2. Interest Rates and Their Role in Valuation Flashcards
Yield to Maturity Definition
Interest rate that equates the present value of cash flow payments received from a debt instrument with its value today.
Price and Yield Relationship
- 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
How Does Wealth Shift Demand Curve for Bonds?
- Increase in wealth leads to an increase in quantity demanded at each bond price causing demand curve to shift outwards.
- Drives equilibrium price up.
How Does Expected Interest Rate Shift Demand Curve for Bonds?
- 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.
How Does Expected Inflation Shift Demand Curve for Bonds
- Increase in expected inflation causes a decrease in quantity demanded at each bond price causing demand to shift inwards.
- Drives equilibrium level down.
How Does Riskiness of Bonds Relative to Other Assets affect Demand Curve for Bonds?
- 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.
How Liquidity of Bonds Relative to Other Assets affect Demand Curve for Bonds?
- 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.
How Does Profitability of Investments, Expected Inflation and Government Deficit affect supply curve of Bonds?
- Increase in all variables causes an increase in quantity supplied at each bond price therefore causing supply to shift outwards.
- Causing equilibrium level down.
What is Real Interest rate?
Inflation adjusted interest rate.
Fisher Equation
Yield to Maturity/Interest Rate approximates to interest rate + pi
What are the three stages of the fisher effect (graphical analysis)?
- 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.
Business Cycle (Graphical Analysis)
- Business cycle expansion shifts the bond supply curve rightwards - more money to invest into bonds
- Shifts the bond D curve outwards but by a lesser amount as different people may benefit more from the booming/recession period.
- Therefore, price of bonds falls and the equilibrium interest rate (yield) rises.
Fixed-Payment Loan Definition
A loan that requires the borrower to make the same payment every period period until the maturity date.
How does a coupon bond pay the owner of the bond?
A fixed interest payment every period, plus the face value of the bond at the maturity date.
Bond Characteristics
- 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.
Yield to Maturity Definition
Interest rate that equates the present values of the cash flow received from a debt instrument with its market price today.
Factors Determining the Demand for an Asset
- 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.
Excess Supply in the Bond Market
When the price of the bond is above the equilibrium price, there is an excess supply of bonds and the price will fall.
S&D Relationship in Bonds
- When the demand for bonds decreases, or supply of bonds increase, interest rates rise.
Government Deficit Impact on the Bond Market
When government deficit increases, the supply curve shifts to the right.
Expected Inflation on the Bond Market
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.
Face Value of Bond Definition
- The amount that the issuer must pay at maturity.
Coupon Payment Every Year Calculation
- Coupon Bond Value * Coupon Rate (%)
- £5000 * 0.13 = £650
Situation if a Bond Sells for more than Original Value
- The Yield to maturity will be less than the original coupon bond.