Lecture 3

Question 1

Cash Flow

Answer 1

» Stream of cash payments to the holder of a debt instrument

Question 2

Maturity

Answer 2

» The length of time an investor must wait to recover the investment in a debt security from the issuer (unless the bond is sold before it matures).

Question 3

Face value

Answer 3

» Price at which bills or bonds are repaid - bonds repay principal at par value on the maturity date.

Question 4

Issue Price

Answer 4

» The price at which the issuer (company, government etc.) sells the bond (i.e. the security) to the market for the first time.

Question 5

Market Price

Answer 5

» The price of the security in the secondary market.

Question 6

Define Yield to maturity

Answer 6

the interest rate that equates the present value of cash flow payments received from a debt instrument with its value today.

• Most accurate measure of the interest rate.
• For simple loans, the simple interest rates equals the yield to maturity.

Question 7

Correlation between yield to maturity and coupon bond price

Answer 7

• When the coupon bond is priced at its face value (FV), the yield to maturity equals the coupon rate.
• The price of a coupon bond and the yield to maturity are negatively related.
• The yield to maturity is greater than the coupon rate when the bond price is below its face value.

Question 8

Differences between interest rates and returns

Answer 8

• The return equals the yield to maturity only if the holding period equals the time to maturity.
• A rise in interest rates is associated with a fall in bond prices, resulting in a capital loss if time to maturity is longer than the holding period.
• The more distant a bond’s maturity, the greater the size of the percentage price change associated with an interest-rate change.
• Interest rates do not always have to be positive as evidenced by recent experience in Japan and several European states.
• The more distant a bond’s maturity, the lower the rate of return the occurs as a result of an increase in the interest rate.
• Even if a bond has a substantial initial interest rate, its return can be negative if interest rates rise.

Question 9

interest-rate risk

Answer 9

• Prices and returns for long-term bonds are more volatile than those for shorter-term bonds.
• There is no interest-rate risk for any bond whose time to maturity matches the holding period.

Question 10

Difference between nominal vs real IR

Answer 10

Nominal interest rate makes no allowance for inflation. Real interest rate is adjusted for changes in price level so it more accurately reflects the cost of borrowing.
» Ex ante real interest rate is adjusted for expected changes in the price level
» Ex post real interest rate is adjusted for actual changes in the price level