Quiz 2 Notes Flashcards
Present value
a dollar paid to you one year from now is now less valuable than a dollar paid to you yesterday because a deposited dollar earns interest
Simple present value calculation
PV=CF (future cash flow)/ (1+i)^n
what are the 4 types of credit market instruments
simple loans, fixed payments, coupon bonds, discount bonds
yield to maturity
the interest rate that equates PV of cash flow payments received from a debt instrument with its value today
use the present equation and solve for i
for simple loans what does interest rate equal
the yield to maturity
Fixed payment loans
same cash flow payment every period throughout life of the loan
LV for fixed payment loans
LV= (FP/1+i) + FP/(1+i)^n
Coupon bond
same strategy as fixed payment loans
how to find price of coupon bond
p=(c/ 1+i) + (c/1+i)^2+….+(c/1+i)^n + (F/(1+i)^n
C= yearly coupon payment
F=face value of bond
n= years to maturity date
when a coupon bond is priced at its face value
yield to maturity equals coupon rate
relationship between price of coupon bond and yield to maturity
negatively related
when is yield to maturity is greater than coupon rate
when bond is priced above face value
What is a perpetuity
a bond with no maturity date that does not repay principle but pays fixed coupon payments forever
equation for a perpetuity
P=c/ic
Pc= price of consol
C= yearly interest payment
Ic= yeild to maturity of consol
if you rearrange you get current yield it is an easy to calculate approximation to yield to maturity
rate of return
payments to the owner plus the change in value expressed as a fraction of purchase price
RET
c/pt + p(t+1)-pt/pt
RET: return from holding bond from time t to time t+1
current yield
Ic=c/pt
Rate of capital gains
g=P t+1 -pt/pt
what does return equal
maturity but only if the holding period equals time to maturity
a rise in interest rates is associated with a _____ in bond prices
fall in bond prices which results in capital loss if time to maturity is longer than holding period
more distant a bonds maturity is
the greater the size of percentage price change associated with an interest rate change, the more distant the bonds maturity the lower the rate of return that occurs as a result of an increase in interest rate
discount bond
for any one year discount bond i=F-P/P
yield to maturity for a discount bond
equals increase in price over the year divided by initial price
for a discount bond how is maturity related to current bond price
yield to maturity is negatively related to current bond price as the same w a coupon bond
volitility of long term vs short term bonds
prices and returns for long term bonds are more volatile than those for short term bonds
interest rate risk for bonds whose time to maturity matches the holding period
no interest rate risk
nominal interest rates
no allowance for inflation
real interest rate
adjusted for changes in price level so it more accurately reflects the cost of borrowing
ante real interest rate
adjusted for expected changes in the price level
post real interest rate
adjusted for actual changes in price level
fisher equation
i=ir+pi^e
i= nominal interest rate
ir= real interest rate
pi^e= expected inflation rate
interest rates and incentives to borrow and lend
when real interest rate is low, there are greater incentives to borrow and fewer incentives to lend , real interest rate is a better indicator of incentives to borrow and lend
what is an asset
anything that can be owned and has value
determinants of asset demand
wealth, expected return, risk, liquidity
wealth
total resources owned by the individual including all assets
expected return
the return expected over the next period on one asset relative to alternative assets
Risk
the degree of uncertainty associated with the return on one asset relative to alternative assets
liquidity
ease and speed which which an asset can be turned into cash relative to alternative assets
how is Qd of asset related to wealth
Qd of an asset is positively related to wealth
how is Qd of an asset related to expected return
Qd of an asset is positively related to its expected return relative to alternative assets
how is Qd of an asset related to risk
Qd of an asset is negatively related to the risk of its returns relative to alternative assets
How is Qd of an asset related to liquidity
Qd of an asset is positively related to its liquidity relative to alternative assets
Prices and Qd in bond market
at lower prices Ie higher interest rates, the Qd of bonds is higher (inverse relationship
Price and Qs in bond market
at lower prices (higher interest rates) Qs of bonds is lower, (direct positive relationship)
excess supply of bonds and price
with excess supply of bonds the bond price falls
with excess demand of bonds and price
with an excess demand of bonds, the bond price tends to rise
greater demand than supply of bonds
price will rise interest rates will fall
greater bond supply
when excess supply of bonds, price will fall and interest rates will rise
demand shift: in an expansion with growing wealth
demand curve for bonds shifts to the right
Demand shift: higher expected interest rates in the future
higher expected interest rates in the future lower the expected return for long term bonds shifting the demand curve to the left
relationship between interest rates and bond prices
inverse relationship between interest rates and bond prices. When interest rates rise, the price of existing bonds typically falls because newer bonds are issued with higher interest rates making them more attractive compared to older bonds with lower rates so prices of prices of existing bonds decrease so that their ROI match prevailing rates
if investors expect that interest rates will be higher in the future they foresee that prices of long term bonds will decrease so this makes long term bonds less attractive lower demand
increase in expected rate of inflation and Dbonds
an increase in the expected rate of inflations lower the expected return for bonds causing the demand curve to shift to the left
increase in risk and change in demand for bonds
an increase in riskiness of bonds causes demand for bonds to shift to the left
increase in liquidity of bonds and change in demand
increase in liquidity of bonds results in the demand curve shifting right
supply shifters of bond market
profitability, inflation, govt budget
expected profitability in expansion shifting supply curve
in an expansion, the supply curve shifts to the right
how does increase in expected inflation affect supply of bonds
increase in expected inflation shifts the supply curve for bonds to the right, decreasing supply of bonds
how does increased budget deficits shift supply for bonds
increase in budget deficits shifts supply curve to the right
Fisher effect: response to change in expected inflation
a rise in expected inflation shifts the bond demand curve leftward and supply curve to the right which causes the price of bonds to fall and the eq interest rate to rise
supply and demand shifts in response to expansion
expansion shifts the bond supply curve rightward, and shifts the bond demand curve to the right but by less so the price of bonds falls and the eq interest rate rises
supply and demand in the money market demand for money in liquidity preference frame work
as the interest rate increases, the opportunity cost of holding money increases and the relative expected return of money decreases and therefore the quantity demanded for money decreases
income effect
a higher level of income causes the demand for money at each interest rate to increase and the demand curve to shift to the right
price level effect
a rise in price level causes the demand for money at each interest rate to increase and demand curve shifts to the right
increase in income
increases demand for money increases interest rate (holding money supply constant)
increase in price level
increases money demand, increasing interest rate (holding money supply constant)
increase in money supply
increasing money supply holding demand constant will decrease the real interest rate
