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Questions and Answers
If the interest rate is zero, a promise to receive a $100 payment one year from now is:
If the interest rate is zero, a promise to receive a $100 payment one year from now is:
Present value is higher when the future value of the payment is:
Present value is higher when the future value of the payment is:
At a price of $400 in the bond market, which of these statements is true?
At a price of $400 in the bond market, which of these statements is true?
How would a period of robust economic growth reflect in the risk structure of interest rates?
How would a period of robust economic growth reflect in the risk structure of interest rates?
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When expected inflation increases, for any given nominal interest rate:
When expected inflation increases, for any given nominal interest rate:
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Which one of the following would lead to an increase in bond supply?
Which one of the following would lead to an increase in bond supply?
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Suppose that the expected return on bonds falls relative to other assets. In the bond market this will result in:
Suppose that the expected return on bonds falls relative to other assets. In the bond market this will result in:
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Which one of the following statements about the result of a deterioration in business conditions that also causes a decrease in a nation's wealth is false?
Which one of the following statements about the result of a deterioration in business conditions that also causes a decrease in a nation's wealth is false?
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Which of the following is true of interest-rate risk?
Which of the following is true of interest-rate risk?
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What would happen if it is expected that the Federal Reserve will be raising interest rates before the end of the year?
What would happen if it is expected that the Federal Reserve will be raising interest rates before the end of the year?
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Explain what happens if an economy continues to grow at robust rates for a long period of time.
Explain what happens if an economy continues to grow at robust rates for a long period of time.
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If a bond's rating improves, we would expect:
If a bond's rating improves, we would expect:
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Fatima holds a one-year $200 face value, taxable bond with a coupon rate of 5%. If she faces a tax rate of 20%, how much tax will she pay for income earned on the investment, and what is the return on the investment when taxes are taken into account?
Fatima holds a one-year $200 face value, taxable bond with a coupon rate of 5%. If she faces a tax rate of 20%, how much tax will she pay for income earned on the investment, and what is the return on the investment when taxes are taken into account?
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What is the yield to maturity of a bond if I purchase a 10 percent coupon bond based on my purchase price and calculate it to be 8 percent?
What is the yield to maturity of a bond if I purchase a 10 percent coupon bond based on my purchase price and calculate it to be 8 percent?
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Study Notes
Interest Rates and Value
- Receiving 100todayismorevaluablethanreceiving100 today is more valuable than receiving 100todayismorevaluablethanreceiving100 in the future because of the opportunity cost of delaying consumption.
- The higher the interest rate, the less valuable a future payment is, as the opportunity cost of delaying consumption increases.
- The present value of a future payment is the amount of money that would have to be invested today to equal the future payment, taking into account the interest rate.
- When the interest rate is zero, there is no opportunity cost of delaying consumption, so receiving 100todayisequaltoreceiving100 today is equal to receiving 100todayisequaltoreceiving100 in the future.
Bond Market Basics
- Bond demand is a function of price, with a higher price leading to lower demand as bonds become relatively more expensive compared to other assets.
- The supply of bonds is influenced by factors such as government spending, wealth, and inflation expectations.
- The equilibrium price in the bond market occurs where the quantity demanded of bonds equals the quantity supplied.
- An excess supply of bonds occurs when the quantity supplied exceeds the quantity demanded, leading to downward pressure on prices.
- An excess demand for bonds occurs when the quantity demanded exceeds the quantity supplied, leading to upward pressure on prices.
Risk Structure of Interest Rates
- The term structure of interest rates describes the relationship between yields and maturities for bonds with similar risk and liquidity.
- The yield curve is a graphical representation of the relationship between maturity and yield.
- A normal yield curve is upward sloping, implying that longer-maturity bonds have higher yields.
- An inverted yield curve is downward sloping, suggesting that investors expect lower interest rates in the future.
- The term spread, or interest rate spread, is the difference in yield between two bonds with different maturities.
Inflation and Interest Rates
- Higher expected inflation leads to an increase in the nominal interest rate, as investors demand higher returns to compensate for the erosion of purchasing power.
- As expected inflation rises, demand for bonds falls, and the supply of bonds increases, pushing prices downward and yields upward.
- A decrease in expected inflation, such as government policies aimed at reducing the money supply, would lead to a decrease in bond yields.
Bond Market Shifts
- A decrease in government spending, leading to a reduction in government debt issuance, would shift the bond supply curve to the left.
- A decrease in the nation's wealth would lead to decreased demand for bonds, shifting the bond demand curve to the left.
- Improved general business conditions would lead to increased demand for bonds, shifting the demand curve to the right.
Interest Rate Risk
- Interest rate risk refers to the risk that changes in interest rates will affect the value of a bond.
- Higher interest rate risk is associated with longer-maturity bonds, as their prices are more sensitive to changes in interest rates.
- The coupon rate of a bond is fixed and does not change as interest rates fluctuate in the market.
Bond Market Dynamics
- The expected increase in interest rates by the Federal Reserve would lead to a decrease in bond prices and an increase in bond yields, as investors anticipate lower returns from existing bonds compared to those issued in the future.
- Robust economic growth leading to strong demand for credit would increase the supply of bonds, pushing prices down and yields upward.
- An improvement in a bond's rating signals decreased risk and may lead to increased demand, pushing prices upward and yields downward.
Tax Considerations
- Bondholders are subject to taxes on the interest income earned from their investments.
- The tax burden on bond income reduces the after-tax return earned by the bondholder, affecting investment decisions.
- The after-tax return is calculated by subtracting the tax payable from the coupon income received.
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