FIN 421 lecture 1 interest rates

unlike a coupon bond,

a discount bond does not make any interest payments; it just pays off the face value.

interest rates

are the most closely watched variables in the economy.

for bonds with maturity > holding period

as interest rate increase, price falls, implying capital loss.

debt instruments are evaluated against one another:

based on the amount of each cash flow and the timing of each cash flow.

A bond's future payments are called its A) cash flows. B) maturity values. C) discounted present values. D) yields to maturity.

cash flows

A frequently used approximation for the yield to maturity on a long-term bond is the A) coupon rate. B) current yield. C) cash flow interest rate. D) real interest rate.

current yield

bond yields are quoted using a variety of conventions

depending on both the type of issue and the market.

cash flows

different debt instruments have very different streams of cash payments to the holder.

A credit market instrument that pays the owner the face value of the security at the maturity date and nothing prior to then is called a A) simple loan. B) fixed-payment loan. C) coupon bond. D) discount bond.

discount bond

the process of calculating today's value of dollars received in the future, as we have done above is called:

discounting the future.

A loan that requires the borrower to make the same payment every period until the maturity date is called a : A) simple loan. B) fixed-payment loan. C) discount loan. D) same-payment loan. E) none of the above

fixed-payment loan.

longer the maturity

greater is price change associated with interest rate change. (that bonds with longer maturities have more volatile prices)

bonds with high intial interest rates can still:

have negative return if interest rate rises.

Yield to Maturity (YTM)

interest rate that equate today's value with present value of all future payments.

The riskiness of an asset's return that results from interest rate changes is called A) interest-rate risk. B) coupon-rate risk. C) reinvestment risk. D) yield-to-maturity risk.

interest-rate risk.

discount bond (also called a zero-coupon bond)

is brought at a price below its face value (at a discount) and the face value is repaid at the maturity date.

Dollars received in the future are worth ________ than dollars received today. The process of calculating what dollars received in the future are worth today is called ________. A) more; discounting B) less; discounting C) more; inflating D) less; inflating

less; discounting

A consol bond is a bond that A) pays interest annually and its face value at maturity. B) pays interest in perpetuity and never matures. C) pays no interest but pays its face value at maturity. D) rises in value as its yield to maturity rises.

pays interest in perpetuity and never matures.

coupon bond defintion

pays the owner of the bond a fixed interest payment (coupon payment) every year until the maturity date, when a specified final amount (face value or par value) is repaid.

The concept of ________ is based on the notion that a dollar paid to you in the future is less valuable to you than a dollar today. A) present value B) future value C) interest D) deflation

present value

The change in the bond's price relative to the initial purchase price is A) the current yield. B) coupon payment. C) yield to maturity. D) rate of capital gain.

rate of capital gain.

simple loan

require payment of one amount which equals the loan principal plus the interest.

note that a simple loan

requires the payment of interest and principal at maturity

note that a discount bond

requires the repayment of face value at maturity.

if holding period= maturity then,

return = YTM

the concept of present value (present discounted value)

that a dollar of cash flow paid to you one year from now is less valuable to you than a dollar paid to you today.

the term present value (PV)

the PV of a single cash flow or the sum of a sequence or group of cash flows

loan principal:

the amount of funds the lender provides to the borrower

interest payment

the cash amount that the borrower must pay the lender for the use of the loan principal.

maturity date

the date the loan must be repaid; the loan term is from initiation to maturity date

when interest rate rise,

the duration of a coupon bond fall. (Intuition: When the interest rate is higher, the cash payments in the future are discounted more heavily and become less important in present‐value terms relative to the total present value of all the payments. The relative weight for these cash payments drops, and so the effective maturity of the bond falls.)

duration is addictive:

the duration of a portfolio of securities is the weighted-average of the duration's of the individual securities, with the weights equaling the proportion of the portfolio invested in each security.

when the maturity of a bond lengthens,

the duration rises as well.

par value

the face value of a bond.

The return on a bond is equal to the yield to maturity when A) the holding period is longer than the maturity of the bond. B) the maturity of the bond is longer than the holding period. C) the holding period and the maturity of the bond are identical. D) none of the above.

the holding period and the maturity of the bond are identical.

Simple interest rate:

the interest payment divided by the loan principal.

the higher the coupon rate on the bond

the shorter duration of the bond. (The explanation is that a higher coupon rate means that a relatively greater amount of the cash payments is made earlier in the life of the bond, and so the effective maturity of the bond must fall.)

for simple loans:

the simple interest rate equals the yield to maturity. the same term i is used to denote both the yield to maturity and the simple interest rate.

relationship between price and YTM

the value of the bond (price) and the YTM are negatively related. If the interest rate (i) increases, YTM increases, the PV of any given cash flow is lower... the price of the bond must be lower.

present value analysis

where the analysis of the amount and timing of a debt instrument's cash flows lead to its YTM or interest rate.

fixed-payment loans

where the loan principal and interest are repaid in several payments, often monthly, in equal dollar amounts over the term.

Financial economists consider the ________ to be the most accurate measure of interest rates. A) simple interest rate B) discount rate C) yield to maturity D) real interest rate

yield to maturity

The interest rate that equates the present value of the cash flow received from a debt instrument with its market price today is the A) simple interest rate. B) discount rate. C) yield to maturity. D) real interest rate.

yield to maturity

(I) A discount bond requires the borrower to repay the principal at the maturity date plus an interest payment. (II) A coupon bond pays the lender a fixed interest payment every year until the maturity date, when a specified final amount (face or par value) is repaid. A) (I) is true, (II) false. B) (I) is false, (II) true. C) Both are true. D) Both are false.

(I) is false, (II) true.

(I) Prices of longer-maturity bonds respond more dramatically to changes in interest rates. (II) Prices and returns for long-term bonds are less volatile than those for short-term bonds. A) (I) is true, (II) false. B) (I) is false, (II) true. C) Both are true. D) Both are false.

(I) is true, (II) false

when a bond is at par:

- yield equals coupon rate -price and yield are negatively related -yield greater than coupon rate when the bond price is below par value

current yield properties:

-if a bond's price is near par and has a long maturity, then CY is a good approximation -A change in the current yield always signals change in same direction as YTM.

maturity and the volatility of bond returns

-prices and returns more volatile for long-term bond because they have higher interest-rate risk -no interest-rate risk for any bond whose maturity equals holding period.

real interest rate properties

-real interest rate more accuratly reflect true cost of borrowing -when the real rate is LOW, there are greater incentive to borrow and less to lend.

although long-term debt instruments have substantial interest-rate risk:

-short-term deb instruments do not. -there is no interest-rate risk for any bond whose time to maturity matches the holding period.

four basic types of cred instruments which incorporate present value concepts:

-simple loan -fixed payment loan -coupon bond -discount bond

duration and interest-rate risk

-the greater the duration of a security, the greater the percentage change in the market value of the security for a given change in interest rates -the greater the duration of a security, the great its interest-rate risk.

Which of the following are generally true of all bonds? A) The only bond whose return equals the initial yield to maturity is one whose time to maturity is the same as the holding period. B) A rise in interest rates is associated with a fall in bond prices, resulting in capital losses on bonds whose term to maturities are longer than the holding period. C) The longer a bond's maturity, the greater is the price change associated with a given interest rate change. D) All of the above are true. E) Only A and B of the above are true.

A) The only bond whose return equals the initial yield to maturity is one whose time to maturity is the same as the holding period. B) A rise in interest rates is associated with a fall in bond prices, resulting in capital losses on bonds whose term to maturities are longer than the holding period. C) The longer a bond's maturity, the greater is the price change associated with a given interest rate change.

Which of the following are true for a coupon bond? A) When the coupon bond is priced at its face value, the yield to maturity equals the coupon rate. B) The price of a coupon bond and the yield to maturity are negatively related. C) The yield to maturity is greater than the coupon rate when the bond price is above the par value. D) All of the above are true. E) Only A and B of the above are true.

A) When the coupon bond is priced at its face value, the yield to maturity equals the coupon rate. B) The price of a coupon bond and the yield to maturity are negatively related.

The Fisher equation states that A) the nominal interest rate equals the real interest rate plus the expected rate of inflation. B) the real interest rate equals the nominal interest rate less the expected rate of inflation. C) the nominal interest rate equals the real interest rate less the expected rate of inflation. D) both A and B of the above are true. E) both A and C of the above are true.

A)the nominal interest rate equals the real interest rate plus the expected rate of inflation. B) the real interest rate equals the nominal interest rate less the expected rate of inflation.