ECMC48 Final Exam Study Guide

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Economics for Management Studies
Jack Parkinson

ECMC48 Notes Post-Midterm Chapters 4-6 Textbook Notes Chapter 4-Understanding Interest Rates Present-Value- 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 fixed-payment loan aka. Fully amortized loan-where 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 Bond a. ( ) ( ) b. Coupon Rate is C/F 4. Perpetuity 1 ( ) ( ) ( ) ( ) ( ) ( ) 5. In general, for a one year discount bond, the yield to maturity can be written as Assumes re-investing in another T-bill with the same term to maturity (until get 1 year) with the same P&F In other words, the yield to maturity equals the increase in price over the year, F-P, 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 price. Three 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 less b. If i > c then P < F. Priced at a discount. c. If i < c then P > F. Priced 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 i=C/P provides an approximation of the yield to maturity 2 When n is large and/or P is close to F the approximation is better (closer) The current yield is negatively related to P The current yield & yield to maturity always move together The distinction between interest rates and returns Rate of return- defined as the payments to the owner plus the change in value, expressed as a fraction of its purchase price The return on a bond will not necessarily equal the yield to maturity on that bond Rate of Capital Gain The only bond whose return equals the initial yield to maturity is the one whose time to maturity is the same as the holding period 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 the holding period The more distant a bonds maturity, the greater the size of the percentage price change associated with an interest-rate change The more distant a bonds maturity, the lower the rate of return that occurs as a result of the increase in the interest rate Even though a bond has a substantial initial interest rate, its return can turn out to be negative if interest rates rise People are often puzzled by the fact that a rise in interest rates can mean that a bond has been a poor investment, it is important to recognize that a rise in the interest rate means the bond price has fallen & hence a capital loss, which can be significant enough to make a bond a poor investment If the investor does not sell the bond, his capital loss would not be realized and is often referred to as a paper loss: this is a loss nonetheless because if he had not bought this bond & had instead put this money in the bank, he would now be able to buy more bonds at their lower price than they presently own The distinction between real and nominal interest rates Nominal interest rate-interest rate that makes no allowance for inflation 3 Real Interest Rate- adjusted by subtracting expected changes in the price level so that it more accurately reflects the true cost of borrowing (ex ante real interest rate) The real interest rate is more accurately defined by the Fisher Equation When the real interest rate is low, there are greater incentives to borrow and fewer incentives to lend Formerly, real interest rates in Canada were not observable; only nominal rates were reported. This all changed on December 10, 1991, when the government of Canada began to issue indexed bonds, whose interest and principal payments are adjusted for changes in the price level Chapter 5-The Behaviour of Interest Rates Goals of this Chapter 1. Describe how the demand and supply analysis for bonds provides one theory of how nominal interest rates are determined 2. Explain how the demand and supply analysis for money, known as the liquidity preference framework, provides an alternative theory of interest-rate determination 3. Outline the factors that cause interest rates to change 4. Characterize the effects of monetary policy on interest rates: the liquidity effect, the income effect, the price-level effect, and the expected-inflation effect Buying depends on four factors Wealth-the total resources owned by the individual, including all assets Expected Return- (the return expected over the next period) on one asset relative to alternative assets Risk (the degree of uncertainty associated with the return) on one asset relative to alternative assets Liquidity (the ease and speed with which an asset can be turned into cash) relative to alternative assets Theory of Asset Demand 1. The quantity demanded of an assert is positively related to wealth (Right Shift) 2. The quantity demanded of an asset is positively related to its expected return relative to alternative assets (Left Shift for Expected Interest Rate and Expected Inflation) 3. The quantity demanded of an asset is negatively related to the risk of its returns relative to alternative assets (Left Shift for an increase) 4. The quantity demanded of an asset is positively related to its liquidity relative to alternative assets (Right shift to an increase) Bond Demand Curve Bond demand curve the relationship between the quantity demanded and the price when all other economic variables are held constant 4
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