Week 1

Question 1

What is a bond and what is the role of the bond market

Answer 1

Bond market:
Bond: debt security that promises to make payments periodically for specified period of time

Role:enables corporations and governments to borrow money to finance their activities, and because it is where interest rates are determined (for monetary policy)

Question 2

What is a stock and what is the role of a stock market

Answer 2

Stock market:
Stock: common stock representing a share of ownership in corporations → a security that is a claim on the earnings and assets of the corporations

Role: public way for corporations to raise funds to finance their activities + important factor in business investment decisions → price of shares affects the amount of funds that can be raised by selling newly issued stock to finance investment spending; higher price = raise larger amount of funds

Question 3

What is the yield to maturity

Answer 3

Yield to maturity (YTM): the interest rate that equates today’s value of bond (price) with present discounted value of all future payments.

Question 4

What does a lower YTM stand for (price wise)

Answer 4

A lower YTM = higher price (greater value of the bond)

Question 5

What is the present value and how do you calculate it

Answer 5

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

Question 6

What are the different debt instruments with different streams of cash flows

Answer 6

Simple loan, fixed payment loan (fully amortized loan), coupon bond, discount (zero-coupon) bond

Question 7

What is a simple loan and how do you calculate it

Answer 7

Simple loan: funds (principal) that must be repaid at maturity date + additional payment for interest.
You calculate the additional payment for the interest by using the same formula to calculate the present value

Question 8

What is a fixed payment loan and how do you calculate it

Answer 8

Fixed-payment loan (or fully amortized loan): funds repaid by making fixed payments (FP), consisting of part of the principal + interest, every period until maturity date.

Question 9

What is a coupon bond and how do you calculate it

Answer 9

Coupon bond: owner of bond receive fixed coupon payment (C) (interest payment) every year until maturity date + final amount (face value, FV).
It is identified by four pieces of information;
1. bond’s face value
2. corporation or government agency that issues the bond
3. maturity date
4. coupon rate

Question 10

What happens when the bond price is priced at its face value (at par)

Answer 10

When the bond is priced at its face value (‘at par’), i.e. P=F, the yield to maturity equals the coupon rate, i.e. i = c.

Question 11

Are prices and YTM positively or negatively related?

Answer 11

prices and yields to maturity are negatively related (inverse relationship), i.e. lower price P = higher interest i

Question 12

What happens when the YTM is larger/ smaller than the coupon rate?

Answer 12

YTM is larger (smaller) than the coupon rate when the bond price is below (above) the par value, i.e. when P < F → i > C. (future payments are worth less so price must fall: discounted bond)

Question 13

What is a consol and how do you calculate it

Answer 13

Special case of coupon bond: consol (perpetuity)
Bond with no maturity date → fixed coupon payment (C) forever and no principal repaid

For coupon bonds, the equation for the yield of a consol gives an easy-to-calculate approximation of the YTM of the coupon bond. This approximation is the more accurate = the nearer the price is to par = the longer the maturity of the coupon bond

Question 14

What is a discount (zero coupon) bond and how do you calculate it?

Answer 14

Discount (zero -coupon) bond (e.g. treasury bills): bought at a price below face value (i.e., is bought at a discount), and the face value is repaid at maturity (similar to a simple loan).
The notion of ‘buying at a discount’ implies that the yield is positive.

Question 15

What is the expected rate of return and how do you calculate it?

Answer 15

(Expected) rate of return (RR) at time t on a coupon bond that will be held from time t until time t+1:

the return of a bond will not necessarily equal the YTM on that bond

Question 16

What happens to the YTM and RR when time to maturity = holding period

Answer 16

When time to maturity = holding period → YTM = rate of return (no change in value)

Question 17

What happens to the interest and price when maturity > holding period

Answer 17

When maturity > holding period: increase interest → decrease price (capital loss, because you sell for less than initial value)

Question 18

What happens to the maturity and the %change in price when there is a %interest change

Answer 18

The longer the maturity, the greater the % price change caused by an % interest change (long term bonds are more sensitive to change → higher ‘interest rate risk’)

Question 19

What happens to maturity and change in RR when there is a change in interest?

Answer 19

The longer the maturity, the more change in rate of return in response to interest change

Question 20

Can a bond with high initial interest rate still have a negative RR if interest increases?

Answer 20

Yes, A bond with high initial interest rate can still have a negative rate of return if interest increases

Question 21

What happens to the interest rate risk if maturity = holding period?

Answer 21

There is no interest rate risk for any bond whose time to maturity matches the holding period, since recognizing the price at the end of the holding period is already fixed at the face value

Question 22

What is the real interest rate and how do you calculate it?

Answer 22

Real interest rate reflects the true cost of borrowing and lending (i.e. in terms of real value of purchasing power)
Real interest rate (r) = nominal interest rate (i) ‘adjusted’ for the expected inflation rate (π).

r = i - π

Question 23

What is the fisher equation?

Answer 23

i = r + π

Question 24

What happens when nominal interest rate (i) is low?

Answer 24

When i is low;
incentives to borrow are larger, because it is less expensive
incentives to lend are smaller, because it is more expensive

Question 25

What are the determinants of asset demands?

Answer 25

Wealth Expected returns on bonds relative to alternative assets Risk of bonds relative to alternative assets Liquidity of bonds relative to alternative assets

Question 26

Explain the supply and demand of bonds

Answer 26

Demand and supply of bonds: Demand (Bd); price increase → interest rates decrease → demand bonds decrease Negative relationship between quantity and price Supply (Bs); price increase → interest rates decrease → supply bonds increase Positive relationship between quantity and price

Question 27

Explain the shifts in demand of bonds by using the determinants of asset demand

Answer 27

Shifts in demand of bonds; Increase wealth (e.g. growth in economy); More to spend (more to invest in bonds) → Bd increases, and shift to right Increase expected return relative to other assets; - Expected rate i increases → P and R decreases (less attractive to hold bonds) → Bd decreases and shifts to left - Expected inflation increases → r decreases (decrease in real return, les attractive) → Bd decreases and shifts to the left Increase risk relative to other assets; Given risk averseness of investors; Bd decreases and shifts to the left Increase liquidity relative to other assets (e.g. more easily converted into cash); Bonds become more attractive → Bd increases and shifts to right

Question 28

Explain the shifts in supply of bonds

Answer 28

Shifts in supply of bonds; Increase expected profitability of investment (e.g. business cycle expansion); Better investment opportunities, so more finance needed for firms: Bs increases and shifts to right Increase expected inflation; Increase inflation → r decreases (Fisher) → cheaper to borrow money through bonds → Bs increases and shifts to right Increase government deficit (G-T); Government needs to borrow more through issuance of bonds → Bs increases and shifts to right

Question 29

What are other effects on demand & supply of corporate bonds

Answer 29

changes in expected inflation; Inflation goes up → interest rate goes down Demand: less return on investment → demand goes down and shifts to left Supply: lower real costs of borrowing → supply goes up and shifts to right → Higher price, lower interest rate Business cycle expansion (economic growth); Demand: more wealth to spend/invest → demand goes up and shifts to right Supply: better investment opportunities, more financing needed → supply goes up and shifts to right → typically, the price of corporate bonds decreases and thus the nominal interest rate increases during a business cycle expansion note that the interest rate could in principle decrease during a business cycle expansion. Indeed, that would happen if demand would have increased to a stronger degree than supply.

Question 30

What are inflation indexed bonds and its charactersitics?

Answer 30

Inflation-indexed bonds: standard coupon bond with the following characteristics characteristics: - face value/ principal adjusted for inflation - coupon rate is fixed - periodic coupon payments; fixed rate of inflation-adjusted value → thus also adjusted for inflation - outcome: income streams (repayment of face value and coupon payments) move up and down with inflation

Question 31

What are the reasons for the existence of inflation-indexed bonds? and how do you calculate the price of non-indexed and indexed bonds?

Answer 31

Reason for existence: In countries with high inflation, the bonds offer (real) constant cash flows → attractive to investors even when there is expectations of high inflation → otherwise may refuse to buy government bonds because expected returns of bonds relative to other assets decrease (see effect of expected price level increase on demand for bonds) Allow market participants and central banks to obtain estimates on expected inflation → when issued in conjunction with identical bonds with no indexation -> since mandated to keep inflation low.