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Questions and Answers
What is the result of an increase in interest rates on bond prices?
If the coupon rate is equal to the discount rate, the bond price is above par.
False
What is the formula to calculate the present value of cash flows in Excel?
=pv(rate,nper,pmt,fv)
In a world with negative interest rates, the discount rate is _______________.
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What is the relationship between bond prices and interest rates?
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Match the following concepts with their descriptions:
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What is the formula to calculate the T-year spot rate?
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The internal rate of return is another term for the yield to maturity.
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What is the single return on a stream of cash flows called?
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The return on a single cash flow that will be received at the end of period T is called a _______-year spot rate.
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Match the following terms with their definitions:
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What is the formula to calculate the present value of a single cash flow instrument?
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The yield to maturity is the same as the discount rate.
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What is the formula to calculate the present value of a multiple cash flow instrument?
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What is the condition for cash flows to be summed?
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The present value of a cash flow is always higher than its future value.
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What is the formula to calculate the present value of a single cash flow?
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A coupon bond can be interpreted as a portfolio of single cash flow instruments, with each cash flow discounted at its own ____________.
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Match the following terms with their definitions:
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What is the price of a 4-year 2% coupon bond with a face value of 1000, assuming a flat term structure with a discount rate of 6% p.a.?
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What was the primary cause of the 2008 financial crisis?
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Who was the Chairman of the Federal Reserve during the 2008 financial crisis?
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What was the consequence of the Lehman Brothers' bankruptcy in 2008?
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What was the impact of the 2008 financial crisis on the Dow Industrials?
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What was the background of Hank Paulson, the former Secretary of the Treasury?
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What was the consequence of the development of mortgage-backed securities?
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What was the impact of the 2008 financial crisis on American homeowners?
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What was the outcome of the 2008 financial crisis on the trust in government and financial institutions?
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What was the primary reason for the surge in housing demand and prices in the early 2000s?
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What was the consequence of the housing prices falling?
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What was the Federal Reserve's response to the crisis?
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What was the situation with Fannie Mae and Freddie Mac?
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What was the reason for the government's takeover of Fannie Mae and Freddie Mac?
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What was the reaction to the government's bailout of the financial system?
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What was the situation with Lehman Brothers?
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What was the consequence of Lehman Brothers' failure?
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What was the goal of the emergency meetings between Wall Street titans and top government officials?
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What was the criticism of President Secretary Hank Paulson and Federal Reserve Chairman Ben Bernanke?
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Study Notes
Yields of Single Cash Flow Instruments
- The return on a single cash flow that will be received at the end of period T is called a T-year spot rate.
- The formula for a single cash flow instrument is: V0 = VT / (1 + sT)T, where V0 is the current market value, VT is the cash flow, sT is the spot rate, and T is the time period.
Yields of Multiple Cash Flows Instruments
- The formula for multiple cash flows is: V0 = CF1 / (1 + y)1 + CF2 / (1 + y)2, where V0 is the current market value, CF1 and CF2 are the cash flows, and y is the yield-to-maturity.
- The single return on a stream of cash flows is called the yield-to-maturity, internal rate of return, actuarial rate of return, or overall yield.
Determining the Yield to Maturity
- The yield-to-maturity is the unknown in the equation: V0 = CF1 / (1 + y)1 + CF2 / (1 + y)2 + ... , where CF1, CF2, ... are the cash flows.
Bond Pricing
- Bond pricing involves finding the present value of a stream of cash flows.
- The formula for bond pricing is: P = CF1 / (1 + y)1 + CF2 / (1 + y)2 + ... , where P is the present value, and CF1, CF2, ... are the cash flows.
Bond Pricing with a Negative Discount Rate
- In a world with negative interest rates, the formula for bond pricing is: P = CF1 / (1 - r)1 + CF2 / (1 - r)2 + ..., where r is the negative discount rate.
Laws of Bond Pricing
- Prices and interest rates are inversely related: if interest rates increase, bond prices decrease, and vice versa.
- If the coupon rate equals the discount rate, the bond prices at par.
Value Additivity
- Cash flows can only be summed if their values are expressed at the same moment.
- The present value of a set of cash flows can be computed by discounting each cash flow at the appropriate interest rate.
Bond Pricing: The New Normal
- A financial instrument that gives rise to a stream of cash flows can be interpreted as a portfolio of single cash flow instruments.
- The present value of each cash flow can be computed using the formula: V0 = CF / (1 + s)T, where s is the spot rate.
- The present values of the cash flows can be summed to find the total present value of the instrument.
2008 Financial Crisis
- The 2008 financial crisis was a global event triggered by the bursting of the housing bubble, fueled by subprime mortgages.
Key Players
- Hank Paulson: Former CEO of Goldman Sachs, nominated as Secretary of the Treasury in 2006.
- Ben Bernanke: Former economics professor, nominated as Chairman of the Federal Reserve.
- Tim Geithner: Government official with experience in global financial panics.
Events Leading to the Crisis
- 2006: Housing market began to slow, turning mortgages into "time bombs".
- 2007: 34 subprime mortgage companies went bust.
- 2008: Lehman Brothers filed for bankruptcy, leading to a global financial panic.
Effects of the Crisis
- The Dow Industrials suffered its worst one-day point loss in history, down 777 points.
- Millions of American homeowners struggled to keep their homes due to unaffordable mortgages.
- The crisis led to widespread distrust in government and financial institutions, contributing to populism in politics.
Hank Paulson's Background
- Hank Paulson was a deal maker, known for his word being his bond.
- He was a leader in the financial industry, having led Goldman Sachs, the most successful financial institution in the world at the time.
Ben Bernanke's Background
- Ben Bernanke was an economics professor at Princeton University, having spent his career studying the Great Depression.
- He was a scholar of monetary policy and financial markets.
Tim Geithner's Background
- Tim Geithner was a government official with experience in global financial panics.
- He was a key player in the response to the 2008 financial crisis.
Evolution of Modern Finance
- Mortgage-backed securities emerged in the 1980s, allowing investors to buy portions of mortgages and spread risk.
- This led to cheaper mortgages and increased home ownership, as well as the development of exotic loan options.
Housing Market Boom
- In the early 2000s, interest rates were low, and housing prices were rising, leading to a surge in housing demand and prices.
- Speculators and individuals were buying multiple homes, and adjustable-rate mortgages became popular.
The Downfall
- Housing prices began to fall, and mortgage-backed securities started to unravel, leading to a loss of investor confidence.
- Foreclosures rose, and banks struggled with the lack of transparency in mortgage-backed securities.
- The crisis spread, and financial institutions began to fail, including Bear Stearns.
The Federal Reserve's Response
- The Federal Reserve, led by Ben Bernanke, made a bold decision to extend a loan to Bear Stearns to prevent its collapse.
- The loan was controversial, as it was the first time the Fed had intervened in a non-bank institution since the Great Depression.
The Fannie Mae and Freddie Mac Crisis
- Fannie Mae and Freddie Mac, government-sponsored enterprises, held roughly half of all US mortgages and were on the brink of collapse.
- The US government took control of the two entities, replacing their CEOs and injecting capital to stabilize the mortgage market.
The Government's Authority
- Hank Paulson, Secretary of the Treasury, needed to ask Congress for expansive authorities to calm the markets and stabilize the financial system.
- The government's implicit guarantee of Fannie Mae and Freddie Mac's debt led to a crisis of confidence and a loss of value.
The Bailout
- The government's takeover of Fannie Mae and Freddie Mac was a secretive operation, with the CEOs being replaced and their golden parachutes revoked.
- The action was necessary to prevent a complete collapse of the financial system.
Political Reaction
- The bailout was highly unpopular, with many politicians and citizens opposing the use of taxpayer money to rescue Wall Street.
- The crisis was a major issue in the 2008 presidential election, with both candidates, Barack Obama and John McCain, weighing in on the issue.
The Aftermath
- The crisis led to a loss of trust in the financial system and widespread criticism of the government's response.
- The US government's actions were seen as a necessary evil to prevent a complete collapse of the economy, but the controversy surrounding the bailout persisted.
Lehman Brothers' Crisis
- Lehman Brothers was heavily leveraged and held a large amount of real estate, which was constantly being marked down in value.
- CEO Dick Fuld was searching for capital and had talks with potential buyers.
Government Involvement
- President Secretary Hank Paulson and Federal Reserve Chairman Ben Bernanke were criticized by Senator Jim Bunning, who accused them of acting like socialists.
- Paulson was also accused of not telling the truth to the Banking Committee.
Potential Buyers for Lehman
- Bank of America and Barclays were potential buyers for Lehman Brothers.
- However, Bank of America eventually bought Merrill Lynch instead.
- Barclays was interested in buying Lehman, but the British government refused to allow it, citing concerns about importing the "U.S. cancer".
Emergency Meetings
- Wall Street titans and top government officials, including CEOs from major firms, were involved in emergency meetings to resolve the crisis.
- The goal was to keep the Federal Reserve out of the process and get other Wall Street firms to take on Lehman's bad assets.
Consequences of Lehman's Failure
- Lehman Brothers filed for Chapter 11 bankruptcy, leading to a massive crisis in the financial markets.
- The Dow Jones fell by 4.4%, more than 500 points, in one day, the worst drop since 9/11.
- Treasury Secretary Hank Paulson and others believed that if Lehman hadn't failed, another financial institution would have, given the poor economic fundamentals at the time.
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Description
Learn about calculating yields of single cash flow instruments and multiple cash flows instruments, including formulas and variables such as spot rate and time period.
