2: Understanding Interest Rates and Credit Market Instruments
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Questions and Answers

What are the four types of credit market instruments explained in the text?

  • Simple loans, fixed-payment loans, coupon bonds, and discount bonds (correct)
  • Mortgages, auto loans, credit cards, and student loans
  • Treasury bonds, corporate bonds, municipal bonds, and government bonds
  • Securities, derivatives, futures, and options

    • What does the term 'present value' refer to?

    The discounted value of future cash flows or income.

    The ______ to maturity is the most accurate measure of interest rates that equates the present value of cash flows from a debt instrument with its value today.

    yield

    If a coupon bond is priced at its face value, the yield to maturity equals the coupon rate.

    <p>True</p> Signup and view all the answers

    What is the formula used for calculating the yield to maturity of a consol, or perpetual bond?

    <p>$P = C/i$</p> Signup and view all the answers

    What is the formula for calculating the current yield of a bond?

    <p>current yield = (yearly coupon payment) / (price paid)</p> Signup and view all the answers

    In the context of bond pricing, what happens to the current yield when the price of a bond falls below its face value?

    <p>The current yield rises.</p> Signup and view all the answers

    Match the following bond features with their corresponding definitions.

    <p>Default risk = The possibility that the issuer of a bond will not be able to make interest payments or pay off the face value at maturity. Inflation risk = The risk that an investor cannot be sure of the real value of the payments, even if they are made. Interest-rate risk = The risk associated with the interest rate changing between the time the bond is purchased and the time it is sold.</p> Signup and view all the answers

    The longer the term of a bond, the smaller the price change for a given change in interest rates.

    <p>False</p> Signup and view all the answers

    What is the difference between the yield to maturity and the holding period return?

    <p>The yield to maturity is an estimate of the bond's return if held until maturity, while the holding period return is the actual return if the bond is sold before maturity.</p> Signup and view all the answers

    What determines the level of interest rates and their movements?

    <p>All of the above</p> Signup and view all the answers

    What are the four factors that influence the quantity demanded of an asset as explained by the Theory of Portfolio Choice?

    <p>Wealth, expected returns, risk, and liquidity.</p> Signup and view all the answers

    The demand curve for a bond is upward sloping.

    <p>False</p> Signup and view all the answers

    The supply curve for bonds is downward sloping.

    <p>False</p> Signup and view all the answers

    What are the three factors that affect the supply curve for bonds?

    <p>Expected profitability of investment opportunities, expected inflation, and government borrowing or budget deficit.</p> Signup and view all the answers

    What is the risk premium?

    <p>The difference between the interest rates on bonds with default risk and default-free bonds of the same maturity.</p> Signup and view all the answers

    What are the three major risks associated with bonds?

    <p>Default risk, inflation risk, and interest-rate risk.</p> Signup and view all the answers

    Which of the following are types of credit rating agencies?

    <p>Moody's Investor Service, Standard &amp; Poor's Corporation, and Fitch Ratings</p> Signup and view all the answers

    Bonds with ratings below BBB are considered investment-grade securities.

    <p>False</p> Signup and view all the answers

    What is the term structure of interest rates?

    <p>The relationship between interest rates on bonds with different maturities but the same risk, liquidity, and tax considerations.</p> Signup and view all the answers

    What are the three theories that attempt to explain the shapes and movements of yield curves?

    <p>The Expectation Theory, the Segmented Market Theory, and the Liquidity Premium Theory.</p> Signup and view all the answers

    The Expectation Theory assumes that the expected returns or interest rates from different bonds are the determining factor regarding which one should be held.

    <p>True</p> Signup and view all the answers

    According to the Expectation Theory, if the interest rate on a one-year bond is 9 percent and it is expected to be 10 percent in the next year, the interest rate on a two-period bond should be 10.0 percent.

    <p>False</p> Signup and view all the answers

    The Segmented Market Theory assumes that bonds of different maturities are perfect substitutes, and investors have no preferences for bonds of a particular maturity.

    <p>False</p> Signup and view all the answers

    What is the key assumption of the Liquidity Premium Theory?

    <p>Bonds of different maturities are substitutes but not perfect substitutes, and investors require a liquidity premium for holding longer-term bonds.</p> Signup and view all the answers

    The Preferred Habitat Theory states that investors have a preference for bonds of a specific maturity and are less willing to hold bonds of other maturities.

    <p>True</p> Signup and view all the answers

    The liquidity premium is always a negative value.

    <p>False</p> Signup and view all the answers

    Which theory attempts to explain why yield curves typically slope upward, but also sometimes appear flat or inverted, based on factors like expectations about future interest rates, market segmentation, and liquidity premiums?

    <p>All of the above</p> Signup and view all the answers

    A steeply rising yield curve indicates that short-term interest rates are expected to fall in the future.

    <p>False</p> Signup and view all the answers

    An inverted yield curve indicates that short-term interest rates are expected to fall sharply in the future.

    <p>True</p> Signup and view all the answers

    Which of the following is NOT a reason why the liquidity preference framework is easier to use when analyzing the effects caused by changes in income, the price level, and the supply of money?

    <p>It emphasizes the role of expected inflation.</p> Signup and view all the answers

    An increase in the money supply always leads to a decrease in interest rates.

    <p>False</p> Signup and view all the answers

    What are the three primary effects of an increase in the money supply on interest rates?

    <p>The liquidity effect, the income effect, and the expected-inflation effect.</p> Signup and view all the answers

    The term structure of interest rates is primarily determined by the level of risk associated with each bond.

    <p>False</p> Signup and view all the answers

    Study Notes

    Understanding Interest Rates

    • Chapter organization covers topics like credit market instruments, present value calculations, yield to maturity, current yield, and holding period returns.
    • Interest rates and returns, yield calculations for money market instruments, and the behavior of interest rates are also addressed.
    • Theory of portfolio choice, demand and supply in the bond market, and risks associated with bonds are included.
    • Concepts like liquidity preference framework, risk and term structure of interest rates, risk structure of interest rates, and term structure of interest rates are discussed.

    Types of Credit Market Instruments

    • Simple Loan: A sum lent with a maturity date, requiring principal and interest repayment.
    • Fixed Payment Loan (Fully Amortized): Repaid with equal payments covering both principal and interest over a set period.
    • Coupon Bond: Pays periodic interest (coupons) until maturity, when the face value is returned.
    • Discount Bond (Zero-Coupon Bond): Purchased at a price below face value, with the full face value repaid at maturity.

    Present Value Calculations & Yields

    • Present value is the discounted value of future cash flows, essential for comparing different instruments.
    • Present value calculations use formulas to adjust future returns for time value of money, typically involving the interest rate.
    • Formula examples for calculating future value from present value with compound interest are given.

    Yield to Maturity (YTM)

    • YTM reflects the total return anticipated on a bond if held until maturity.
    • It's calculated by equating the present value of all future cash flows (coupon payments and face value) to the current market price.
    • YTM is a crucial measure of interest rates for evaluating debt instruments.

    Current Yield

    • Current yield is a simplified measure of a bond's return.
    • It's derived from annual coupon payments divided by the current market price of the bond.

    Holding Period Returns

    • Holding period return (HPR) is a bond's return earned over a specific period, considering price appreciation or depreciation.
    • HPR calculations involve considering the initial and final prices, and any coupon payments received during the holding period.

    Yield Calculations for Money Market Instruments

    • In India, the Reserve Bank of India (RBI) uses formulas to determine the yield to maturity (YTM) for Treasury Bills (T-Bills) based on face value, price, and maturity period.
    • Annualized yield is how investors earn if they hold short-term instruments for one year.

    Theory of Portfolio Choice

    • It explores factors influencing the demand for assets, including wealth, expected returns, risk, and liquidity.
    • The theory emphasizes that higher wealth usually correlates to greater asset demand.

    Demand and Supply in the Bond Market

    • Demand curve for bonds shows the relationship between bond price and total bond demand.
    • The supply curve shows the relationship between price and supply of bonds.
    • Prices and interest rates are inversely related in the bond market. Increased demand/reduced supply leads to higher prices and lower interest rates and vice versa.

    Risks Associated with Bonds

    • Default Risk: The risk that the issuer may not make promised payments.
    • Inflation Risk: The risk that future purchasing power will be lessened due to inflation.
    • Interest Rate Risk: The risk that the bond's price will fall if interest rates rise.

    Liquidity Preference Framework and Behaviour of Interest Rates

    • The liquidity preference framework analyzes interest rate determination via demand and supply of money and bonds.
    • There are two assets, money and bonds, used for determining interest rates. Excess demand of one asset leads to excess supply of another. Arise in interest rates implies reduced demand for that asset.
    • Income, expected inflation, and risk of bonds play a role in the demand and supply behaviour . 

    Risk and Term Structure of Interest Rates

    • Risk structure of interest rates is determined by risks inherent in default, liquidity, and various forms of taxes
    • The term structure of interest rates is how interest rates vary depending on terms to maturity
    • Different theories explain the shape and movements within the term structure.

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    Description

    This quiz explores key concepts related to interest rates and various credit market instruments. It covers topics such as present value calculations, yield to maturity, and the risks associated with bonds. Test your knowledge on the behavior of interest rates and the theory of portfolio choice.

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