ECON 301 Ch 3 Interest Rates and Rates of Return

Perpetuities

streams of equal payments that are expected to continue forever. A perpetuity does not mature. The price of a coupon bond that pays an infinite number of coupons equals: P=c/i

capital gain

the difference between the selling price and purchase price that results in a financial gain for the seller. occurs when the market price of an asset increases.

capital loss

the difference between the selling price and purchase price that results in a financial loss for the seller. occurs when the market price of an asset declines

Interest rate risk

the risk that bond prices will change in response to changes in market interest rates

Some Important Points About Discounting

1.Present value is also known as "present discounted value." 2.The further in the future a payment is to be received, the smaller its present value. 3.The higher the interest rate used to discount future payments, the smaller the present value of the payments. 4.The present value of a series of future payment is simply the sum of the discounted value of each individual payment.

Expected interest rate

Because lenders and borrowers don't know what the actual real interest rate will be during the period of a loan, they must estimate nominal interest rate - expected inflation rate

Discounting

Funds in the future are worth less than funds in the present, so they have to be reduced, or discounted, to find their present value. PV=FV/(1+i)^n

law of one price

Identical products should sell for the same price everywhere.

Nominal Interest rates

Interest rates that are not adjusted for changes in purchasing power

Debt instrument

Methods of financing debt, including simple loans, discount bonds, coupon bonds, and fixed payment loans.

Maturity

The length of time before the bond expires and the issuer makes the face value payment to the buyer

Rate of Return (R)

The return on a security as a % of the initial price. For a bond, R equals the coupon payment plus the change in the price of a bond divided by the initial price

Current Yield

The value of the coupon expressed as a percentage of the current price

Simple loan

a debt instrument in which the borrower receives from the lender an amount called the principal and agrees to repay the lender the principal plus interest on a specific date when the loan matures.

Discount bond

a debt instrument in which the borrower repays the amount of the loan in a single payment at maturity but receives less than the face value of the bond initially.

Coupon bond

a debt instrument that requires multiple payments of interest on a regular basis, and a payment of the face value at maturity

Fixed Payment loan

a debt instrument used that requires the borrower to make regular periodic payments of principal and interest to the lender

Interest rate provides

a link between the financial present and the financial future

Return

a security's total earnings. •For a bond, its return is the coupon payment plus the change in its price.

Real interest rates

interest rates that are adjusted for changes in purchasing power

Financial arbitrage

is the process of buying and selling securities to profit from price changes over a brief period of time.

Future Value

is the value at some future time of an investment made today. FV=PV(1+i)^N

Time value of money

is the way that the value of a payment changes depending on when the payment is received.

The importance of interest rates

most financial transactions involve payments in the future

Bond Prices and Yields to Maturity

move in opposite directions. Reason: If interest rates rise, existing bonds issued with lower interest rates become less desirable to investors, and their prices fall. This relationship should also hold for other debt instruments.

What Happens to Bond Prices When Interest Rates Change?

new bonds are issued at a higher interest rate, holders of existing bonds would have to adjust their bond prices. As the bond yield is higher, the bond's market price will fall below its face value. So, when interest rates rise, bond prices fall.

Face or Par Value

• The amount to be repaid by the bond issuer (the borrower) at maturity.

Coupon

•The annual fixed dollar amount of interest paid by the issuer of the bond to the buyer.

Coupon Rate

•The value of the coupon expressed as a percentage of the par value of the bond.

Equity

•is a claim to part ownership of a firm. -Example: common stock issued by a corporation.