H2: fixed income markets

Question 1

interest

Answer 1

The rate of interest is the price of money.
the price to ‘rent’ money
the reward for the lender to postpone consumption

Question 2

interest variability

Answer 2

The interest rate charged depends on the risks taken by the lender.
This risks depend (at least) on the
credit worthiness of the borrower.
maturity of the debt.
Hence, we cannot speak about the interest rate. There will be a
different interest rate per maturity and per borrower.

Question 3

term structure of interest rates

Answer 3

What kind of graph do we get if we plot the “interest rate” that would
be charged vis-a-vis a certain counterparty for maturities ranging from
1 day to 30 years?
Notice this is a graph on a particular day, keeping all the loan characteristics constant except for the maturity of the loan.
What would you get for a different, less credit worthy borrower?

Question 4

Demand and supply for loanable funds determine a short term risk free
interest rate. This interest rate rewards the delay in consumption.

Answer 4

The lender faces risks for which a compensation (premium) is required.
1 A longer maturity of the debt instrument delays consumption more than a shorter maturity
and hence the lender will ask for a maturity premium. This gives rise to a term structure
of the real riskless interest rates.
2 There is no guarantee that the purchasing power of the funds repaid in the future will be
the same as the purchasing power of the funds lent out. Therefore the lender adds a(n
expected inflation) premium to each risk free rate to obtain the term structure of nominal
risk free interest rate. Of course the expected inflation premium can be different for
different maturities.
3 The lender will charge the borrowers with a credit spread for expected credit losses. Often
this credit spread also embeds a liquidity premium. Of course the credit spread can be
different for different maturities and for different borrower qualities. This results in a term
structure of nominal rates for risky assets.

Question 5

time value of money

Question 6

simple interest rate

Answer 6

you do not capitalize: you don’t calculate the rate during the loan, only at the end

Question 7

compounding interest

Answer 7

interest on interest: interest during the period becomes capital