Week 1 Flashcards
What is a bond and what is the role of the bond market
Bond market:
Bond: debt security that promises to make payments periodically for specified period of time
Role:enables corporations and governments to borrow money to finance their activities, and because it is where interest rates are determined (for monetary policy)
What is a stock and what is the role of a stock market
Stock market:
Stock: common stock representing a share of ownership in corporations → a security that is a claim on the earnings and assets of the corporations
Role: public way for corporations to raise funds to finance their activities + important factor in business investment decisions → price of shares affects the amount of funds that can be raised by selling newly issued stock to finance investment spending; higher price = raise larger amount of funds
What is the yield to maturity
Yield to maturity (YTM): the interest rate that equates today’s value of bond (price) with present discounted value of all future payments.
What does a lower YTM stand for (price wise)
A lower YTM = higher price (greater value of the bond)
What is the present value and how do you calculate it
dollar paid to you one year from now is less valuable than a dollar paid to you today.
What are the different debt instruments with different streams of cash flows
Simple loan, fixed payment loan (fully amortized loan), coupon bond, discount (zero-coupon) bond
What is a simple loan and how do you calculate it
Simple loan: funds (principal) that must be repaid at maturity date + additional payment for interest.
You calculate the additional payment for the interest by using the same formula to calculate the present value
What is a fixed payment loan and how do you calculate it
Fixed-payment loan (or fully amortized loan): funds repaid by making fixed payments (FP), consisting of part of the principal + interest, every period until maturity date.
What is a coupon bond and how do you calculate it
Coupon bond: owner of bond receive fixed coupon payment (C) (interest payment) every year until maturity date + final amount (face value, FV).
It is identified by four pieces of information;
1. bond’s face value
2. corporation or government agency that issues the bond
3. maturity date
4. coupon rate
What happens when the bond price is priced at its face value (at par)
When the bond is priced at its face value (‘at par’), i.e. P=F, the yield to maturity equals the coupon rate, i.e. i = c.
Are prices and YTM positively or negatively related?
prices and yields to maturity are negatively related (inverse relationship), i.e. lower price P = higher interest i
What happens when the YTM is larger/ smaller than the coupon rate?
YTM is larger (smaller) than the coupon rate when the bond price is below (above) the par value, i.e. when P < F → i > C. (future payments are worth less so price must fall: discounted bond)
What is a consol and how do you calculate it
Special case of coupon bond: consol (perpetuity)
Bond with no maturity date → fixed coupon payment (C) forever and no principal repaid
For coupon bonds, the equation for the yield of a consol gives an easy-to-calculate approximation of the YTM of the coupon bond. This approximation is the more accurate = the nearer the price is to par = the longer the maturity of the coupon bond
What is a discount (zero coupon) bond and how do you calculate it?
Discount (zero -coupon) bond (e.g. treasury bills): bought at a price below face value (i.e., is bought at a discount), and the face value is repaid at maturity (similar to a simple loan).
The notion of ‘buying at a discount’ implies that the yield is positive.
What is the expected rate of return and how do you calculate it?
(Expected) rate of return (RR) at time t on a coupon bond that will be held from time t until time t+1:
the return of a bond will not necessarily equal the YTM on that bond
What happens to the YTM and RR when time to maturity = holding period
When time to maturity = holding period → YTM = rate of return (no change in value)
What happens to the interest and price when maturity > holding period
When maturity > holding period: increase interest → decrease price (capital loss, because you sell for less than initial value)
What happens to the maturity and the %change in price when there is a %interest change
The longer the maturity, the greater the % price change caused by an % interest change (long term bonds are more sensitive to change → higher ‘interest rate risk’)
What happens to maturity and change in RR when there is a change in interest?
The longer the maturity, the more change in rate of return in response to interest change
Can a bond with high initial interest rate still have a negative RR if interest increases?
Yes, A bond with high initial interest rate can still have a negative rate of return if interest increases
What happens to the interest rate risk if maturity = holding period?
There is no interest rate risk for any bond whose time to maturity matches the holding period, since recognizing the price at the end of the holding period is already fixed at the face value
What is the real interest rate and how do you calculate it?
Real interest rate reflects the true cost of borrowing and lending (i.e. in terms of real value of purchasing power)
Real interest rate (r) = nominal interest rate (i) ‘adjusted’ for the expected inflation rate (π).
r = i - π
What is the fisher equation?
i = r + π
What happens when nominal interest rate (i) is low?
When i is low;
incentives to borrow are larger, because it is less expensive
incentives to lend are smaller, because it is more expensive
What are the determinants of asset demands?
Wealth
Expected returns on bonds relative to alternative assets
Risk of bonds relative to alternative assets
Liquidity of bonds relative to alternative assets
Explain the supply and demand of bonds
Demand and supply of bonds:
Demand (Bd); price increase → interest rates decrease → demand
bonds decrease
Negative relationship between
quantity and price
Supply (Bs); price increase → interest rates decrease → supply
bonds increase
Positive relationship between
quantity and price
Explain the shifts in demand of bonds by using the determinants of asset demand
Shifts in demand of bonds;
Increase wealth (e.g. growth in economy);
More to spend (more to invest in bonds) → Bd increases, and shift to right
Increase expected return relative to other assets;
- Expected rate i increases → P and R decreases (less attractive to hold bonds) → Bd decreases and shifts to left
- Expected inflation increases → r decreases (decrease in real return, les attractive) → Bd decreases and shifts to the left
Increase risk relative to other assets;
Given risk averseness of investors; Bd decreases and shifts to the left
Increase liquidity relative to other assets (e.g. more easily converted into cash);
Bonds become more attractive → Bd increases and shifts to right
Explain the shifts in supply of bonds
Shifts in supply of bonds;
Increase expected profitability of investment (e.g. business cycle expansion);
Better investment opportunities, so more finance needed for firms: Bs increases and shifts to right
Increase expected inflation;
Increase inflation → r decreases (Fisher) → cheaper to borrow money through bonds → Bs increases and shifts to right
Increase government deficit (G-T);
Government needs to borrow more through issuance of bonds → Bs increases and shifts to right
What are other effects on demand & supply of corporate bonds
changes in expected inflation; Inflation goes up → interest rate goes down
Demand: less return on investment → demand goes down and shifts to left
Supply: lower real costs of borrowing → supply goes up and shifts to right
→ Higher price, lower interest rate
Business cycle expansion (economic growth); Demand: more wealth to spend/invest → demand goes up and shifts to right
Supply: better investment opportunities, more financing needed → supply goes up and shifts to right
→ typically, the price of corporate bonds decreases and thus the nominal interest rate increases during a business cycle expansion
note that the interest rate could in principle decrease during a business cycle expansion. Indeed, that would happen if demand would have increased to a stronger degree than supply.
What are inflation indexed bonds and its charactersitics?
Inflation-indexed bonds: standard coupon bond with the following characteristics
characteristics:
- face value/ principal adjusted for inflation
- coupon rate is fixed
- periodic coupon payments; fixed rate of inflation-adjusted value → thus also adjusted for inflation
- outcome: income streams (repayment of face value and coupon payments) move up and down with inflation
What are the reasons for the existence of inflation-indexed bonds? and how do you calculate the price of non-indexed and indexed bonds?
Reason for existence:
In countries with high inflation, the bonds offer (real) constant cash flows → attractive to investors even when there is expectations of high inflation → otherwise may refuse to buy government bonds because expected returns of bonds relative to other assets decrease (see effect of expected price level increase on demand for bonds)
Allow market participants and central banks to obtain estimates on expected inflation → when issued in conjunction with identical bonds with no indexation -> since mandated to keep inflation low.
