2/3. YIELD TO MATURITY

Question 1

what do interest rates determine?

Answer 1

how well the economy functions

Question 2

yield to maturity

Answer 2

most accurate measure of interest rate from point of view of who wants to invest in debt

Question 3

debt instruments are evaluated based on:

Answer 3

• amount of each cash flow
• timing of each cash flow

resulting in yield to maturity/interest rate

Question 4

basis concept of present value

Answer 4

money in the future is less valuable than the money I have today

Question 5

assumptions of present value

Answer 5

-interest rate are positive
-investors prefer to minimize risk and maximize returns

Question 6

single cash flow

Answer 6

zero-coupon or discount bond

Question 7

multiple cash flows

Answer 7

coupon bond, consol bond (perpetuity)

Question 8

zero-coupon bond

Answer 8

short-maturity bond (< 1 year) that pays the face value (par value) of the bond at expiry and no coupon in between

Question 9

what do investors pay when they buy a bond?

Answer 9

market price of the bond < face value –> face value - market price = return earned on the investment

Question 10

perpetual/consol bonds

Answer 10

• bonds that live forever/ in perpetuity
• investor receives a fixed coupon payment of C forever

P = C / i

Question 11

relation of price/value of the bond and ytm

Answer 11

negatively related
i increases = PV lower

Question 12

bond at par

Answer 12

price = face value
ytm = coupon rate

Question 13

rate of return

Answer 13

how well an investor does by holding a bond over a certain holding period

payments to owner + change in its value

Question 14

interest rate risk

Answer 14

• change over time
• it affects the return on the investment

Question 15

return (formula)

Answer 15

return = current yield + capital gain yield
R = (C/Pt) + (Pt+1-Pt/Pt)

Question 16

current yield

Answer 16

coupon payment over the purchase price, how much return I can get from the coupon

Question 17

capital gain yield

Answer 17

rate of capital gain (change in bond’s price relative to the initial purchase price)

if negative = capital loss yield

Question 18

bonds with maturity = holding period

Answer 18

only bonds with return = yield

Question 19

bonds with maturity > holding period

Answer 19

• interest rate increases
• price falls
  –> capital loss

Question 20

the longer the maturity

Answer 20

• the higher the price change associated with interest rate change
  -more return changes with change in interest rate

Question 21

duration

Answer 21

average lifetime of a debt security’s stream of payments (effective maturity)

Question 22

duration - when maturity of bond lengthens

Answer 22

duration rises

Question 23

duration - when interest rate rises

Answer 23

duration of coupon bond falls

Question 24

duration - the higher the coupon rate on bond

Answer 24

the shorter the duration of the bond

Question 25

the greater the duration of a debt security

Answer 25

-the greater the % change in the market value of debt security

-the greater its interest rate risk