LECTURE 2 Flashcards
(33 cards)
Perpetuity =
assets with a constant stream (fixed payment each year) of cash flows each year with no end.
Example of perpetuity
Consol bonds
How do we obtain ROR of perpetuity?
PV = C/r –> r = C/PV
How do we find PV for delayed perpetuity?
Adjust normal PV by discount factor
PV = C/r * 1/(1 + r)^m
if starts after m years
Annuity =
a financial asset that pays a fixed amount each year for a specific number of years.
How do we find 2-year IR from a stated 1-year IR?
1-year IR = 6%
(1.06)^2 - 1 = 12.36%
Do not just double it since compound IR.
Why does frequency of payments matter when calculating interest?
COMPOUND interest = interest on the interest so frequency matters.
2 types of IR when we do compound interest
- Effective APR/annual % yield
2. Nominal/quoted APR
Relationship between effective and nominal APR when we do continuous compounding:
r = e^i - 1
How does frequency affect effective APR?
Effective APR increases with frequency of compounding
3 things stated on a bond
- Face value
- Coupon rate
- Redemption date
Years for short, medium and long bonds
Short: 0-7
Medium:7-15
Long: 15+
All bonds have an expiry debt except…
CONSOL BONDS
3 types of bonds
- Pure discount bonds/zero coupon bonds
- Level coupon bonds
- Consol bonds
What are pure discount bonds?
AKA zero coupon bonds
No coupons - just pay face value on maturity
What are level coupon bonds?
Regular cash payments every year + principal back on final year.
Like an annuity + face value
Do you receive face value back for consol bonds?
NO - regular payments every year forever like perpetuity
Yield to maturity =
the IR r that brings equality between PV of cash flows and asked price.
Relationship between bond price and YTM?
INVERSELY RELATED
When we PV cash flows and bond returns, what do we assume about IR?
That it’s FIXED over the period
Normal yield curve shape + explanation + implication
Yield increases with term: SR yields < LR yields.
Lenders demand higher yields for longer term bonds as compensation for greater risk.
Normal economic situation - lenders happy to provide LR loans.
We plot the yield curve for…
Different yields and different terms for a specific bonds or similar bond in terms of quality.
Inverted yield curve shape + explanation + implication
Yield decreases with term: SR yields > LR yields.
Lenders want to get money back ASAP - not happy to provide LR loans.
Lack of confidence/financial crisis.
Flat yield curve shape + explanation + implication
Yield unchanged with term: SR yields = LR yields.
Lenders unsure about economic situation
Transitory period - economy not expanding or contracting.
