Topic 3 Flashcards
What is future value?
The value on some future date of an investment made today
FV = ?
PV + PV(i) = PV(1+i)
More than one year:
PV(1+i)^n
What is present value?
The value today of a payment that is promised to be made in the future
PV = ?
FV/(1+I)^n
What makes the present value higher? (3)
The higher future value of the payment (FV)
The shorter time period until payment (n)
The lower the interest rate (i)
What are zero-coupon or discount bonds?
Bonds with one single future payment
What are fixed-payment loans?
Type of bond with a sequence of fixed payments
What are coupon bonds?
Periodic interest payments + principal repayment at maturity
How do you calculate the price of a zero coupon bond?
Because it is a single payment on a future date, it’s price is just the present value:
Face value/(1+i)
Price Ida coupon bond?
CP = coupon payment
CP/(1+i) + CP/(1+i)^2…. + CP/(1+i)^n + FV/(1+i)^n
FV = face value here
How to calculate the value of a fixed payment loan?
FP/(1+i) + FP/(1+i)^2 ….. ^n
Here FP is fixed payment
What is nominal yield?
The stated rate of the bond
What is yield to maturity?
The amount the bond holders receive if they hold the bond to its maturity, when the principal payment is made
What is current yield?
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
Current yield equation?
Current yield = yearly payment/price paid
Price yield diagram
Page 80
What is the relationship between bond price and yield to maturity?
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
What is a par bond and what are its characteristics?
Par bond: BP = FV
Tf CR = CY = YM
BP = bond price FV = face value CR = coupon rate YM = yield to maturity CY = current yield
Why is it called a coupon ‘rate’ when it is a fixed payment?
Because the coupon rate is equal to the yield on the date of issue
What is a discount bond?
BP less than FV
TF CR
What is a premium bond?
BP>FV
Tf CR>CY>YM
government security that offers no interest or capital gain but is entered into regular draws for cash prizes
3 assumptions regarding equilibrium in the bond market?
No change in stocks of bonds
Price proportional to 1/interest rate
Hold bond to maturity
Factors that shift bond supply? (3)
Change in expenditure of government relative to revenue
Change in business conditions
Change in EXPECTED inflation
Why do increases in gov expenditure relative to tax revenue increase bond supply?
Increase in expenditure -> increase borrowing tf -> increase supply
Why do improving business conditions lead to increase bond supply?
As conditions improve, firms want to borrow more to invest tf issue more bonds tf bond supply shifts right
Why does an increase in expected inflation cause an increase in bond supply?
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
Learn bond equilibrium diagram
Now
Why are bond prices inversely related to interest rates?
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
6 factors that shift bond and demand and why?
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)
Explain the effect of increasing expected inflation in bonds (inc. diagram)?
Reduces cost of borrowing tf Supply increases
Lowers real return on lending tf demand decreases
result: fall in price, no change in equilibrium quantity
3 reasons bonds are risky and explanations?
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
