Financial Markets & Institutions Exam II Study Guide

The Real Interest Rate The equilibrium rate of interest Determined by the real output of the economy About 3% for the US and varies between 2% and 4% The higher the interest rate, the smaller the quantity of loanable funds to DSUs Higher Interest Rates Cause state and local governments to postpone capital expenditures Reduce consumer installment purchases If Inflation Rates Rise During the Life of a Loan Contract The purchase power of money decreases Borrowers repay lenders in inflated dollars (dollars with less purchasing power) If Inflation Rates Fall During the Life of a Loan Contract The purchasing power of loaned money increases Lenders receive an increase in purchasing power at the expense of the borrower

The Fisher Equation Nominal Rate = Real Interest Rate + Expected Inflation (Real Interest Rate * Expected Inflation) Nominal Interest Rate The rate of interest actually observed in financial markets (the market rate of interest) Determinants of Interest Rates Changes in the Money Supply Government Spending Economic Activity Inflation Rates

Chapter 5
Time Value of Money People prefer to consume goods today rather than similar goods in the future (Positive Time Preference for Consumption) A dollar today is worth more than a dollar tomorrow

Future Value (FV) The value of a given amount of money invested today (PV) at some point in the future at a given interest rate Formula (Compounding) FV = PV(1 + i)n The more frequent the compounding periods the higher the FV Quarterly o n(4) and i/4 Compounding Finding the FV of some present sum of money Present Value (PV) The value of a given sum of money to be received at some point in the future, today Formula (Discounting) PV = FV[1 / (1 + i)n] The part in brackets is the discount factor (DF) and is equal to the reciprocal of the interest factor (IF) or (1/IF) Discounting Finding the PV of a given sum of money to be received at some point in the future

Bond A Contractual obligation of a borrower to make periodic cash payments to a lender over a given period of time Borrower = Issuer Lender = Investor or Bondholder Term-to-Maturity The number of years over which the bond contract extends Used to determine the timing of cash flows The yield on a bond varies with changes in supply and demand for credit or with changes in the issuers risk

Bonds Consist of 2 Types of Contractual Cash Flows Principle, Face Value, or Par Value Payment of the original sum of money borrowed Coupon Payments Periodic interest payments to the bondholders Coupon Rate o The amount of coupon payments received in a year as a percentage of the FV o Determines the magnitude of coupon payments o Generally set at or near the market rate of interest or yield on similar bonds available in the market o Fixed throughout the life of a bond o Coupon Rate = Coupon Payment / Face Value

Bond Price The PV of future cash flows discounted by the interest rate, which represents the time value of money PV or Market Price of a Bond Is the sum of the discounted values of all future cash flows Below Face Value Discount Bond Above Face Value Premium Bond When the coupon rate is equal to the market rate of interest (yield) the bond always sells at par value To increase a bond yield the seller must reduce the price Interest Rates Fall Bond Prices Increase Interest Rates Rise Bond Prices Decrease Premium Bonds Bond Price > Par Value Interest Rate < Coupon Rate

Discount Bonds Bond Price < Par Value Interest Rate > Coupon Rate Provides owner with additional capital Par Bonds Interest Rate = Coupon Rate Always sells at par value Bond Price = Par Value Zero Coupon Bonds Have NO coupon payment but promise a single payment at maturity The interest paid to the bondholder is the difference between the price paid for the security and the amount received at maturity of when sold All coupon payments are set to 0 Examples U.S. Treasury Bills U.S. Savings Bonds

Bond Yields Coupon Rate on a bond only reflects the annual cash flow promised by the borrower to the lender Actual Rate of Return Depends on Several Factors Credit or Default Risk o The risk that the borrower will fail to make coupon or principle payments on time and in the right amount Reinvestment Risk o The risk that the interest rate will fall, and future cash flows will have to be invested at lower rates, hence reducing coupon income Price Risk o Lender The risk that an increase in the interest rate will cause the market value of a bond to fall resulting in capital losses o Borrower The risk that a decrease in the interest rate will cause the market value of a bond to fall resulting in capital losses

Yield to Maturity AKA promised yield, is the yield promised to the bondholder on the assumption that The bond is held to maturity All coupon and principal payments are made as promised The coupon rates are reinvested at the bonds promised yield for the remaining term-to-maturity Expected Yield Reflects the expected sales price of a bond Must estimate future interest rates, and then use that estimation to find the price of the bond when sold Realized Yield The return earned on a bond given the cash flows actually received by the investor and assuming that the coupon payments are reinvested at the realized yield Useful to the investor because it allows an individual investor or a financial institution to evaluate the return on a bond ex-post

Total Return on a Bond Is the return we receive on a bond that considers capital gains or losses and changes in the reinvestment rate 2 things must be determined in order to calculate total return Terminal Value o Selling price if we sell the bond o Call price if the bond is called prior to maturity o Par or face value of the bond if it is held to maturity Accumulated Future Value of All the Coupon Payments o Based on a known (or assumed) reinvestment rate Typical Fixed Rate Contracts Are most corporate, municipal, and treasury bonds, as well as automobile loans and conventional home mortgage loans Bond Prices and Yields Vary Inversely This is because the coupon rate or interest rate on a bond is fixed at the time the bond is issued Long-Term Bonds Have Greater Price Volatility than Short-Term Long-term bonds have greater interest rate risk than short-term bonds

Bond Volatility Is the percent change in bond prices for a given change in interest rates Bond Price Volatility Is a measure of how sensitive a bonds price is to changes in yields The lower the coupon rate of a bond, the greater the bonds price volatility, therefore low-coupon bonds have greater interest rate risk than higher coupon bonds The price volatility of a long-term bond is greater than that of a short-term bond, holding the coupon rate constant The price volatility of a low-coupon bond is greater than that of a high-coupon bond, holding maturity constant Price-Yield Relationship The Yield Curve shows the relationship between a bonds price and the prevailing market yield

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Duration A weighted average of the number of years until each of the bonds cash flows are received A measure of interest rate risk or bond price volatility that considers both coupon rate and maturity Gets smaller with an increase in interest rates Bonds with higher coupon rates have shorter durations than bonds with smaller coupons of the same maturity There is generally a positive relationship between term-tomaturity and duration Bonds with a single payment (principal only), duration is equal to term-to-maturity For discount bonds, duration increases at a decreasing rate up to maturity and then it declines There is a direct relationship between a bonds price volatility and duration Duration is positively related to maturity and inversely related to coupon rates making it a good measure of interest rate risk The most important use of duration is as a tool for reducing or eliminating interest rate risk over a given holding period

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3 Possible Approaches to Dealing with Interest Rate Risk 1. Zero Coupon Approach The simplest way to avoid interest rate risk is to invest in a zero coupon bond 2. Maturity Matching Approach Invest in a coupon bond with a maturity equal to the holding period 3. Duration Matching Approach The best way to eliminate interest rate risk is to structure your bond investment such that the duration of the bond or bond portfolio equals your holding period a situation where capital gains or losses from interest rate changes are exactly offset by changes in reinvestment income

Chapter 6
5 Major Characteristics Responsible for the Differences in Interest Rates Among Securities 1. Term-to-Maturity 2. Default Risk 3. Tax Treatment 4. Marketability and Special Features Term Structure of Interest Rates The relationship between yield and term-to-maturity on securities that differ only in length of time to maturity

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Yield Curves Plots term-to-maturity on the horizontal axis and a securitys yield on the vertical axis Shows the relationship between maturity and a securitys yield at a point in time Generally upward sloping The Expectation Theory Holds that the shape of the yield curve is determined by the investors expectations of future interest rate movements and that changes in these expectations change the shape of the yield curve If the market expects interest rates to increase the yield curve is upward sloping If the market expects interest rates to decrease the yield curve is downward sloping If the market expects interest rates to stay the same the yield curve is flat Liquidity Premium Borrowers who seek long-term funds to finance capital projects must pay lenders a liquidity premium Increases as maturity increases because the longer the maturity of a security, the greater its price risk and the less marketable the security Causes the observed yield curve to be more upward sloping than that predicted by the expectation theory
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Market Segmentation Theory States that market participants have strong preferences for securities of a particular maturity, and they buy and sell securities consistent with these maturity preferences Yield Curve is determined by the supply of and the demand for securities at or near a particular maturity Preference for Short-Term Securities Commercial Banks Preference for Long-Term Securities pension funds, life insurance companies Changes in interest rates in one segment of the yield curve have little or no effect on interest rates in other maturities Discontinuities of the yield curve are possible Preferred-Habit Theory Asserts that investors will not hold debt securities outside of the preferred habitat (maturity preference) without an additional reward in the form of a risk premium Extends the Market Segment Theory and explains why we dont observe discontinuities in the yield curve Holding securities with longer maturities than desired exposes an investor to price risk Holding securities with shorter maturities than desired exposes an investor to reinvestment risk Unlike the Market Segmentation Theory it does not assume that investors are completely risk averse

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 It allows investors to reallocate their portfolios in response to expected yield premiums Interest Rates & the Business Cycle are Procyclical Because of This Increasing interest rates imply that market participants expect a period of economic expansion Decreasing interest rates imply that market participants expect a period of slow economic growth Many practitioners believe that inverted yield curves can predict recessions Financial Intermediaries & Yield Curves To financial intermediaries an upward sloping yield curve is usually the most favorable because They borrow most of their funds short-term Lend most of their funds long-term The more steeply the yield curve slopes upward The wider the spread between borrowing and lending rates The greater the profit At the beginning of a period of economic expansion Interest rates tend to be low The yield curve is upward sloping

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Yield Curve Affects on Business Strategy Beginning of an Expansion The yield curve slopes upward Interest rates are low The strategy is to borrow short-term and lend long-term Mid-Cycle The yield curve is flat Interest rates are high Profits decrease Businesses implement cost reduction strategies Beginning of Contraction The yield curve slopes downward Interest rates are higher The strategy is to shorten the maturity of liabilities and lengthen the maturity of loans

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Default Risk Debt Security A formal promise by the borrower to pay the lender coupon payments and principal payments according to a predetermined schedule Default Failure of a borrower to meet any condition of a bond contract A securities default risk can be measured as the difference between the rate paid on a risky security and the rate paid on a default free security (all other factors held constant) DRP = i irfi DRP Default Risk Premium i The Promised Yield-to-Maturity rfI The Yield on a default-free security Yields on US Treasury Securities are the best estimate for the default free rate The Larger the Default Risk Premium The higher the probability of default The higher the securitys market yield During Periods of Economic Decline Default risk premiums tend to widen
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 During Periods of Economic Expansion Default risk premiums tend to narrow and investors are willing to hold bonds with low credit ratings because theres little chance of default and these bonds have high yields Bond Ratings Credit ratings assigned by rating agencies (Moodys, S & P, and Fitch) The Highest Grade Bonds Those with the lowest default risk, are rated Aaa (AAA) The default risk premium on corporate bonds increases as the bond rating decreases Investment Grade Bonds Rated Baa or above by Moodys Rated BBB by S & P and Fitch Speculative Grade Bonds Rated below Baa Financial institutions are typically allowed to purchase only investment grade bonds Moodys Applies Modifiers 1, 2, & 3 to the Ratings Aa to Caa 1 Higher end of its rating 2 Mid range of its rating 3 Lower end of its rating S & P and Fitch modify ratings AA to CCC with + or to indicate higher or lower end of its rating category

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 As bond credit ratings decrease, the percent of bonds defaulting increases Factors to Consider When Rating Bonds Firms expected cash flow Amount of fixed contractual payments Length of time the firm has been profitable The variability of the firms earnings Credit Spreads The difference between a yield on a security being evaluated and the yield on a risk free security of similar maturity The Interest Rate Most Relevant to Investors The Rate of Return After Taxes The lower the taxes on the income from a security, the greater the demand for the security and the lower its before tax yield All Coupon Income on State and Local Government Debt Is exempt from federal taxes Sell for lower market yields than comparable issued by the US treasury or private corporations Taxable vs Tax Exempt Securities The decision to purchase either a taxable or a tax exempt security depends on The relative yields between the 2 securities The investors marginal tax rate
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Formula for After Tax Yield iat = ibt (1 T) iat After Tax Yield ibt Before Tax Yield T Marginal Tax Rate of the Investor Assumes that the return on securities is composed entirely of coupon income, with no capital gains Investors in High Tax Brackets Usually hold portfolios of municipal securities because of their higher after tax yield compared to taxable securities of the same risk and maturity Investors in Low Tax Brackets Receive high after tax yields from taxable securities because they pay fewer taxes The Tax Payer Relief Act of 1997 & the Reform Act of 1998 Allowed capital gains to again be taxed at lower rates than ordinary income The Advantage of Capital Gains to Ordinary Income Taxes on capital gains are not paid until the gains are realized from the disposal of the security, whereas ordinary income such coupon interest is paid on receipt Since capital gains can be deferred the present value of capital gains tax is less than an equivalent amount of ordinary income tax
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An Option A contract that gives the holder the right but not the obligation, to buy or sell an asset at some specified price and date in the future Call Option Right to Buy Put Option Right to Sell Conversion Option Right to convert a security into another type of security Call Option Gives the bond issuer the option to buy back the bond at a specified price in advance to the maturity date Sell at higher market yield Works to the benefit of the issuer When would an issuer of a bond use their call option? If interest rates decline below the coupon rate on a callable bond the issuer can call the old bond and refinance it with a new one at a lower interest rate The result is the issuer achieves an interest cost savings, but the investor is now forced to reinvest funds at the current lower market interest rate, suffering a loss of interest income The Call Interest Premium The compensation paid to investors who own callable bonds for potential financial injury if their bonds are called The difference in interest rates between callable and otherwise comparable noncallable bonds

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 The lower the interest rates are expected to fall the more valuable the call option and the greater the call interest premium

Put Options Allows investors to sell a bond back (put the bond) to the issuer at a predetermined price Exercised when interest rates are rising and bond prices are declining Bonds with put options sell at lower yields than nonputable bonds Investors can protect themselves against capital losses as a result of unexpected rises in interest rates If interest rates rise above the coupon rate, the investor can sell the bond back to the issuer at the exercise price, and then buy a new bond at the current market yield The Put Interest Discount The difference in yield between a putable bond and similar nonputable bonds The higher interest rates are expected to rise, the more valuable the put option and the greater the put interest discount
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Conversion Options Allows an investor to convert a security into another type of security at a predetermined price Most common conversion feature is the option to convert a bond into an issuers stock Another common option is in volatile interest rate periods the conversion of a variable-coupon bond into a fixed-coupon bond The timing of the conversion is at the option of the investor, however the terms under which the conversion may take place are agreed on when the security is purchased Advantage for Investors they pay higher prices or require lower yields for convertible securities The Conversion Yield Discount The difference between the yield on a convertible bond and the yield on a nonconvertible bond The price investors are willing to pay for the conversion option
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 Most Valuable When stock market prices are rising Bond prices are falling

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