Yields of Cash Flow Instruments
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Questions and Answers

What is the result of an increase in interest rates on bond prices?

  • Bond prices increase
  • Bond prices become zero
  • Bond prices remain unchanged
  • Bond prices decrease (correct)

    • 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 _______________.

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

    What is the relationship between bond prices and interest rates?

    <p>Inversely related</p> Signup and view all the answers

    Match the following concepts with their descriptions:

    <p>Discount Rate = The rate used to calculate the present value of cash flows Yields = The rate of return on investment Bond Pricing = The process of calculating the value of a bond Cash Flows = The series of payments or receipts made or received</p> Signup and view all the answers

    What is the formula to calculate the T-year spot rate?

    <p>sT = (V0 / VT)^(1/T) - 1</p> Signup and view all the answers

    The internal rate of return is another term for the yield to maturity.

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

    What is the single return on a stream of cash flows called?

    <p>yield-to-maturity aka the internal rate of return, the actuarial rate of return or the overall yield</p> Signup and view all the answers

    The return on a single cash flow that will be received at the end of period T is called a _______-year spot rate.

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

    Match the following terms with their definitions:

    <p>Yield-to-maturity = The single return on a stream of cash flows T-year spot rate = The return on a single cash flow that will be received at the end of period T Internal rate of return = Another term for the yield-to-maturity</p> Signup and view all the answers

    What is the formula to calculate the present value of a single cash flow instrument?

    <p>VT = V0 / (1 + sT)^T</p> Signup and view all the answers

    The yield to maturity is the same as the discount rate.

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

    What is the formula to calculate the present value of a multiple cash flow instrument?

    <p>V0 = CF1 / (1 + s1)^1 + CF2 / (1 + s2)^2</p> Signup and view all the answers

    What is the condition for cash flows to be summed?

    <p>Their values are expressed at the same moment</p> Signup and view all the answers

    The present value of a cash flow is always higher than its future value.

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

    What is the formula to calculate the present value of a single cash flow?

    <p>V0 = CF / (1 + s)^n</p> Signup and view all the answers

    A coupon bond can be interpreted as a portfolio of single cash flow instruments, with each cash flow discounted at its own ____________.

    <p>interest rate</p> Signup and view all the answers

    Match the following terms with their definitions:

    <p>Term structure = The rate at which the present value of a cash flow is discounted Spot rate = The rate at which the present value of a cash flow is discounted at a specific point in time Discount rate = The rate at which the present value of a cash flow is discounted over a period of time Yield = The total return on an investment</p> Signup and view all the answers

    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.?

    <p>861.40</p> Signup and view all the answers

    What was the primary cause of the 2008 financial crisis?

    <p>The bursting of the housing bubble</p> Signup and view all the answers

    Who was the Chairman of the Federal Reserve during the 2008 financial crisis?

    <p>Ben Bernanke</p> Signup and view all the answers

    What was the consequence of the Lehman Brothers' bankruptcy in 2008?

    <p>A global financial panic</p> Signup and view all the answers

    What was the impact of the 2008 financial crisis on the Dow Industrials?

    <p>It suffered its worst one-day point loss in history</p> Signup and view all the answers

    What was the background of Hank Paulson, the former Secretary of the Treasury?

    <p>A deal maker and leader in the financial industry</p> Signup and view all the answers

    What was the consequence of the development of mortgage-backed securities?

    <p>Cheaper mortgages and increased home ownership</p> Signup and view all the answers

    What was the impact of the 2008 financial crisis on American homeowners?

    <p>They struggled to keep their homes due to unaffordable mortgages</p> Signup and view all the answers

    What was the outcome of the 2008 financial crisis on the trust in government and financial institutions?

    <p>A decrease in trust</p> Signup and view all the answers

    What was the primary reason for the surge in housing demand and prices in the early 2000s?

    <p>Low interest rates and rising housing prices</p> Signup and view all the answers

    What was the consequence of the housing prices falling?

    <p>Loss of investor confidence and rise in foreclosures</p> Signup and view all the answers

    What was the Federal Reserve's response to the crisis?

    <p>Extending a loan to Bear Stearns to prevent its collapse</p> Signup and view all the answers

    What was the situation with Fannie Mae and Freddie Mac?

    <p>They were on the brink of collapse and held roughly half of all US mortgages</p> Signup and view all the answers

    What was the reason for the government's takeover of Fannie Mae and Freddie Mac?

    <p>To prevent a complete collapse of the financial system</p> Signup and view all the answers

    What was the reaction to the government's bailout of the financial system?

    <p>Strong opposition from politicians and citizens</p> Signup and view all the answers

    What was the situation with Lehman Brothers?

    <p>It was heavily leveraged and held a large amount of real estate</p> Signup and view all the answers

    What was the consequence of Lehman Brothers' failure?

    <p>A massive crisis in the financial markets</p> Signup and view all the answers

    What was the goal of the emergency meetings between Wall Street titans and top government officials?

    <p>To keep the Federal Reserve out of the process and get other Wall Street firms to take on Lehman's bad assets</p> Signup and view all the answers

    What was the criticism of President Secretary Hank Paulson and Federal Reserve Chairman Ben Bernanke?

    <p>They were accused of acting like socialists</p> Signup and view all the answers

    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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