Chapter 5 Flashcards
asset prices affected by
current and expected future activity
asset prices affect
decisions that influence current economic activity
Understanding “their” determination is thus central to understanding fluctuations
asset prices
Do we need to buy a machine? profit > cost. It is the concept of… Sequence of future payments is the value today of this expected sequence of payments.
concept of expected present discounted
Expected presented discounted values
- not directly observable
- must be constructed from information on the sequence of expected payments and expected interest rates
formule discount factor
1/(1 + 𝑖𝑡)
bond promises to repay a fixed amount called …
the face value
on a specified date
called the maturity date
sometimes with additional periodic payments that occur before the maturity dat
called coupon payments
The amount of money initially paid
loaned
Maturity
The length of time over which the bond promises to make payments to the holder of the bond.
Risk
- Default risk as the risk that the issuer of the bond will not pay back the full amount promised by the bond.
- Price risk as the uncertainty about the price you can sell the bond for if you want to sell it in the future before maturity.
Yield to maturity or yield:
The interest rates associated with bonds of different
maturities
Short-term interest rates:
Yields on bonds with a short maturity, typically a year or less
• Long-term interest rates:
Yields on bonds with a longer maturity than a year
Term structure of interest rates or yield curve
The relation between maturity and
yield
Government (or Sovereign) bonds
Bonds issued by the governments
Corporate bonds
Bonds issued by firms
Bond ratings
ratings for default risk
Risk premium
The difference between the interest rate paid on a given bond and the interest rate on the bond with the best rating
Junk bonds
Bonds with high default risk
Discount bonds
Bonds that promise a single payment at maturity called the face value
Coupon bonds
Bonds that promise multiple payments before maturity and one
payment at maturity
Coupon payments:
The payments before maturity
Coupon rate:
The ratio of the coupon payments to the face value
• Current yield
The ratio of the coupon payment to the price of the bond
Life:
The amount of time left until the bond matures
Treasury bills (T-bills)
U.S. government bonds with a maturity of one year or less
Treasury notes
U.S. government bonds with a maturity of 2 to 10 years
Treasury bonds
U.S. government bonds with a maturity of more than 10 years
Term premium
The premium associated with longer maturities
Indexed bonds:
Bonds that promise payments adjusted for inflation
Treasury Inflation Protected Securities (TIPS):
Indexed bonds introduced in the United States in 1997
Yield
the amount of return that an investor will realize on a bond. It’s important to remember that a bond’s yield to maturity is inversely related to its price
As a bond’s price increases
its yield to maturity falls.
Arbitrage
The expected returns on two assets must be equal.
Expectations hypothesis
Investors care only about the expected returns and do not care about
risk.
Why do bonds with the same default rate and tax status but different maturity dates have different yields?
• Long-term bonds are like a composite of a series of short-term bonds. • Their yield depends on what people expect to happen in the future.
Comparing 3-month and 10-year Treasury yields we can see:
- Interest rates of different maturities tend to move together.
- Yields on short-term bonds are more volatile than yields on long-term bonds.
- Long-term yields tend to be higher than short-term yields.
The liquidity premium theory focuses
The liquidity premium theory focuses on the question of how quickly an asset can be sold in the market without lowering its stated price.
Liquidityrefers to
how quickly an asset can be sold without lowering its price.
A higher equity premium leads to a
lower stock price.
Higher current and expected future one-year real interest rates lead to
lower real stock price.
Fundamental value:
is given by the present discounted value of the expected stream of future earnings (for example, the present value of expected dividends). In reality, stocks are often underpriced or overpriced.
Rational speculative bubbles
Stock prices increase just because investors expect them to.
Fads
Stocks become high priced for no reason other than its price has increased in the past.
