Money & Banking Chapter 6

The time to bond maturity is called the _____.

investment horizon

Consider a consol (perpetuity) that promises to pay $2 per year forever at an interest rate of 10%. What would the price of the consol be?

$20 To calculate the price of a consol that promises a yearly coupon payment forever, divide that yearly coupon payment by the interest rate in decimal form: here $2/0.1 = $20

A one-year Treasury bill with a face value of $100 sells for $95.24. The interest paid in this case is equal to $ _____ and the rate of interest in percentage terms is equal to _____.

$4.76; 5% Interest for a zero-coupon bond like a T-bill is calculated by taking its face value less its price: $100 - $95 = $5. This interest can be expressed in percentage terms by dividing the interest by the bond's face value and then multiplying by 100: $5/$100 × 100 = 5%.

Consider a consol (perpetuity) that promises to pay $20 per year forever at an interest rate of 5%. What would the price of the consol be?

$400 To calculate the price of a consol that promises a yearly coupon payment forever, divide that yearly coupon payment by the interest rate in decimal form: here $20/0.05 = $400.

Consider a one-year Treasury bill that pays $500 at maturity and interest in the amount of 4%. Which of the following would be its price rounded to the nearest penny?

$480.77 The price of a one-year Treasury bond is calculated by dividing its face value by (1 + the interest rate): $500/(1 + 0.04) = $480.77.

Consider a six-month Treasury bill that pays $500 at maturity and pays interest in the amount of 4%. Which of the following would be its price rounded to the nearest penny?

$490.29 The price of a six-month Treasury bond is calculated by dividing its face value by (1 + the interest rate)0.5: $500/(1 + 0.04)0.5 = $490.29.

Which of the following can definitely not cause a curve to shift in the market for a bond?

A change in the price of the bond A change in the price of the bond causes movement along the supply and demand curves. Anything else relevant to bond demand or supply, such as changes in government borrowing, the bond's perceived relative risk, or overall business conditions, can cause a curve to shift leftward or rightward.

Which term best describes a fixed payment loan that pays some of the principle and the interest with each regular payment?

Amortization

Which of the following can be considered part of the interest rate?

Compensation for risk The real interest rate Expected inflation

A bondholder's investment horizon may be shorter than the time to maturity of the bond. This leads to which of the following kinds of risk?

Interest-rate risk Interest-rate risk arises because the bondholder's investment horizon may be shorter than the time to maturity of the bond. Inflation risk increases uncertainty about the real value of payments.

Which of the following is not a way securitization uses the efficiency of markets to lower the cost of borrowing?

Removing systemic risk Securitization allows for risk diversification, increases asset liquidity, allows greater specialization within finance, broadens markets, and fosters innovation. However, it cannot eliminate systemic risk.

The measure of uncertainty about the future payoff to an investment is called ______.

Risk

Which of the following happens when inflation is expected to increase in an economy?

The supply curve for bonds shifts rightward and the price of bonds falls. When inflation is expected to increase, the cost of borrowing falls and more bonds are issued, shifting the supply curve for bonds to the right. This causes the price of bonds to fall.

The investment horizon describes the

The time to bond maturity

What is the yield to maturity?

The yield bondholders receive if they hold the bond until maturity until final principal payment is made

Why are governments the only borrowers of perpetuities or consols?

They are the only borrowers that can credibly promise to make payments forever.

Which of the following is not true about zero-coupon bonds?

They pay regular interest payments.

When a bond's yield to maturity falls below its coupon rate, the bondholder has experienced

a capital loss.

To calculate the one-year holding period return,

add the current yield to the capital gain.

Because price and yield have _______ relationship, when the price of a bond is greater than its face value, its coupon rate will be _______ the current yield.

an inverse; above

Current yield has ______ relationship with bond price; when the bond price rises, current yield ______.

an inverse; falls

Holding period return is calculated when a bond is sold ____ maturity.

before

In the market for bonds, when the price of bonds is above the equilibrium price

bond sellers will start dropping their prices. As with any market, when price is above the equilibrium price, the market will be out of equilibrium. Quantity supplied will be greater than quantity demanded and excess supply will exist. To move the market back toward equilibrium, bond sellers will lower their prices, increasing quantity demanded and decreasing quantity supplied until they again become equal at the equilibrium price.

Expected inflation affects

both bond supply and bond demand.

We can value a coupon bond using

the present value formula.

As the default risk of a bond rises, we expect the price of the bond to _____ and its yield to ____.

fall; rise As the default risk of a bond rises, bond buyers will be less willing to purchase that bond (lowering demand and therefore its price), and those that do buy will demand a higher risk premium, increasing its yield.

When the price of a bond rises, its yield ______. Therefore, when a bond's price is lower than its face value, its yield to maturity must be ______ its coupon rate.

falls; above

There is some evidence that increased inflation is associated with ______ nominal interest rates, particularly in nations where inflation is especially _________.

higher; unstable Some evidence indicates that higher inflation is associated with higher nominal interest rates. The effect is not frequently observed in the USA or EU, where inflation is well-controlled and stable, but it is stronger where inflation is less stable.

Even if bond payments are made, increases in overall prices may reduce those payments' real value. This is referred to as ______.

inflation risk Inflation risk refers to the risk that, even though payments are made, the lender loses real value due to rising prices. Interest-rate risk refers to the risk of rates rising before the bond reaches maturity.

Interest-rate risk arises because of a mismatch between an investor's _________ and the _______ of the bond.

investment horizon; time to maturity Interest-rate risk arises because of a mismatch between an investor's investment horizon and the time to maturity of the bond. If the bondholder needs the principal of a long-term bond quickly, interest-rate risk becomes a major problem.

All else equal, when the demand for a bond increases

its price rises and its yield falls. When demand for a bond increases, shifting its demand curve rightward, its price increases. Since price and yield have an inverse relationship, as price rises, yield falls.

As a bond is perceived to provide a higher return, or to be more liquid or less risky than other bonds,

its price will rise and its yield will fall. As a bond is perceived to provide a higher return, or to be more liquid or less risky than other bonds, demand for the bond will increase, shifting the demand curve to the right. This will cause an increase in the price of the bond and, since price and yield move in opposite directions, a decrease in its yield.

Consider a coupon bond with a face value of $500. If its price is currently $525, then

its yield to maturity must be below its coupon rate, because price and yield have an inverse relationship Since the coupon bond's price is above its face value, its yield to maturity must be below its coupon rate. This is true because price and yield have an inverse relationship.

In the market for bonds, when the price of bonds is below the equilibrium price

quantity demanded will be greater than quantity supplied. As with any market, when price is below the equilibrium, quantity demanded will be greater than quantity supplied and excess demand will exist. To move the market back toward equilibrium, buyers will start bidding up prices, decreasing quantity demanded and increasing quantity supplied until the two quantities become equal at the equilibrium price. This will be shown as a leftward movement along (not a shift of) the demand curve and a rightward movement along (not a shift of) the supply curve.

Risk tends to

reduce the expected value of a given promise. lower the price an investor is willing to pay. raises the yield received by investors.

An increase in wealth shifts the demand curve for bonds _______, causing the price of bonds to ________.

rightward; increase An increase in wealth increases the demand for all assets, including bonds. The demand curve for bonds shifts rightward, increasing their price.

Suppose you want to know the risk associated with a specific investment strategy. The most appropriate benchmark would be the

risk associated with other strategies

When financial institutions pool assets that generate payment streams and turn them into tradeable bonds, this is called ______.

securitization Securitization is the process by which financial institutions pool assets that generate payment streams and turn them into tradeable bonds. Hedging is a form of diversification done by investors.

An increase in expected inflation,

shifts bond demand to the left. shifts bond supply to the right.

When the government wants to spend more relative to the taxes it brings in,

the price of bonds falls and their yield rises. When the government wants to spend more relative to the funds it brings in via taxes, it issues more bonds, shifting the supply curve of bonds rightward. This causes the price of bonds to fall and, since price and yield move in opposite directions, yield to rise.

When general business conditions decline,

the price of bonds increases and their yield falls. When general business conditions decline, fewer bonds are issued, shifting the supply curve of bonds to the left. This pushes up the price of bonds and, since price and yield move in opposite directions, decreases their yield.

Current yield measures

the proceeds a bondholder receives for lending.

When the price of the bond is below the face value,

the return exceeds the coupon rate.

Interest-rate risk increases as the bond's __________ increases.

time to maturity Interest-rate risk arises when a bondholder needs to sell a bond before its maturity date; therefore, it increases as the bond's time to maturity does.

The most useful measure of the return on holding a bond is _____, which can be defined as the interest rate that _____.

yield to maturity; bondholders receive if they hold the bond until the final principal payment is made