Interest Rates Flashcards
What is the market value of securities (shares, bonds, etc.)?
The PV of all expected cash flows to the investor.
What are all the expected cash flows to the investor?
- divident payments
- interest payments
- repayment of principal sum
What are the types of financial markets?
- stock markets & bond markets
- forex and derivative markets
- capital markets
- debt markets
What is a capital market?
It is a debt & equity market where companies raise their capital.
What are debt markets?
- Money market (short-term)
- Bond market (long-term)
- This is the place where interest rates are determined.
What are the types of interest rates?
- Simple vs compound interest
- Nominal vs real interest rate
- Short vs long term interest rates
What is the difference between real and nominal interest rate?
In a financial context we use the nominal interest rate, but the real interest rate is adjusted for inflation and reflects the economical situation.
What is the formula for real interest rate?
Real = nominal - inflation rate
Are short term or long term rates higher?
Long term interest rates are higher.
Why are long-term interest rates higher?
Because the longer we wait, the more uncertainty, the higher risk.
What is the short-term interest rate based on?
- Monetary policy (base rate - official rates and the interbank money market rate)
- International transactions money market
- Economic fundamentals (risk premium)
What is the central bank’s policy?
To have price stability and maximum employment.
What does price stability mean?
Inflation is at 2% (almost all central bank decisions are aimed at this inflation target)
What is the formula for the monetary equation of exchange?
M x V = P x T
What do the values in the monetary equation of exchange stand for?
M - money in circulation
V - velocity (frequency at which money is spent)
P - price level (inflation)
T - transactions (amount of goods and services in the economy)
What do the left and right side in the monetary equation of exchange represent?
Left side - money supply (total spending)
Right side - real economy (total GDP)
What can the central bank do to adjust inflation?
- adjust the money supply
- adjust the interest rates
What does the CB do when inflation is too high?
Decrease money supply
Increase interest rates
What does the CB do when inflation is too low?
Increase money supply
Decrease interest rates
What happens with velocity when interest rates go up?
Velocity goes down
What happens with velocity when interest rates go down?
Velocity goes up (people want to spend more because it’s no longer lucrative to keep money in a savings account)
What is a bond?
A long-term loan with fixed interest payments (coupons) and repayment at maturity.
What is the yield to maturity (YTM)?
The return on the bond if you buy it and hold it until maturity.
How is the long-term interest rate in a country derived?
It is the YTM on 10-year government bonds.
How do you calculate return?
how much you get per yer / how much you paid
How do you calculate YTM?
(coupon/bond price) + [((face value - bond price)/remaining years until maturity)] / bond price
What changes bond yields?
Supply and demand for bonds determine the price and the only thing that changes and affects the yield is the price.
What happens with the YTM if the price goes up?
It goes down
What happens with the YTM if the price goes down?
It goes up
Why does the yield move opposite to price?
Because you get the same cash flows always (coupon + principal), but you pay more/less
What are the determinants of long-term interest rates?
- Economic fundamentals (business cycle, government budget balance, inflation)
- International transactions bond markets
- Monetary policy
What are international transactions bond markets?
Interest rate differentials between countries, exchange rate expectations, economical and political stability
What is quantitative easing?
Increasing money supply by buying government bonds.
What does it mean for the YTM when the bond is trading at a discount?
YTM > coupon
What does it mean for the YTM when the bond is trading at a premium?
YTM < coupon
