Interest Rates and Loan Valuation
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Questions and Answers

What effect does an increase in expected inflation have on the supply curve for bonds?

  • It shifts the supply curve to the left.
  • It shifts the supply curve to the right. (correct)
  • It causes the supply curve to become vertical.
  • It has no effect on the supply curve.

Which factor is negatively related to the quantity demanded of an asset?

  • Expected return
  • Liquidity
  • Wealth
  • Risk (correct)

Which statement accurately describes a characteristic of US Treasury bonds?

  • They are susceptible to income tax considerations.
  • They are considered default free. (correct)
  • They have high liquidity but high default risk.
  • Their interest rates are always lower than municipal bonds.

What happens to the quantity supplied of bonds as prices increase?

<p>It increases. (B)</p> Signup and view all the answers

What does the yield curve represent?

<p>The relationship between bond yields and time to maturity. (A)</p> Signup and view all the answers

How does an increase in government budget deficits affect the supply of bonds?

<p>It shifts the supply curve to the right. (D)</p> Signup and view all the answers

Which type of bond interest payments are exempt from federal income taxes?

<p>Municipal bonds (B)</p> Signup and view all the answers

What primarily determines heterogeneity across the yields of bonds with the same maturity?

<p>Default risk and liquidity (C)</p> Signup and view all the answers

What does the present value of a future cash flow consider?

<p>The interest rate over time (A)</p> Signup and view all the answers

How is yield to maturity (YTM) defined?

<p>The interest rate that equates the present value of cash flows to today's value (A)</p> Signup and view all the answers

When the price of a coupon bond is below its face value, how does the yield to maturity compare to the coupon rate?

<p>It is greater than the coupon rate (D)</p> Signup and view all the answers

What is a characteristic of a consol or perpetuity?

<p>It pays fixed coupon payments indefinitely (C)</p> Signup and view all the answers

For a discount bond, how is the yield to maturity calculated?

<p>By taking the change in bond price over a year and dividing by the initial price (C)</p> Signup and view all the answers

What does the equation $i_c = \frac{C}{P_c}$ represent for a consol bond?

<p>The relationship between yield to maturity and price (D)</p> Signup and view all the answers

What is the characteristic of a fixed payment loan?

<p>The same cash flow payment every period (A)</p> Signup and view all the answers

Which calculation defines the rate of return?

<p>Payments plus change in value as a fraction of purchase (A)</p> Signup and view all the answers

Flashcards

Present Value

The value of a future cash flow expressed in today's dollars. A dollar today is worth more than a dollar tomorrow due to the potential for earning interest.

Yield to Maturity (YTM)

The interest rate that equates the present value of future cash flows from a debt instrument to its current market value.

Consol or Perpetuity

A bond that pays a fixed coupon payment forever and does not have a maturity date.

Discount Bond

A bond that is sold at a discount to its face value and doesn't pay any coupon payments. It's basically a loan without any interest payments.

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Coupon Rate

The rate of return a bond investor receives when the bond is priced at its face value. It is simply the coupon rate.

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Current Yield

The annual interest payment divided by the current market price of the bond. This provides a rough estimate of a bond's yield to maturity.

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Coupon Payment

The annual interest payment on a coupon bond expressed as a percentage of the bond's face value.

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Face Value (Par Value)

The total value of a bond at maturity. The amount the bondholder will receive when the bond matures.

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Inverse Relationship between Bond Prices and Interest Rates

The relationship between bond prices and interest rates. As prices go down, interest rates go up, and vice versa. This is because investors demand a higher interest rate for a bond with a lower price.

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Bond Demand

The quantity of bonds that investors are willing to buy at a given price. It's affected by factors like wealth, expected return, risk, and liquidity.

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Bond Supply

The quantity of bonds that issuers are willing to sell at a given price. Factors like expected profitability, inflation, and government budget deficits influence it.

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Default Risk

The risk that a bond issuer will be unable or unwilling to make interest payments or repay the face value of the bond. This risk is higher for bonds issued by companies with a lower credit rating.

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Bond Liquidity

The ease with which a bond can be bought or sold in the market. Higher liquidity means the bond can be easily converted to cash. This is important for investors who may need to sell their bonds quickly.

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Term Structure of Interest Rates

The relationship between interest rates and the maturity of bonds. It's depicted by the yield curve, which shows how yields change across different maturities.

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Factors Affecting Bond Yields

The yield on a bond is determined by the risk, liquidity, and tax considerations associated with it. Similar bonds may have different yields depending on these factors.

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Yield Curve

A plot of the yields on bonds with different maturities but the same risk, liquidity, and tax considerations. It shows how interest rates change based on the time until maturity.

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Study Notes

Measuring Interest Rates

  • Present value: a dollar received today is worth more than a dollar received in the future
  • Simple present value: PV = CF / (1 + i), where PV is present value, CF is future cash flow, and i is the interest rate. This is useful for comparing payments at different points in time.

Simple Loan

  • The value of an initial amount borrowed is related to future cash flows by the interest rate over the appropriate period
  • Future cash flow equals the initial amount borrowed plus interest
  • For simple loans, the yield to maturity equals the simple interest rate.

Fixed Payment Loan

  • Fixed cash flows paid every period throughout the life of the loan.
  • Loan value (LV) is equal to the sum of the future fixed payments (FP) discounted to the present value (using the yield to maturity or YTM) over the maturity period.
  • Formula for calculated Loan Value (LV): LV = FP / (1 +i) + FP/ (1+i)^2 + ... + FP/(1+i)^n

Coupon Bond

  • Pricing: present value of future coupon payments + face value at maturity
  • The price and yield to maturity are negatively related (higher yields, lower prices).
  • Yield to maturity is greater than the coupon rate if the bond price is below face value.

Discount Bond

  • Price of the bond is less than the face value.
  • The yield to maturity (YTM) is calculated by the difference between the face value and current price, divided by the initial price.

Market Instruments

  • Simple loan: a loan with a single payment at maturity
  • Fixed payment loan: equal payments made over the life of the loan.
  • Coupon bond: periodic interest payments (coupons) and a final payment at maturity (face value)
  • Discount bond: purchased at a discount from the face value, paying face value at maturity; no periodic interest payments.

Yield to Maturity (YTM)

  • The interest rate that equates the present value of all cash flows (coupons and principal repayment) from a bond to its current market price.

Consol or Perpetuity

  • A bond with no maturity date that pays fixed coupon payments forever.
  • Price equals the coupon payment divided by the yield to maturity

Rate of Return

  • The total return on an investment expressed as a percentage of the initial investment. This is also known as the realized rate of return, or an ex post rate of return.

Supply and Demand in the Bond Market

  • At lower prices (higher interest rates), the quantity demanded of bonds is higher (negative relationship)
  • At lower prices (higher interest rates), the quantity supplied of bonds is lower (positive relationship)

What Shifts Bond Demand?

  • Higher wealth, higher expected return (relative to other assets), lower risk of return (relative to other assets), and higher liquidity relative to other assets.

What Shifts Bond Supply?

  • Profitability of investments, inflation expectations, and government budget influence supply.

Determining Heterogeneity in Bond Yields

  • Default risk: the probability that a bond issuer won't make interest payments or pay back face value.
  • Liquidity: the ease with which a bond can be converted to cash.
  • Income taxes: tax considerations relating to interest payments.

Term Structure of Interest Rates

  • Yield curve: a plot of yields on bonds with different terms to maturity.
  • Upward-sloping: long-term rates are higher than short-term rates.
  • Flat: short- and long-term rates are the same.
  • Inverted: long-term rates are lower than short-term rates.

Theories to Explain Yield Curve Facts

  • Expectations theory
  • Segmented markets
  • Liquidity premium theory

Expectations Theory

  • Long-term interest rates are an average of expected future short-term interest rates.

Segmented Markets Theory

  • Bond investors prefer bonds of specific maturities and these preferences determine the yields of different maturity bonds ( independent to the expectations of future short-term rates)

Liquidity Premium Theory

  • Long-term interest rates equal an average of expected future short-term interest rates plus a liquidity premium that reflects investors' preference for bonds with shorter maturities.

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Interest Rates Notes PDF

Description

This quiz covers concepts related to interest rates, present value, simple loans, and fixed payment loans. You'll explore the mathematical relationships between cash flows and interest, as well as the fundamentals of coupon bonds. Test your understanding of these key financial principles!

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