Chapter 2 - Determination of interest rates. This chapter reviewed the determinants of nominal interest rates and their effects on security prices and values in domestic and foreign financial markets. It described the way funds flow through the financial system from lenders to borrowers and how the level of interest rates and its movements over time are determined. The chapter also introduced theories regarding the determination of the shape of the term structure of interest rates. | Chapter Two Determination of Interest Rates 2- McGraw-Hill/Irwin Interest Rate Fundamentals Nominal interest rates: the interest rates actually observed in financial markets affect the values (prices) of securities traded in money and capital markets affect the relationships between spot and forward FX rates 2- McGraw-Hill/Irwin Time Value of Money and Interest Rates The time value of money is based on the notion that a dollar received today is worth more than a dollar received at some future date Simple interest: interest earned on an investment is not reinvested Compound interest: interest earned on an investment is reinvested 2- McGraw-Hill/Irwin Present Value of a Lump Sum Discount future payments using current interest rates to find the present value (PV) PV = FVt[1/(1 + r)]t = FVt(PVIFr,t) PV = present value of cash flow FVt = future value of cash flow (lump sum) received in t periods r = interest rate per period t = number of years in investment horizon PVIFr,t = present value interest factor of a lump sum 2- McGraw-Hill/Irwin Future Value of a Lump Sum The future value (FV) of a lump sum received at the beginning of an investment horizon FVt = PV (1 + r)t = PV(FVIFr,t) FVIFr,t = future value interest factor of a lump sum 2- McGraw-Hill/Irwin Relation between Interest Rates and Present and Future Values Present Value (PV) Interest Rate Future Value (FV) Interest Rate 2- McGraw-Hill/Irwin Present Value of an Annuity The present value of a finite series of equal cash flows received on the last day of equal intervals throughout the investment horizon PMT = periodic annuity payment PVIFAr,t = present value interest factor of an annuity 2- McGraw-Hill/Irwin Future Value of an Annuity The future value of a finite series of equal cash flows received on the last day of equal intervals throughout the investment horizon FVIFAr,t = future value interest factor of an annuity 2- McGraw-Hill/Irwin Effective Annual Return Effective or . | Chapter Two Determination of Interest Rates 2- McGraw-Hill/Irwin Interest Rate Fundamentals Nominal interest rates: the interest rates actually observed in financial markets affect the values (prices) of securities traded in money and capital markets affect the relationships between spot and forward FX rates 2- McGraw-Hill/Irwin Time Value of Money and Interest Rates The time value of money is based on the notion that a dollar received today is worth more than a dollar received at some future date Simple interest: interest earned on an investment is not reinvested Compound interest: interest earned on an investment is reinvested 2- McGraw-Hill/Irwin Present Value of a Lump Sum Discount future payments using current interest rates to find the present value (PV) PV = FVt[1/(1 + r)]t = FVt(PVIFr,t) PV = present value of cash flow FVt = future value of cash flow (lump sum) received in t periods r = interest rate per period t = number of years in investment horizon PVIFr,t = .
