Bonds and Interest Rates

The model that correctly specifies the relationship between the nominal rate and the real rate is:R = the nominal rate r = the real rate, h = inflation

(1 + R ) = (1 + r) x (1+h)

-increase in wealth -reduction in expected inflation -decrease in expected future interest rates -increase in expected return on bond -a fall in the risk of the bond

*bond demand shifts to the right *bond prices up *interest rates down

-Any increase in the government's desired expenditure relative to its revenue -An improvement in general business conditions -An increase in expected inflation

*bond supply shifts to the right *bond prices down *interest rates up

Which six factors determine the yield on a bond?

-real rate of return -interest rate risk -expected future inflation -liquidity -default risk -taxability

interest rate risk

1. The risk that the interest rate will change, causing the price of a bond to change with it. 2. The risk that changes in interest rates will affect a financial intermediary's net worth. It arises from a mismatch in the maturity of assets and liabilities.

What is the effective annual rate on a bond with yield to maturity of 6 percent that pays semiannual interest?

6.09% [1+(.06/2)]^2-1

taxability premium

The portion of a nominal interest rate or bond yield that represents compensation for unfavorable tax status.

The rates on financial securities are generally quoted as

Nominal rates

Coupon Bond Formula

P=C/1+i + C/(1+i)^2 + C/(1+i)^n...+ F/(1+i)^n P=price of coupon bond C=yearly coupon payment F=face value of the bond n=years to maturity

consol formula

P=C/i C= yearly coupon payment

treasury yield curve

Plot of Treasury yields relative to maturity.

Securitization

Pooling loans into standardized securities backed by those loans, which can then be traded like any other security.

How are TIPS different from traditional bonds?

Promised payments are specified in real terms.

coupon rate

The annual coupon a bond pays divided by its face value

interest rate risk premium

The compensation required by bondholders for bearing interest rate risk.

bid-ask spread

The difference between the bid and ask prices

Yield to Maturity (YTM)

The discount rate that equates the present value of the interest payments and par value of a bond with the current price of a bond

liquidity premium

The portion of a nominal interest rate or bond yield that represents compensation for lack of liquidity.

default risk premium

The portion of a nominal interest rate or bond yield that represents compensation for the possibility of default

inflation premium

The portion of a nominal interest rate that represents compensation for expected future inflation

asked price

The price at which a dealer is willing to sell a security. Also called the ask price

dirty price

The price of a bond including accrued interest

par value

The principal amount of a bond that is repaid at the end of the term. For stock, it is a relatively unimportant value except for bookkeeping purposes

face value

The principal value of a bond that is repaid at the end of the term. Also referred to as par value or principal

clean price

The quoted price on a bond

term structure of interest rates

The relationship between nominal interest rates on default-free, pure discount securities and time to maturity; that is, the pure time value of money

maturity

The specified date on which the face value of a bond is paid

coupons

The stated interest payment on a debt instrument

What does empirical data indicate about the relationship between nominal interest rates and the rate of inflation?

There is a positive relationship between interest rates and inflation.

What does TIPS stand for?

Treasury Inflation Protected Securities

bid

What a dealer is willing to pay for a security

zero coupon bond

a promise to pay the face value of the bond on a specific future date, with no coupon payments *price is present value *U.S Treasury bill

US Treasury Bills

a zero-coupon bond in which the U.S government agrees to pay the bondholder a fixed dollar amount on a specific future date; has a maturity of less than one year

If interest rates decreases

bond value goes up

holding period return =

current yield + capital gain

If the liquidity of a bond increases, then the bond's yield will

decrease

If the liquidity of a bond increases, then the bond's yield will ______

decrease

According to the approximation formula for the nominal rate of return (R), the nominal rate will Blank______ if inflation (h) increases.

increase

As the time to maturity increases, the interest rate risk premium

increases at a decreasing rate

determining the shape of the term structure of interest rates

inflation

fixed-payment loans

loans where the loan principal and interest are repaid in several payments, often monthly, in equal dollar amounts over the loan term *conventional mortgages

coupon bonds

make periodic interest payments and repay the principal at maturity *U.S Treasury bonds and most corporate bonds

Consols (perpetuities)

make periodic interest payments forever, never repaying the principal that was borrowed

real rate

nominal rate - inflation rate

Historically, nominal interest rates and inflation are Blank______ correlated.

positively

What is the present value of the annual interest payments on a 10-year, $1,000 par value bond with a coupon rate of 10 percent paid annually, if the yield on similar bonds is 9 percent?

pv of coupons= C*((1-(1/1+r^t)/r)= 641.77

According to the Fisher effect hypothesis, the real rate of return Blank______ as inflation increases

remains the same

inflation risk

risk faced by investors due to uncertainty about future inflation

the bond supply curve

slopes upward

Value of a fixed payment loan

sum of present value of payments

capital loss

the difference between the price that has been paid for an asset and the lower price at which it is sold

investment horizon

the length of time an investor plans on holding an asset, the time to bond maturity

current yield

the measure of the proceeds the bondholder receives for making a loan *= yearly coupon payment/ price paid

capital gain

the positive change in the value of an asset

default risk

the probability that a borrower will not repay a loan

what is the difference between quoted yield and effective yield?

the quoted yield does not adjust for compounding, while the effective yield adjusts for compounding

Holding Period Return

the rate of return over a given period

A TIPS bondholder will not know

the size of expected payments in nominal terms

yield to maturity

the yield bondholders receive if they hold the bond to its maturity when the final principal payment is made

because the price falls as the yield rises, when the price is below $100,

the yield to maturity must be above the coupon rate

because the price rises as the yield falls, when the price is above $100,

the yield to maturity must be below the coupon rate

if the price of the bond is $100

then the yield to maturity equals the coupon rate