Week One B

Question 1

What do interest rates do as a mechanism (3)

Answer 1

Link the present to the future
Tell the future reward for lending today
Tell the cost of borrowing now and repaying later

Question 2

What is future value

Answer 2

the value on some future date of an investment made today.

Question 3

What is future value equation

Answer 3

FV =PV +PV ×(i)=PV ×(1+i)
The higher the interest rate or the higher the amount invested the higher the future value

Question 4

What is the equation of future value with compound interest

Answer 4

FV = PV × (1 + i)^n

Question 5

What is present value

Answer 5

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

Question 6

What is the present value equation

Answer 6

PV = FV/ (1+i)^n

Question 7

When is present value higher

Answer 7

• The higher future value of payment, FV
• the shorter time until payment, n
• the lower the interest rate, i
  Doubling the future value of the payment, without changing the time of the payment or the interest rate, doubles the present value.

Question 8

How are high interest rates and present value connected

Answer 8

Higher interest rates are associated with lower present values no matter the size or timing of the payment

Question 9

What is a bond

Answer 9

• A bond is a promise to make a series of payments on specific future dates.
• Bonds create obligations, and are therefore thought of as legal contracts that:
  Require the borrower to make payments to the lender, and
  specify what happens if the borrower fails to do so.

Question 10

How much should you be willing to pay for a bond?

Answer 10

The price of a bond depends on the bond characteristics.

Question 11

What is a zero coupon bond

Answer 11

single future payment.

Question 12

What is a fixed payment loans

Answer 12

Sequence of fixed payments

Question 13

What are coupon bonds

Answer 13

periodic interest payments + principal repayment at maturity.

Question 14

What are consol or perpetuity bonds

Answer 14

like coupon bonds whose payments last forever

Question 15

What is a zero coupon bond

Answer 15

• They represent a pro use to pay a certain amount on a fixed future date
• there price is less than their face value as they sell at discount
• the price is the present value

Question 16

Price of one year zero coupon bond

Answer 16

Face value / (1+i)

Question 17

What is the price of s six month zero coupon bond

Answer 17

Face value /(1+)^1/2

Question 18

What is an example of a fixed payment loan

Answer 18

Conventional home mortgages and car loans are fixed-payment loans.

Question 19

What is a fixed payment loan equation

Answer 19

Fixed payment / (1+i) …..the sum of the present value of the payments

Question 20

What is a coupon bond

Answer 20

The issuer of a coupon bond promises to make a series of periodic interest payments (coupon payments), plus a principal payment at maturity.

Question 21

What is the coupon bond equation

Answer 21

Coupon payment/ (1+i)

Question 22

What is a consol or perpetuity bonds

Answer 22

The issuer of a perpetuity promises to make a series of periodic interest payments forever.

Question 23

Consol or Perpetuity equation

Answer 23

Yearly Coupon Payment/ i

Question 24

How do we determine the return to an investment based on a bonds price

Answer 24

By combining information about the promised payments with the bond’s price to obtain the yield

Question 25

What does yield represent in the context of investing?

Answer 25

Yield serves as a measure of both the cost of borrowing for the issuer of the bond and the reward for lending for the bondholder.

Question 26

Can yield and interest rate be used interchangeably?

Answer 26

Yes, in the context of bonds and other fixed-income securities, yield and interest rate are often used interchangeably to refer to the return on investment.

Question 27

What is the nominal yield of a bond?

Answer 27

The nominal yield is the stated rate of the bond.

Question 28

Why is yield to maturity considered the most useful measure of the return on holding a bond?

Answer 28

Yield to maturity represents the yield bondholders receive if they hold the bond to its maturity when the final principal payment is made.

Question 29

Define current yield

Answer 29

Current yield is the interest rate of the bond given its current price, calculated as Yearly Coupon Payment divided by Price Paid. It measures the return from buying the bond that arises solely from the coupon payments.

Question 30

Current yield equation

Answer 30

Yearly coupon payment / price paid

Question 31

What is the fundamental property of a bond regarding its price and the required yield?

Answer 31

A fundamental property of a bond is that its price changes in the opposite direction to the change in the required yield.

Question 32

Why does the price of a bond move inversely to changes in yield?

Answer 32

The price of the bond is the present value of its cash flows. As the required yield increases, the present value of future cash flows decreases, leading to a decrease in bond price. Conversely, as the required yield decreases, the present value of future cash flows increases, leading to an increase in bond price.

The price of a bond moves inversely to changes in yield due to the relationship between bond prices and interest rates. When interest rates rise, newly issued bonds offer higher yields to investors, making existing bonds with lower yields less attractive. As a result, the prices of existing bonds decrease to make their yields more competitive with the new bonds.

Conversely, when interest rates fall, newly issued bonds offer lower yields, making existing bonds with higher yields more attractive. This increased demand for higher-yielding existing bonds causes their prices to rise.

Question 33

What happens to the yield to maturity when the bond price increases?

Answer 33

When the bond price increases, the yield to maturity decreases

Question 34

Par bond

Answer 34

Bond Price = Face value (par value): Coupon rate = Current yield = Yield to maturity

Question 35

Discount Bond

Answer 35

Bond price < Face value (par value): Coupon rate < Current yield< Yield to maturity

Question 36

Premium bond

Answer 36

Bond price > Face value (par value): Coupon rate > Current yield > Yield to maturity

Question 37

What is Holding Period Return (HPR)?

Answer 37

Holding Period Return is the return of holding a bond and selling it before maturity.

Question 38

How does Holding Period Return (HPR) differ from yield to maturity?

Answer 38

HPR can differ from yield to maturity because it accounts for capital gains or losses when selling the bond before maturity, whereas yield to maturity assumes holding the bond until maturity.

Question 39

What happens whenever the price of a bond changes?

Answer 39

Whenever the price of a bond changes, there is a capital gain or loss associated with the price change.

Question 40

Why does the importance of Holding Period Return increase with larger price changes?

Answer 40

The greater the price change of a bond, the more significant the impact on the overall return, making Holding Period Return more important to consider.

Question 41

How does the term of the bond affect price movements and associated risks?

Answer 41

The longer the term of the bond, the greater the potential for price movements and associated risks due to changes in interest rates and market conditions.

Question 42

Fisher equation

Answer 42

I = r + πe
- The nominal interest rate you agree on (i) must be based on expected inflation (πe) over the term of the loan plus the real interest rate you agree on (r).
The higher expected inflation, the higher the nominal interest rate.

Question 43

Real interest rate equation

Answer 43

R= i - πe