chapter 4 Flashcards
What is present value?
PV, the common sense notion that a dollar paid to you one year from now is less valuable than a dollar you paid today
What is the present value formula?
PV = CF / (1 + i)^n
where
PV = present value
CF = future cash flow
i = interest rate
n = period of time (usually years)
what are the 4 types of credit market instruments?
Simple loan
Fixed payment loan
Coupon bond
Discount bond
Describe a fixed payment loan
a loan where the borrower must repay by making the same payment consisting of part of the principal and interest every period i.e. monthly for a set number of years
Describe a coupon bond?
pays owner fixed interest payment every year until maturity date when a specified (face value or par value) is repaid.
Describe a discount bond?
(also a zero-coupon bond) bought at price below face value and the face value is repaid at maturity date. Unlike coupon bonds, a discount bond doesn’t make any interest payments, just pays off.
What is Yield to Maturity?
Of the several ways of calculating interest rate, Yield to Maturity is most important.
Is the interest rate that equates the present value of cash flow payments received from a debt instrument with its value today.
What are the rules of YTM and coupon bonds?
YTM = coupon rate when priced at face value
When YTM rises, price of bond falls and vice versa
YTM > coupon rate when bond price is below face value
YTM < coupon rate when bond price is above face value
What is a console/perpetuity? State its formula.
As special case of a coupon bond. It is a perpetual bond with no maturity date and no repayment of principal that makes fixed coupon payments of $C forever.
Pc = C/ic
Pc = price of the perpetuity
C = yearly payment
ic = yield to maturity of the perpetuity
What is the rate of return?
the amount of each payment to the owner plus the change in the security’s value, expressed as a fraction of its purchase price.
(how well a person does financially by holding a bond or any other security over a particular time period)
What length of bonds are prices and returns most volatile?
most volatile for long term bonds i.e. (20 years)
What is interest rate risk?
The risk level associated with an asset’s return that results from interest rates
What does the fisher equation state?
nominal interest rate i equals the real interest rate r plus the expected rate of inflation pi^e
