C.4 The Meaning of Interest Rates Flashcards
Cash flows
Cash payments to the holder of a security
Present value a.k.a.
Present discounted value
Simple loan
Debt repaid to lender at maturity date with a payment of interest
Four types of Credit Market Instruments
- Simple loan
- Fixed-payment loan
- Coupon bond
- Discount bond
Fixed-payment loan (def and a.k.a.)
Repay loan at a fixed payment periodically for a set number of time.
A.k.a. Fully amortized loan
Coupon bond
Pays the owner fixed-interest payment every year until the maturity date when a specified final amount is repaid
What is the final amount paid on a coupon bond known as
Face value or par value
What pieces of information identify a coupon bond
- FV
- Corp or govt that issued the bond
- Maturity date
- Coupon rate
Coupon rate
Dollar amount of the yearly coupon payment expressed as a % of the FV of the bond
Discount bond
Bought at a price below its FV and whose FV is repaid at the maturity date. No interest payments
Discount bond a.k.a.
Zero-coupon bond
Yield to maturity
The interest rate that equates the PV of cash flow payments received from a debt instruments with its value today
Yield to maturity of a simple loan
Simple interest rate
When a coupon bond is priced at its FV, the YTM equals
The coupon rate
The price of a coupon bond and YTM are ______ related
Negatively
The YTM is _____ than the coupon rate when the bond price is below its FV
Greater
Consol (def and a.k.a.)
A perpetual bond with no maturity date and no repayment of principal that periodically makes fixed coupon payments.
A.k.a. a perpetuity
How to calculate price of consol
P_c = C/i_c where, P_c = price of the perpetuity C = yearly payment i_c = YTM of perpetuity
Current yield
An approximation of the YTM that equals the yearly coupon payment divided by the price of a coupon bond
Rate of return
The payments to the owner of a security plus the change in the security’s value, expressed as a fraction of its purchase price.
Eq’n for return on a bond held from time t to time t+1
R = (C + P_t+1 - P_t)/P_t
where,
C = coupon pmt
Rate of capital gain
The change in a security’s price relative to the initial purchase price
Eq’n for rate of capital gain. How can you rewrite R (return) from this?
g = (P_t+1 - P_t)/P_t
R = i_c + g
where,
i_c = C/P_t
What happens when there’s a rise in the interest rate and the term to maturity is longer than their holding periods
Capital losses
The more distant a bond’s maturity rate, the _____ the size of the % price change associated with an interest rate change
Greater
The more distant a bond’s maturity rate, the _____ the rate of return that occurs as a result of an increase in the interest rate
Lower
Prices and returns for long-term bonds are more _______ than those for shorter-term bonds
Volatile
Interest-rate risk
The possible reduction in returns associated with changes in interest rates
There is no interest rate risk for any bond whose…
time to maturity matches the holding period
Real interest rate is a.k.a.
ex ante real interest rate
Fisher eq’n
i = r + pi^e where, i = nominal r = real interest rate pi^e = expected inflation
When the real interest is low, there are ______ incentives to borrow and _____ incentives to lend
greater; fewer
