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Questions and Answers
What are the four types of credit market instruments explained in the text?
What are the four types of credit market instruments explained in the text?
What does the term 'present value' refer to?
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.
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.
If a coupon bond is priced at its face value, the yield to maturity equals the coupon rate.
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What is the formula used for calculating the yield to maturity of a consol, or perpetual bond?
What is the formula used for calculating the yield to maturity of a consol, or perpetual bond?
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What is the formula for calculating the current yield of a bond?
What is the formula for calculating the current yield of a bond?
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In the context of bond pricing, what happens to the current yield when the price of a bond falls below its face value?
In the context of bond pricing, what happens to the current yield when the price of a bond falls below its face value?
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Match the following bond features with their corresponding definitions.
Match the following bond features with their corresponding definitions.
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The longer the term of a bond, the smaller the price change for a given change in interest rates.
The longer the term of a bond, the smaller the price change for a given change in interest rates.
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What is the difference between the yield to maturity and the holding period return?
What is the difference between the yield to maturity and the holding period return?
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What determines the level of interest rates and their movements?
What determines the level of interest rates and their movements?
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What are the four factors that influence the quantity demanded of an asset as explained by the Theory of Portfolio Choice?
What are the four factors that influence the quantity demanded of an asset as explained by the Theory of Portfolio Choice?
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The demand curve for a bond is upward sloping.
The demand curve for a bond is upward sloping.
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The supply curve for bonds is downward sloping.
The supply curve for bonds is downward sloping.
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What are the three factors that affect the supply curve for bonds?
What are the three factors that affect the supply curve for bonds?
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What is the risk premium?
What is the risk premium?
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What are the three major risks associated with bonds?
What are the three major risks associated with bonds?
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Which of the following are types of credit rating agencies?
Which of the following are types of credit rating agencies?
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Bonds with ratings below BBB are considered investment-grade securities.
Bonds with ratings below BBB are considered investment-grade securities.
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What is the term structure of interest rates?
What is the term structure of interest rates?
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What are the three theories that attempt to explain the shapes and movements of yield curves?
What are the three theories that attempt to explain the shapes and movements of yield curves?
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The Expectation Theory assumes that the expected returns or interest rates from different bonds are the determining factor regarding which one should be held.
The Expectation Theory assumes that the expected returns or interest rates from different bonds are the determining factor regarding which one should be held.
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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.
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.
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The Segmented Market Theory assumes that bonds of different maturities are perfect substitutes, and investors have no preferences for bonds of a particular maturity.
The Segmented Market Theory assumes that bonds of different maturities are perfect substitutes, and investors have no preferences for bonds of a particular maturity.
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What is the key assumption of the Liquidity Premium Theory?
What is the key assumption of the Liquidity Premium Theory?
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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.
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.
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The liquidity premium is always a negative value.
The liquidity premium is always a negative value.
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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?
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?
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A steeply rising yield curve indicates that short-term interest rates are expected to fall in the future.
A steeply rising yield curve indicates that short-term interest rates are expected to fall in the future.
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An inverted yield curve indicates that short-term interest rates are expected to fall sharply in the future.
An inverted yield curve indicates that short-term interest rates are expected to fall sharply in the future.
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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?
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?
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An increase in the money supply always leads to a decrease in interest rates.
An increase in the money supply always leads to a decrease in interest rates.
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What are the three primary effects of an increase in the money supply on interest rates?
What are the three primary effects of an increase in the money supply on interest rates?
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The term structure of interest rates is primarily determined by the level of risk associated with each bond.
The term structure of interest rates is primarily determined by the level of risk associated with each bond.
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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.
