Interest Rates and Financial Instruments Flashcards
What is the present value (PV)?
PV is the current worth of a future sum of money or stream of cash flows, given a specific rate of return. It helps compare the value of money received at different points in time.
What is the net present value (NPV)?
NPV is the difference between the PV of cash inflows and the PV of cash outflows over a period of time. It is a useful tool for evaluating investment projects and determining their profitability.
What are the four main types of credit market instruments?
- Simple loan: involves a single payment at the maturity date.
- Fixed-payment loan: involves multiple fixed payments at pre-specified dates, like a mortgage.
- Coupon bond: pays fixed amounts (coupons) at fixed dates, plus a final payment (face value) at maturity.
- Discount bond: pays zero coupons and only a final payment at maturity. Its price is typically less than its face value.
What is a fixed-payment loan and what are some examples? What does each payment contain?
A fixed-payment loan requires the borrower to make equal periodic payments to the lender over the loan’s term. Each payment covers both interest and a portion of the principal. Like mortgages and car loans.
How does extending the maturity of a fixed-payment loan affect the monthly payments and the total cost?
Extending the maturity lowers the monthly payment but increases the total cost because the borrower pays interest for a longer period.
What is yield to maturity (YTM)?
YTM is the interest rate that equates the Present Value of all cash flow payments received from a debt instrument with its value today (current price). It is the most important way to calculate interest rates.
How is the YTM calculated for a simple loan?
YTM = (CF - PV) / PV
where CF is the cash flow in one year and PV is the amount borrowed.
How is the YTM calculated for a fixed-payment loan or a coupon bond?
Calculating YTM for these instruments involves complex formulas that cannot be solved by hand and require a computer or financial calculator.
What is a consol or perpetuity?
It is a bond with no maturity date that does not repay principal but pays fixed coupon payments forever. Its YTM is calculated as: C / Pc, where C is the yearly interest payment and Pc is the price of the consol.
How is the YTM calculated for a discount bond?
YTM = (F - P) / P, where F is the face value and P is the current price of the discount bond.
What are the three key facts about coupon bonds?
- When a coupon bond is priced at its face value, its YTM equals its coupon rate.
- The price of a coupon bond and its YTM are negatively related, meaning as YTM rises, the bond price falls.
- The YTM is greater than the coupon rate when the bond price is below its face value.
What is the rate of return and what factors does it depend on?
The rate of return is a measure of how well an investor performs financially by holding a bond over a period of time. It depends on the coupons received, the price at which the bond is sold, the purchase date, and the holding period.
What is the relationship between the rate of return and the YTM?
The return equals the YTM only if the holding period equals the time to maturity. If the holding period is shorter than the maturity and interest rates rise, the investor may experience a capital loss, leading to a rate of return lower than the YTM.
How does the maturity of a bond affect its sensitivity to interest rate changes?
Bonds with longer maturities are more sensitive to interest rate changes.
A rise in interest rates will lead to a larger percentage price change for a long-term bond compared to a short-term bond.
Can a bond with a high initial interest rate have a negative return?
Yes, even if a bond offers a substantial initial interest rate, its return can become negative if interest rates rise significantly during the holding period, leading to a capital loss that outweighs the coupon payments.
