Week 2 Flashcards
If bond prices increase, interest rates….
decrease
If interest rates increase, bond prices….
decrease, bonds will trade at discount to par
If bond prices decrease, interest rates….
increase
If interest rates decrease, bond prices….
increase, bonds will trade at a premium to par
What is a bond?
debt contract where the borrower (issuer) borrows a predetermined amount and pays periodic interest on loan
What is the coupon rate?
rate of interest being paid on face value quoted as an APR
What is YTM?
Yield to maturity is the discount rate for a bond
What is maturity?
date which the loan is repaid
what are the three components of discount rate?
inflation
Opportunity cost
default risk
What is inflation?
rate of interest on investment with repayment in the future
What is oppourtunity cost?
financial markets are subject to supply and demand
Lots of investors with money to lend, OC typically low
During contraction less investors, OC increases
Inflation + Opportunity cost =
Risk-free rate
What is risk-free rate of return?
reflects inflation and opportunity cost collectively such an investment has zero default risk
What is default risk?
rate of interest must adequately compensate the investor for bearing the risk that the borrowing company or government will be unable to repay the loan and default on the contract
Higher default risk becomes
higher interest rates demanded by investors
What is the value of a bond?
PV of all future cash flows (PV of all remaining interest payments and the final face value payment)
Buying a bond after it is issued gives the right to…
all future interest payments and FV payments
Coupon payments are
annuity
T/F: Once a bond is issued coupon rates can change over time while the yield to maturity typically remains constant
False
T/F: When a bond is issued the coupon rate and the yield to maturity are normally equal
True
If the issuer of a bond is viewed to have a higher default likelihood now than when the bond was issued the yield to maturity will be _______ than when the bond was issued and the bond value will be ____ than its face value.
Higher, lower
You expect that interest rates are going to decrease due to a shift in inflation expectations. You have two bonds you are considering buying, the only difference is one matures in 10 years and the other matures in 5 years. Which would you prefer?
10 year maturity bond
Does YTM change over time?
Yes, but it is compensated for bearing risk (coupon payments don’t change)
YTM lower than coupon rate, value is higher than its face value, bond is trading at…
premium
Investors are overcompensated for the risk they are bearing
(default risk, inflation expectations or opportunity costs have decreased since the bond was issued)
