Money and Banking final study guide

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University of Toronto Scarborough
Economics for Management Studies
Jack Parkinson

ECMC48 Notes PostMidterm Chapters 46 Textbook Notes Chapter 4Understanding Interest Rates PresentValue based on the notion that a dollar paid one year from now is less valuable to you than a dollar paid today Generally we can generalize the simple loan with this equation There are basically four basic types of credit market instruments 1 A simple loan already outlined in the equation above 2 A fixedpayment loan aka Fully amortized loanwhere the lender provides the borrower a loan of which they will need to pay back in fixed installments for the loan period 3 A coupon bond pays the owner of the bond a fixed interest payment coupon payment every year until the maturity date when a specified final amount face value or par value is repaid a A coupon bond has three pieces if information and that is the issuing party usually a corporation or government the maturity date and the coupon rate the dollar amount of the yearly coupon payment expressed as a percentage of the face value of the bond 4 A discount bond is bought at a price below the face value The most common way to calculate interest rates is the yield to maturity the interest rate that equates the present value of cash flow payments received from a debt instrument with its value today 1 Simple Loan a 2 Fixed Payment Loan a b 3 Coupon Bondab Coupon Rate is CF 4 Perpetuity 15 In general for a one year discount bond the yield to maturity can be written asAssumes reinvesting in another Tbill with the same term to maturity until get 1 year with the same PFIn other words the yield to maturity equals the increase in price over the year FP divided by the initial price P In normal circumstances investors earn positive returns from holding these securities and so they sell at a discount meaning that the current price of the bon is below the face value As with a coupon bond the YTM is negatively related to the current bond priceThree interesting facts emerge 1 When the coupon bond is priced at its face value the yield to maturity equals the coupon rate 2 The price of a coupon bond and the yield to maturity are negatively related that is as the yield to maturity rises the price of the bond falls As the yield to maturity falls the price of the bond rises a The reasoning behind this is because with a higher interest rate the payments are worth lessb If ic then PFPriced at a discount c If ic then PFPriced at a premium 3 The yield to maturity is greater than the coupon rate when the bond price is below its face value Current Yield The current yield iCP provides an approximation of the yield to maturity 2
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