week 14 Flashcards
what are interest rates per period
most straightforward
not on an annual basis
what are stated annual interest rate / quoted rate
periodic compounding
most available rate
known as APR - the interest charged per period times the number of periods per year
what is effective interest rate
most informative rate
what is the frequency of compounding
investments pay more interest more than once a year,
semi-annual interest rate that compounds twice a year
how can future value be expressed
PV (1 + (rs/m)) ^ mN
m is the number of compounding periods
N is number of years
what is effective annual rate (EAR)
the actual rate paid after accounting for compounding that occurs during the year
used to compare two alternative investments with different compounding periods
how do you calculate EAR
(1 + (APR / m))^m - 1
how do you calculate APR from EAR
APR = m x ((1 + EAR) ^1/m -1)
what are loan types
there are unlimited possibilities of how loan principal and interest is paid
pure discount loans
interest-only loans/bullet bonds
amortised loans (fully or partially)
what are pure discount loans
the borrower receives money today and repays a single lump sum at end of the loan
what are interest only loans
interest only loans require payment of interest each period and the repayment of the principal at a later date
what are amortised loans
principal is repaid overtime
the amount of principal is decreasing overtime
as part of the principal gets repaid, interest is calculated only on the remainder of the principal
periodic payments = interest + repayment of a portion of the principal
what are the two types of amortised loans
fixed principal
fixed payments
what is an amortisation schedule
a table that describes the periodic payments as well as the interest and principal balance after each payment
what is fixed principal
the principle balance is reduced by the same amount each period
the periodic payment is different each year
what is fixed payment
the principal balance is reduced by a different amount each period, at the end of the last period the principal is reduced to 0
the periodic payment is fixed each year
what are bonds
a debt instrument requiring the issuer to repay to the investors the amount borrowed plus interest over a specified period of time
issuers - the parties that borrow money and issue debt securities
investors - the parties that lend money to issuers by buying the debt securities
other parties - underwriters: investment banking firms that act as agents to distribute bonds to investors
what is face value
a bond is normally an interest-only loan
the borrower will pay the interest every period, but none of the principal will be paid until the end of the loan
face amount, repaid at maturity, most of the time it is not equal to bond price
what are coupons
periodic payments that issuers promise to make
usually constant, determined upon issue, usually expressed as a percentage of par value
how do you calculate coupon payment
(coupon rate x par value) / number of coupon payments per year
how do you calculate current yield
coupon / market price
what is maturity
the number of years until the face value is paid
the maturity date of a bond refers to the date when the debt will cease to exist
bonds may be short term and long term
years to maturity
what is yield to maturity
the yield to maturity is the interest rate investors want to earn on a bond
the investor holds the bond to maturity
the issuer makes all the coupon and principal payments in full on scheduled dates
the investor is able to reinvest coupon payments at the same yield
how do you calculate bond pricing equation
C x (1- (1/(1+r)^t)) /r + F x (1/(1+r)^T)
what are bond prices, the relationship between coupon and yield
YTM = coupon rate, par value = bond price
YTM > coupon rate, par value > bond price - discount bond
YTM < coupon rate, par value < bond price - premium bond
what are bond price movements
passage of time - price of a bond changes as the bond approaches maturity
changes in interest rates - for a standard, option free board, the cash flows will not change during the life of a bond, any changes are reflected in price
who cares about price changes of the bond
investors
issuers
what is bond price convergence
bond value differs from par value before maturity
regardless of required yield, price converges toward par value as maturity approaches
