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Ebook Capital investment & financing - A practical guide to financial evaluation: Part 2

(BQ) Part 2 book “Capital investment & financing - A practical guide to financial evaluation” has contents: Straight bond pricing, forward pricing, basic option pricing, option pricing applications, interest rate and currency options. | B2 STRAIGHT BOND PRICING INTRODUCTION TO INTEREST RATES Simple and Compound Interest Simple Rates If interest is received only once at the end of a deposit term (on maturity), there would be no opportunity to earn interest on any interest received during that term (interest on interest). For a one year deposit, the actual, ‘Effective’ rate of interest earned would be the quoted, ‘Simple’ (or ‘Nominal’) rate per annum. Example B2.1 Simple interest, paid annually £100m placed on deposit at 5.0% p.a. for 1 year (no interim interest) Today Principal Interest received on Principal Future Value Quoted, nominal rate Actual return 1 year 365 days (100.00) 100.00 5.00 105.00 5.00% per year = { Future Value (£105.00m) / Principal (£100.00m) }^(365/365) - 1 = 5.00% for 365 days A quoted simple annual rate assumes interest is paid once on maturity after 1 year. The interest paid on a period shorter than one year is calculated as follows: Simple Interest and Future Value (1 year) where Interest = Future Value = P + Interest = P x 1 + r x P P x r x B2.1 t Y t Y Principal repaid in t days r Simple (‘Nominal’) interest rate (%) for 1 year Y Year in days (some securities / countries use 360 days – see B2.7 – 365 will be used in this Appendix) t Number of days after which interest is received (see B2.7 for 30 day month restriction for some securities) 205 206 APPENDIX B2 - STRAIGHT BOND PRICING If interest is paid during the year, the actual interest earned over the 1 year would be higher than the Simple rate due to the compounding effect of receiving interest on interest (the equivalent Effective rate earned over the whole period would be higher than the Simple rate). Example B2.2 Simple interest, paid semi-annually £100m placed on deposit at 5.0% p.a. for 1 year (interest paid half yearly). Note: it is assumed that interest is paid exactly half way through the year (182.5 days) – this would not be the case in practice, but an equal interest .