Interest Rate Determination Flashcards
How does inflation effect bonds?
Inflation effects coupon bonds.
Ie: issued at £1000, with 10% coupon rate (£100 every period/annually).
As inflation increases, this 100 value decreases every period -> returns are eaten away by inflation -> people sell bonds bonds
What happens when people sell bonds?
If everyone begins selling bonds, demand for bonds falls, so now price falls.
As price of bonds fall, their yield to maturity increases
As interest rates (yield to maturity) increase, people start saving and investment decreases. Expansion in economy is decreased, income is decreased, and as a result, output is decreased. -> this impacts the stock market negatively too.
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As interest rates rise in times of inflation, what will the government do?
Government will need to fund the higher interest payments by borrowing - they’ll do this by issuing bonds, but in a time of uncertainty (inflation), they would need to increase their yield to maturity in order for companies to uptake these bonds rather than save.
Relationship between yields and prices
As yields increase, prices fall
What is ‘present value’
Present value is based on the concept that a pound paid to you one year from now is worth less than a pound paid to you right now (ie: you could hold a pound in your pocket for a year, or deposit in a savings account and earn interest)
What is a simple loan?
Lender provides borrower with an amount of funds (called the ‘principle’) that must be repaid to the lender at the maturity date, along with one additional payment for the interest.
What is ‘discounting the future’?
The equation?
Calculating today’s value of pounds received in the future
PV = CF/(1 + I)^n
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What is a fixed payment loan?
Lender provides the borrower with an amount of funds that must be repaid by making the same payment (made up of part of the principal [the amount borrower] and the interest every period. - no final payment
Ie: borrow 1000, you may pay 126 every year for 25 years (this is a mixture of the principle and the interest)
What is a coupon bond?
How is coupon rate calculated?
A coupon bond pay the owner of a band a fixed interest payment (coupon payment) every year until the maturity date, and then the face value is repaid in the final year.
(Face value aka par value)
Coupon rate is a percentage of the face value.
What is a discount bond?
A discount bond is bought at a price below its face value (at a discount) and the face value is repaid at the maturity date. -> no interest payments are made.
Ie: buy a discount bond at 900, pay back 1000
What does yield to maturity equate?
The calculation for yield to maturity equates today’s value of the debt instrument = PV of all future cash flow payments
