Present Value and Bond Pricing 4 questions Present Value or Present Discounted Value Based on the ideal that a dollar today is worth more than a dollar in one year This is due to interest i PMT PV Interest Rate for a Simple Loan PV FV 1 i n Coupon Bond Fixed interest payment every pay period until maturity date then Par Value is paid Discount Bond Yield to Maturity YTM interest rates Bond bought at less than par Par paid at maturity Makes no interest payments The interest rate that equates present value of cash flows to Simple Loans YTM Interest Rate Fixed Payment Loan YTM i for PV PMT 1 i n Coupon Bond YTM i for Face Value PMT 1 i n When coupon bond in priced at face value the YTM YTM and price are negatively related one up one YTM coupon rate if price face value Consol Bond YTM i for P PMT i Discount Bond YTM i for i FV PV PV Current prices and interest rates are negatively related one up coupon rate down one down Rate of Return R The gain of owning a bond R PMT P1 P0 P0 Current Yield ic gain of returns ic PMT P0 Rate of Capital Gain g gain on capital gains g P1 P0 P0 R ic g Bond Supply and Demand 3 Questions Wealth total resources owned by an individual including all assets A rise in wealth raises demand of an asset Shifts demand curve right Recession will shift demand curve left Expected Return the return expected over the next period on one asset relative to alternative assets A rise in expected return raises demand of an asset Rise in expected interest rates decrease demand Demand curve shifts left Rise in expected inflation decreases demand Demand curve shifts left Risk the degree of uncertainty associated with the return on one asset relative to alternative assets A rise in risk of an asset lowers demand of an asset A rise in riskiness of bonds lowers demand Demand curve shifts left A rise in riskiness of another asset raises bond demand Demand curve shifts right Liquidity the ease and speed with which an asset can be turned into cash relative to alternative assets A rise in liquidity raises the demand of an asset Trading in the bond market raises bond liquidity Raises demand Curve shifts right Equilibrium Market Clearing is found at Bd Bs P and i denote equilibrium price and interest rate Expected Profitability of Investment Opportunities Business cycle expansion occurs so borrowers are more likely to borrow for investments meaning suppliers will want to supply more bonds Supply curve shifts left Recession will cause supply to fall Supply curve shifts right Expected Inflation An increase in expected inflation causes the supply to increase borrowing Curve shifts right Expected inflation rising will lower the real cost of Government Budget Deficits Higher deficits increase the supply of bonds Treasury will issue more bonds in a deficit Liquidity Preference Framework Compares the money market and the bond market to find supply and demand of both other is too rise BS MS BD MD or BS BD MD MS This shows that if one market is in equilibrium then the At a higher level of wealth the demand for money increases MD curve shifts right As wealth is rises during cycle expansion interest rates As price levels raise the demand for money increases MD curve shifts right As price levels rise interest rates will rise When Fed increases the money supply the supply increases MS curve shifts right As the money supply increases interest rates decline Term Structure 4 Questions Risk Structure of Interest Rates Relationship between bonds with the same term of maturity the different terms of maturity Term Structure of Interest Rates Relationship between bonds with Risk Premium how much additional interest one must earn to be willing to hold riskier bonds iC iT Default Free Bonds Treasury bonds that hold no risk because Fed can always print more money Expectations Theory The interest rate of a long term bond will equal an average of the short term interest rates that people expect to occur of the life of the long term bond Assumption bonds of different maturities are perfect substitutes int it ie t 1 ie t n 1 n where int current interest rate on n year bond it current interest rate on 1 year bond ie maturity period Explains the notion that t 1 expected interest rate on 1 year bond in next Interest rates on bonds with different maturities move together Yield curves tend to have an upward slope when short term interest rates are low and vice versa Segmented Markets Theory markets for different maturity bonds are completely separated and segmented Assumption Bonds of different maturities are not perfect substitutes Investors might be looking for a certain maturity period meaning they will only be interested in certain bonds Explains that yield curves typically slope upwards Short term bonds will have lower interest rates and higher prices than long term bonds Liquidity Premium Theory the interest rate on a long term bond will equal an average of short term interest rates expected to occur over the life of the long term bond plus a liquidity premium that responds to supply and demand conditions for the bond Assumption bonds of different maturities are substitutes while allowing expected returns to influence different bonds and allowing investors to prefer certain maturity terms Investor typically prefer short term bonds hence the liquidity premium being added to the long term interest rate int it ie t 1 ie lnt liquidity premium t n 1 n lnt where Explains that together Interest rates on bonds with different maturities move Yield curves tend to have an upward slope when short term interest rates are low and vice versa Short term bonds will have lower interest rates and higher prices than long term bonds Because of the liquidity premium Financial Instruments and Markets 2 Questions Debt a contractual agreement by the borrower to pay the holder of the instrument fixed dollar amounts interest principal until a specific date maturity date Short term less than 1 year Long term more than 10 years Intermediate term between 1 and 10 years Equity claims to share in net income and assets of a business Dividends periodic payments to equity holders Primary Market financial market in which new issues of a security are sold to initial buyers by the corporation agency borrowing the funds Allow corporations agency s to acquire funds Secondary Market financial market in which securities that have been previously issues are resold Make financial instruments more liquid Exchanges buyers and sellers of securities meet in