ECO 3223 FA 2015 EVANS STUDY GUIDE FOR FINAL EXAM Note This is intended to direct you to the relevant topics that will be covered on the exam Questions will be worded differently so don t MEMORIZE this content use it to help you understand the concepts CHAPTER 4 UNDERSTANDING INTEREST RATES For the exam you need to know how to calculate 1 Simple and compound interest single period and multiple periods Simple interest interest payment divided by the amount of the loan Simple future present value single period Future Present value multiple a b periods Simple future original x 1 interest rate x of years Compound future original x 1 interest rat e of years Simple present CF 1 i n Discount Bond Yield to Maturity i F P P c d Return Which portion of this formula gives us the capital gain RET R C Pt Rate of capital gain change in the bond s price relative to the initial Pt 1 Pt Pt purchase price o P t 1 Pt Pt 2 3 Be able to explain why bond prices and interest rates are inversely related o current bond prices and interest rates are negatively related when the interest rate rises the price of the bond falls and vice versa Why will rising interest rates make prices for previously issued bonds fall What will happen to the true yield on a bond if its selling price falls rises o prices and returns for long term bonds are more volatile than those for o changes in interest rates lead to capital gains and losses that produce shorter term bonds substantial differences between the return and the yield to maturity known at the time the bond is purchased 1 4 What is the difference between the real interest rate and the nominal rate of interest Which is the better measure of the true cost of borrowing or return from lending and how will this affect the decisions of borrowers and lenders an interest rate that does not take inflation into account o nominal interest rate interest rate adjusted for expected changes in the price level o real interest rate inflation so that it more accurately reflects the true cost of borrowing o often do not move together when U S nominal rates were high in the o when the real interest rate is low greater incentives to borrow and fewer 1970s real rates were actually extremely low often negative incentives to lend CHAPTER 5 THE BEHAVIOR OF INTEREST RATES 1 Curve for bonds According to the Theory of Asset Demand what factors will shift the Demand Make sure you know in which direction an increase decrease will shift the curve How would these shifts affect bond prices and interest rates Know the same for Bond Supply wealth increases quantity demanded increases demand curve for bonds shits to the right expected interest rate higher expected interest rates in the future lower the o wealth decreases quantity demanded decreases curve shifts left expected return for long term bonds expected interest rate increases quantity demanded decreases shifts to the left to the right o expected interest rate decreases quantity demanded increases shifts risk increases quantity demanded decreases demand curve shits to the left liquidity increases quantity demanded increases shifts to the right o risk decreases quantity demanded increases curve shifts right o liquidity decreases quantity demanded decreases shifts to the left expected profitability of investment opportunities 1 in an expansion supply increases curve shifts right 2 recession supply decreases shift to the left expected inflation increases quantity supplied increases shift to right government budget increased budget deficits quantity supplied increases shift curve to the right o surplus quantity supplied decreases shift to left Fischer Effect when expected inflation rises interest rates will When price level increases interest rates will rise rise 2 What is the impact upon bond prices and interest rates of a an increase in expected inflation 2 b a business cycle expansion o When income is rising during business cycle expansion interest rates c a business cycle contraction When money supply increases interest rates will decline will rise CHAPTER 6 THE RISK AND TERM STRUCTURE OF INTEREST RATES 1 2 interest rates on bonds Be able to calculate tax equivalent yield on a municipal bond How do default risk liquidity and income tax considerations affect bond prices and o Default risk influences interest rate occurs when issuer of bond is unable or unwilling to make interest payments when promised or pay off face value when bond matures Default free bonds U S Treasury Bonds o Spread between interest rates on bonds with default risk and default free bonds both some maturity called risk premium indicates how much additional interest people must earn to be willing to hold risky bond o A bond with default risk will always have a positive risk premium and an increase in its default risk will raise risk premium o Liquidity influences interest rate the more liquid the more desirable o Income tax consideration municipal bonds are not default free U S Treasury Bonds are most liquid corporate bonds are not Interest payments on municipal bonds are exempt from federal income taxes a factor that has same effect on demand for municipal bonds as an increase in expected return interest rate lower 3 What theory best explains why yield curves are generally upward sloping o Liquidity premium preferred habitat theory best describes slope Be able to interpret the various yield curve shapes visually and discuss their 4 macroeconomic When yield curves slope upward long term interest rates are above implications short term interest rates Flat short and long term rates are same Inverted downward sloping long term are below short term Extremely upward short term interest rates will rise in future 3 CHAPTER 7 THE STOCK MARKET 1 Understand the Gordon Growth Model and what the variables represent be able to calculate the price of a stock From the resulting price you calculate interpret what the market price is telling you about investors beliefs when compared to the previous price for the stock o Superior information about an asset can increase its value by reducing risk the buyer who has best information about these cash flows will discount them at a lower interest rate than will a buyer who is very uncertain P0 D0 1 g ke g D1 ke g D0 the most recent dividend paid g the expected constant growth rate in dividends ke the required return on an investment in equity Dividends are assumed to continue growing at a constant rate forever The growth rate is assumed to be less