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Financial Markets And Institutions > Topic 3 > Flashcards

Topic 3 Flashcards

1
Q

What is future value?

A

The value on some future date of an investment made today

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2
Q

FV = ?

A

PV + PV(i) = PV(1+i)

More than one year:

PV(1+i)^n

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3
Q

What is present value?

A

The value today of a payment that is promised to be made in the future

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4
Q

PV = ?

A

FV/(1+I)^n

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5
Q

What makes the present value higher? (3)

A

The higher future value of the payment (FV)
The shorter time period until payment (n)
The lower the interest rate (i)

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6
Q

What are zero-coupon or discount bonds?

A

Bonds with one single future payment

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7
Q

What are fixed-payment loans?

A

Type of bond with a sequence of fixed payments

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8
Q

What are coupon bonds?

A

Periodic interest payments + principal repayment at maturity

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9
Q

How do you calculate the price of a zero coupon bond?

A

Because it is a single payment on a future date, it’s price is just the present value:

Face value/(1+i)

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10
Q

Price Ida coupon bond?

A

CP = coupon payment

CP/(1+i) + CP/(1+i)^2…. + CP/(1+i)^n + FV/(1+i)^n

FV = face value here

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11
Q

How to calculate the value of a fixed payment loan?

A

FP/(1+i) + FP/(1+i)^2 ….. ^n

Here FP is fixed payment

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12
Q

What is nominal yield?

A

The stated rate of the bond

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13
Q

What is yield to maturity?

A

The amount the bond holders receive if they hold the bond to its maturity, when the principal payment is made

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14
Q

What is current yield?

A

The interest rate of the bond given its current price

It measures the part of the return from buying the bond that arises solely from the coupon payments

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15
Q

Current yield equation?

A

Current yield = yearly payment/price paid

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16
Q

Price yield diagram

A

Page 80

17
Q

What is the relationship between bond price and yield to maturity?

A

Increase in bond price -> decrease in yield to maturity

Why? Because the coupon payments on bonds are fixed, therefore as the price falls the payments become a larger proportion of the bond so the yield increases

18
Q

What is a par bond and what are its characteristics?

A

Par bond: BP = FV

Tf CR = CY = YM

BP = bond price
FV = face value
CR = coupon rate
YM = yield to maturity
CY = current yield
19
Q

Why is it called a coupon ‘rate’ when it is a fixed payment?

A

Because the coupon rate is equal to the yield on the date of issue

20
Q

What is a discount bond?

A

BP less than FV

TF CR

21
Q

What is a premium bond?

A

BP>FV

Tf CR>CY>YM

government security that offers no interest or capital gain but is entered into regular draws for cash prizes

22
Q

3 assumptions regarding equilibrium in the bond market?

A

No change in stocks of bonds
Price proportional to 1/interest rate
Hold bond to maturity

23
Q

Factors that shift bond supply? (3)

A

Change in expenditure of government relative to revenue
Change in business conditions
Change in EXPECTED inflation

24
Q

Why do increases in gov expenditure relative to tax revenue increase bond supply?

A

Increase in expenditure -> increase borrowing tf -> increase supply

25
Q

Why do improving business conditions lead to increase bond supply?

A

As conditions improve, firms want to borrow more to invest tf issue more bonds tf bond supply shifts right

26
Q

Why does an increase in expected inflation cause an increase in bond supply?

A

Increase in expected inflation means that there is an expected decrease in the cost of real repayment tf more profitable tf increase in bond supply

27
Q

Learn bond equilibrium diagram

A

Now

28
Q

Why are bond prices inversely related to interest rates?

A

Because as interest rates rise, bonds become less attractive relative to interest rate paying investments, therefore their demand falls and so the bond price falls

Vice versa

29
Q

6 factors that shift bond and demand and why?

A

Δwealth (inc. wealth -> inc. D)
Δexpected inflation (dec. Inflation means future payments have increased value tf inc. D)
Δexpected returns (inc. exp. returns -> inc. D)
Δinterest rates (inverse relationship)
Δrisk relative to alternatives (dec. risk -> increase D)
Δliquidity relative to alternatives (inc. liquidity leads to increase demand)

30
Q

Explain the effect of increasing expected inflation in bonds (inc. diagram)?

A

Reduces cost of borrowing tf Supply increases
Lowers real return on lending tf demand decreases

result: fall in price, no change in equilibrium quantity

31
Q

3 reasons bonds are risky and explanations?

A

Default risk = risk bond’s issuer can’t make promised payment

Inflation risk = means investors can’t be sure of real value of payments

Interest rate risk = increase in interest rate may reduce the market value of a bond you hold

Financial Markets And Institutions (8 decks)

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