Finance Chapter: Interest Rates and Bonds

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Questions and Answers

What does the nominal interest rate primarily indicate?

The rate of growth of money if invested over a specified period (correct)

The difference between real and inflation rates

The overall increase in economic value of investments

The growth of purchasing power after adjusting for inflation

How does an increase in interest rates generally affect investment attractiveness?

It makes investments more favorable regardless of cost

It has no significant effect on investment attractiveness

It shifts the focus towards saving instead of investing

It increases the costs of an investment relative to its benefits (correct)

What is the formula to approximate the real interest rate?

Real rate = (Nominal rate + Inflation rate)/(1 - Inflation rate)

Real rate = (Nominal rate – Inflation rate)/(1+Inflation rate) (correct)

Real rate = Nominal rate - Inflation rate

Real rate = Nominal rate + Inflation rate

Why might a central bank lower interest rates?

To stimulate investment during an economic slowdown Signup and view all the answers

What effect does inflation have on the real interest rate?

It diminishes the rate of purchasing power growth Signup and view all the answers

What does the value of a coupon bond represent?

The total coupon payments and the face value at maturity. Signup and view all the answers

How often do coupon bonds typically pay their interest payments when they have a semiannual coupon?

Every six months. Signup and view all the answers

In the given example, what is the amount of each semiannual coupon payment?

$11. Signup and view all the answers

What is the primary source of return on a coupon bond?

Periodic coupon payments and the difference between purchase price and principal value. Signup and view all the answers

What information is necessary to compute the Yield to Maturity (YTM) of a coupon bond?

The current market price, coupon payments, and payment schedule. Signup and view all the answers

What is the equivalent monthly interest rate for an effective annual rate (EAR) of 6%?

0.4868% Signup and view all the answers

How can you compute an equivalent discount rate for multiple periods from a single-period discount rate?

(1 + r)^n - 1 Signup and view all the answers

If you want to accumulate $100,000 in 10 years with monthly contributions, how many payments will you make?

120 Signup and view all the answers

Which adjustment is necessary when computing present or future values?

Adjust the discount rate to match the time period Signup and view all the answers

How much will you need to save each month to accumulate $100,000 in 10 years with a monthly interest rate of 0.4868%?

$615.47 Signup and view all the answers

What is the opportunity cost of lending money to a friend offering to pay back $110 after one year when you could have earned 8% elsewhere?

$8 Signup and view all the answers

Which of the following represents a fractional power adjustment for interest rates?

(1 + r)^(1/12) Signup and view all the answers

In bond terminology, what is the 'face value' of a bond?

The notional amount used to compute interest payments Signup and view all the answers

What is the significance of the exponent 1/12 in the calculation of monthly interest from an effective annual rate?

It reflects the number of months in a year. Signup and view all the answers

Which statement accurately describes the term 'maturity date' in the context of bonds?

The final repayment date of the bond Signup and view all the answers

What is the formula used to calculate the future value of an annuity?

FV = C * [(1 + r)^n - 1] / r Signup and view all the answers

What does the coupon payment of a bond represent?

The periodic interest payments made to the bondholder Signup and view all the answers

If the coupon rate is 5% and the face value of a bond is $1,000 with yearly payments, how much will be paid in coupons annually?

$50 Signup and view all the answers

What is the primary reason companies and governments issue bonds?

To raise funds for future payments Signup and view all the answers

Which of the following best describes the relationship between opportunity cost and investment alternatives?

Opportunity cost is the potential return missed from not choosing the best alternative. Signup and view all the answers

What does the term 'term' refer to in bond terminology?

The duration until the final repayment date Signup and view all the answers

What is credit risk in the context of corporate bonds?

The risk of default by the issuer of any bond Signup and view all the answers

Why do corporations with higher default risk have to pay higher coupons?

To compensate for the increased credit risk Signup and view all the answers

How does the yield to maturity (YTM) of a defaultable bond typically differ from its expected return?

YTM is calculated with the assumption that all cash flows will be paid Signup and view all the answers

What characterizes investment-grade bonds?

They are rated AAA through BBB Signup and view all the answers

Which of the following is true regarding speculative bonds?

They are considered high-yield bonds Signup and view all the answers

Which organization is NOT listed among the top bond-rating companies?

Deloitte Signup and view all the answers

What do bond ratings assist investors in determining?

The creditworthiness and risk of bankruptcy Signup and view all the answers

How can a higher yield to maturity (YTM) be misleading?

It suggests a better than average expected return Signup and view all the answers

What is the correct formula for calculating the fair price of a 3-year, 5% coupon bond with a $1,000 face value?

$50/(1+0r1) + $50/(1+0r2)^2 + $1,050/(1+0r3)^3 Signup and view all the answers

How does changing the coupon rate to a semiannual rate affect the fair price of the bond?

The fair price will increase because the cash flows will be higher. Signup and view all the answers

What is the total present value of cash flows from a 5% coupon bond over 3 years when using annual rates?

$953.27 Signup and view all the answers

In a term structure, what effect does an increasing interest rate have on the fair value of fixed coupon bonds?

It reduces the fair value of the bonds. Signup and view all the answers

What is indicated by the term 'coupon rate' in a bond?

The interest paid to bondholders as a percentage of face value. Signup and view all the answers

Study Notes

Lecture Note 4: Interest Rates and Bonds

Interest rates are the price of using money
Rates are commonly quoted daily, monthly, semi-annually, or annually
Effective annual rate (EAR) or annual percentage yield (APY) is the total interest earned at the end of one year
Earning an EAR of 5% for two years is equivalent to earning 10.25% in total interest over the entire period
Interest rates can be adjusted to different time periods, for example, an annual rate of 5% is equivalent to 2.47% semi-annually
Computing loan payments involves amortizing loans
A 30,000carloanwitha6.7530,000 car loan with a 6.75% APR (monthly compounding) for 5 years has a monthly payment of 30,000carloanwitha6.75590.50
Computing outstanding loan balances uses the present value (PV) of remaining payments
Interest rates are determined by market forces based on the relative supply and demand of funds Factors include inflation, current economic activity, expectations future growth
Nominal interest rates are the rate at which your money will grow when invested for a particular period
Real interest rate is the rate of growth of your purchasing power, after adjusting for inflation
Real rate ≈ Nominal rate – Inflation rate
Investment and interest rates influence individual's propensity to save and firms' incentive to raise capital and invest.
Central banks use interest rates to guide the economy, stimulating investment during slowdowns and reducing it during overheating.
The yield curve displays the relationship between the investment term and the interest rate
The yield curve is crucial for computing present values and future values of risk-free cash flows.
Risk-free rate is the rate at which money can be borrowed or lent without risk.
Understanding the opportunity cost of capital is determining the best available expected return offered in the market
This relates to the return forgone when an investor decides to invest in a new project, and sets the minimum required return for similar risk-term investments
Bond pricing changes due to the passage of time and changes in interest rates
Bond prices converge to their face value as maturity approaches
A bond's market price reflects the current market interest rates which affect its yield to maturity

Bond Valuation

Bond Terminology:
- Bond certificate: stipulates bond terms, payment amounts, and dates
- Face value, par value, or principal amount: the notional amount
- Maturity date: the final payment date for the bond
- Term: time remaining until the final repayment
- Coupons: periodic interest payments

Zero-Coupon Bonds

Zero-coupon bonds do not pay coupons during their life
Zero-coupon bonds have only two cash flows: the purchase price and the face value at maturity
Determining the fair price of a zero-coupon bond involves calculating the present value of the future face value, using the market interest rate as the discount rate

Coupon Bonds

Coupon bonds make regular coupon interest payments and pay the face value at maturity
The value of a coupon bond is the sum of the present values of all future coupon payments and the face value

Corporate Bonds

Credit risk is the possibility of default by the issuer of a bond
Corporate bonds have credit risk because corporations may fail to pay promised cash flows
Rating agencies assess creditworthiness
Corporate bonds with higher credit risk (default risk) need to pay higher coupons to attract investors.
Bond ratings help investors evaluate credit worthiness
Investment-grade bonds have low default risk.
Speculative/high-yield bonds have higher default risk

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Description

Dive into the crucial concepts of interest rates and bonds in this finance quiz. Learn about different interest rate types, effective annual rates, and how to calculate loan payments and outstanding balances. Test your knowledge about the factors influencing interest rates and market dynamics.