6 FV=1000 r = 3% pmt= 45 Price=?
26.1081Price
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Example
Find Bond Price Annual bond YTM=6% Coupon rate = 9% Matures 3 years FV=1000
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Example
Finding Price: N=3 (this is an annual bond) FV=1000 r = 6% pmt= 90 Price=?
19.1080Price