Chapter 4

Question 1

Present value

Answer 1

• a dollar paid to you one year from now is less valuable than a dollar paid to you today.
• Why: a dollar deposited today can earn interest and become $1 x (1+i) one year from today

Question 2

Yield to maturity

Answer 2

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

Question 3

Coupon bond

Answer 3

• When the coupon bond is priced at its face value, the yield to maturity equals the coupon rate.
• The price of a coupon bond and the yield to maturity are negatively related.
• The yield to maturity is greater than the coupon rate when the bond price is below its face value

Question 4

Consol or perpetuity

Answer 4

a bond with no maturity date that does not repay principal but pays fixed coupon payments forever

Question 5

The distinction between interest rates and returns

Answer 5

• The return equals the yield to maturity only if the holding period equals the time to maturity.
• A rise in interest rates is associated with a fall in bond prices, resulting in a capital loss if time to maturity is longer than the holding period.
• The more distant a bond’s maturity, the greater the size of the percentage price change associated with an interest-rate change.
• The more distant a bond’s maturity, the lower the rate of return the occurs as a result of an increase in the interest rate.
• Even if a bond has a substantial initial interest rate, its return can be negative if interest rates rise.

Question 6

Interest rate risk

Answer 6

• Prices and returns for long-term bonds are more volatile than those for shorter-term bonds.
• There is no interest-rate risk for any bond whose time to maturity matches the holding period.

Question 7

Nominal interest rate

Answer 7

makes no allowance for inflation

Question 8

Real interest rate

Answer 8

is adjusted for changes in price level so it more accurately reflects the cost of borrowing; better indicator of incentives to borrow and lend; when low, greater incentives to borrow and fewer to lend

Question 9

Fisher equation

Answer 9

Nominal interest rate = real interest rate + expected inflation rate