Econ 308 Exam 2

Present Value

A dollar paid to you one year from now is less valuable than a dollar paid to you today

Simple Loan

Lender provides funds which must be repaid at maturity date with interest

Fixed Payment Loan (Full amortized loan)

Lender provides funds which must be repaid by making the same payment every period (interest + principle)

Coupon Bond

Pays owner a fixed interest payment every year until maturity date when face value is repaid

Discount Bond

Purchased at a price below face value which is paid at maturity

Yield to Maturity

The interest rate that equates to PV of cash flow payments from a debt instrument

T

(T/F) The rates of bonds and interest rates are inversely related, when an interest rate rises, the price of a bond falls and vice versa

F

(T/F) The rates of bonds and interest rates are positively related, when an interest rate rises, the price of a bond also rises and vice versa

Rate of Return

The payments to the owner plus the change in value expressed as a fraction of the purchase price

T

(T/F) The return equals the yield to maturity only if the holding period equals the time to maturity

F

(T/F) The return equals the yield to maturity when the holding period is greater than the time to maturity

T

(T/F) A rise in interest rates is associated with a fall in bond prices, resulting in capital losses on bonds whose terms to maturity are longer than that holding period

F

(T/F) A rise in interest rates is associated with a rise in bond prices, resulting in capital losses on bonds whose terms to maturity are shorter than that holding period

T

(T/F) The longer the time to maturity, the greater the size of the percentage price change associated with an interest rate change

F

(T/F) The longer the time to maturity, the less the size of the percentage price change associated with an interest rate change

T

(T/F) The longer the time to maturity, the lower the rate of return that occurs as a result of the increase in the interest rate

F

(T/F) The longer the time to maturity, the higher the rate of return that occurs as a result of an increase in the interest rate change

T

(T/F) Even if a bond has substantial initial interest rate, its return can be negative if interest rates rise

F

(T/F) When a bond has substantial initial interest rate, its returns can't be negative if interest rates rise

Interest Rate Risk

The riskiness of an assets return that results from interest rate changes

Nominal Interest

Contract interest rate or interest rate today. Does not account for inflation

Real Interest

Interest rate that adjusts for inflation

Portfolio Theory

Another word for diversification

Liquidity Preference framework

An alternative method of determining equilibrium interest rates in the market for money developed by John Keynes

Default Risk

Occurs when the issuer of the bond is unable/unwilling to make interest payments when promised or unable to pay the face value at maturity

Risk Premium

Is the spread between interest rates on bonds with risk & default-free bonds (Same maturity). It indicates how much additional interest people must earn to be willing to hold that risky bond (Interest rate-Risk Free Rate)

Default Free Bonds

Bonds issued by the U.S. Gov't that have almost zero default risk

Credit Rating Agencies

Asses quality of corporate and gov't bonds in terms of the probability of default

Junk Bonds

Are bonds with ratings of BAA and below. They are dubbed speculative-grade due to their high risk of default

Term Structure

The relationship among interest rates on bonds with different terms to maturity

Yield Curve

A plot of the yields on bonds with differing terms of maturity, but the same risk, liquidity and tax considerations

Expectation Theory

Theory that makes the assumption that all bonds, regardless of term to maturity with the same expected returns are perfect substitutes (Not realistic)

Segmented Markets Theory

Theory that believes bonds with different maturities are completely separate and belong in segmented markets. Bonds with different maturity dates are not perfect substitutes at all.

Preferred Habitat Theory

Liquidity preference theory that assumes investors will prefer a given maturity over others available. Investors must be compensated for breaking their preferred purchase which is likely to be short term bonds

Asymmetric Information

Occurs when one party has more information than the other when conducting a transaction which leads to market failure

Income Effect (Part of Liquidity Preference Theory)

Higher income causes demand for money at each interest rate to increase shifting the demand for money out

Price Level Effect (Part of Liquidity Preference Theory)

Higher price level causes the demand for money at each interest rate to increase shifting the demand for money out

Business Cycle Expansion

Shifts bond demand outward, because of rising national income and in turn, causes bond supply to ship outward because businesses become more likely to borrow funds