2. Interest Rates and Their Role in Valuation

Question 1

Yield to Maturity Definition

Answer 1

Interest rate that equates the present value of cash flow payments received from a debt instrument with its value today.

Question 2

Price and Yield Relationship

Answer 2

• Negative Relationship
• When Price = Face Value of the Bond, interest rate = coupon price.
• When Price > Face Value of the Bond, interest rate < coupon rate.
• When price < face value of bond, I > coupon rate

Question 3

How Does Wealth Shift Demand Curve for Bonds?

Answer 3

• Increase in wealth leads to an increase in quantity demanded at each bond price causing demand curve to shift outwards.
• Drives equilibrium price up.

Question 4

How Does Expected Interest Rate Shift Demand Curve for Bonds?

Answer 4

• Increase in expected interest rate causes a decrease in quantity demanded at each bond price causing the demand curve to shift inwards.
• Drives equilibrium price down.

Question 5

How Does Expected Inflation Shift Demand Curve for Bonds

Answer 5

• Increase in expected inflation causes a decrease in quantity demanded at each bond price causing demand to shift inwards.
• Drives equilibrium level down.

Question 6

How Does Riskiness of Bonds Relative to Other Assets affect Demand Curve for Bonds?

Answer 6

• Increase in riskiness of bonds of bonds relative to other assets causes the quantity demanded at each bond price causing demand to shift inwards.
• Drives equilibrium level down.

Question 7

How Liquidity of Bonds Relative to Other Assets affect Demand Curve for Bonds?

Answer 7

• Increase in Liquidity of Bonds relative to other assets causes the quantity demanded for bonds to increase causing demand to shift outwards.
• Drives equilibrium level up.

Question 8

How Does Profitability of Investments, Expected Inflation and Government Deficit affect supply curve of Bonds?

Answer 8

• Increase in all variables causes an increase in quantity supplied at each bond price therefore causing supply to shift outwards.
• Causing equilibrium level down.

Question 9

What is Real Interest rate?

Answer 9

Inflation adjusted interest rate.

Question 10

Fisher Equation

Answer 10

Yield to Maturity/Interest Rate approximates to interest rate + pi

Question 11

What are the three stages of the fisher effect (graphical analysis)?

Answer 11

• A rise in expected inflation shifts the bond demand curve inwards.
• And also shifts the supply curve rightwards.
• Causing the price of bonds to fall and the equilibrium interest rate to rise.

Question 12

Business Cycle (Graphical Analysis)

Answer 12

1. Business cycle expansion shifts the bond supply curve rightwards - more money to invest into bonds
2. Shifts the bond D curve outwards but by a lesser amount as different people may benefit more from the booming/recession period.
3. Therefore, price of bonds falls and the equilibrium interest rate (yield) rises.

Question 13

Fixed-Payment Loan Definition

Answer 13

A loan that requires the borrower to make the same payment every period period until the maturity date.

Question 14

How does a coupon bond pay the owner of the bond?

Answer 14

A fixed interest payment every period, plus the face value of the bond at the maturity date.

Question 15

Bond Characteristics

Answer 15

• Prices and returns for long-term bonds are more volatile than those for shorter-term bonds.
• Longer a bond’s maturity, the lower the rate of return that occurs as a result of the increase in the interest rate.
• Even though a bond has a substantial interest rate, its return can turn out to be negative if interest rates rise.

Question 16

Yield to Maturity Definition

Answer 16

Interest rate that equates the present values of the cash flow received from a debt instrument with its market price today.

Question 17

Factors Determining the Demand for an Asset

Answer 17

• Wealth of Investors
• Liquidity of bonds relative to alternative assets.
• Expected returns on bonds relative to alternative assets.
• Risk of bonds relative to alternative assets.

Question 18

Excess Supply in the Bond Market

Answer 18

When the price of the bond is above the equilibrium price, there is an excess supply of bonds and the price will fall.

Question 19

S&D Relationship in Bonds

Answer 19

• When the demand for bonds decreases, or supply of bonds increase, interest rates rise.

Question 20

Government Deficit Impact on the Bond Market

Answer 20

When government deficit increases, the supply curve shifts to the right.

Question 21

Expected Inflation on the Bond Market

Answer 21

When the inflation rate is expected to increase, the real cost of borrowing declines at any given interest rate; as a result, the supply of bonds increases and the supply curve shifts to the right.

Question 22

Face Value of Bond Definition

Answer 22

• The amount that the issuer must pay at maturity.

Question 23

Coupon Payment Every Year Calculation

Answer 23

• Coupon Bond Value * Coupon Rate (%)
• £5000 * 0.13 = £650

Question 24

Situation if a Bond Sells for more than Original Value

Answer 24

• The Yield to maturity will be less than the original coupon bond.

Question 25

Calculation for Real Interest Rate

Answer 25

Yield to Maturity - Expected Inflation Rate

Question 26

Relationship Between Old Bond Market Value, Par Value and New Bonds

Answer 26

• When an old bond’s market value is above its par value, the bond is selling at a premium. This occurs because the old bond’s coupon rate is above the coupon rate of new bonds with similar risk.

Question 27

What are implications of negative interest rates or yields on household savers?

Answer 27

• Reduced Earnings on Savings: Savings accounts and fixed-income investments yield less, often leading to a loss after accounting for inflation.
• Encouragement to Spend or Invest: With little to no returns on traditional savings, individuals may be more inclined to spend or invest in riskier assets.
• Decreased Borrowing Costs: Loans and mortgages may become cheaper, benefiting those looking to borrow.

Question 28

What are the implications of negative interest rates or yields on commercial banks or firms holding negative yield bonds?

Answer 28

• Lower Profit Margins on Loans: The interest earned on loans is reduced, impacting the profitability of banks.
• Potential for Increased Loan Demand: Cheaper borrowing costs may increase demand for loans.
• Challenges in Asset-Liability Management: Managing the balance between assets and liabilities becomes more complex with negative yields.
  Incentive to Lend or Invest in - Riskier Assets: To maintain profitability, banks and firms might seek higher returns through riskier investments.

Question 29

What are the implications of negative interest rates/yields on central banks?

Answer 29

• Stimulus to the Economy: Negative rates are often used as a tool to stimulate economic activity by making borrowing cheaper.
• Limited Monetary Policy Tools: With rates already negative, central banks have less room to manoeuvre in case of economic downturns.
• Risk of Asset Bubbles: Prolonged low or negative rates can lead to asset price inflation and potential bubbles.
• Potential Impact on Currency Values: Negative rates can lead to depreciation of the national currency, which might be a desired policy outcome in some cases.