ECO 3223 EVANS FA 2014 STUDY GUIDE FOR FINAL EXAM 1 CHAPTER 4 UNDERSTANDING INTEREST RATES For the exam you need to know how to calculate a Simple and compound interest single period and multiple periods Simple Interest p i n where p principal original amount borrowed or loaned i interest rate for one period n number of periods b c d Simple future present value single period Future Present value multiple periods PV multiple periods coupon bond P C 1 i 1 Face Value 1 i 3 Simple PV C 1 i Discount Bond Yield to Maturity YTM FV Pt Pt Discount Bond A discount bond pays no interest payments It is bought at a price below face value at a discount and the face value is repaid at the maturity date Ex A one year discount bond with a face value of 1000 might be bought for 900 in a year s time the owner would be repaid the face value of 1000 Return Which portion of this formula gives us the capital gain Return C Pt P2 P1 P1 note the first portion of the equation C Pt gives you your current yield 2 Be able to explain why bond prices and interest rates are inversely related Bond prices and interest rates are inversely related due to supply and demand If you were to buy a bond yielding 4 with a maturity of one year and interest rates rise giving newly issued bonds a yield of 12 the 4 yield would no longer be attractive For it remain in demand the price of the 4 bond would drop to whatever price that would match a 12 yield Therefore as interest rates rise bond prices fall to where demand takes them and vice versa Why will rising interest rates make prices for previously issued bonds fall What will happen to 3 the true yield on a bond if its selling price falls rises Ret C Pt P2 P1 P1 As explained in the last question the rising interest makes prices for previously issued bonds fall because of increased demand for the higher yield The interest rate on a bond will increase if its selling price falls 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 Real interest rate is the interest rate that is adjusted by subtracting expected changes in the price level inflation so that it more accurately reflects the true cost of borrowing Nominal interest rate does not allow for inflation Real interest rate is the better measure of the true cost of borrowing or return from lending because it is adjusted for expected changes in the price level The real interest rate is also a more accurate indication of the tightness of credit market conditions CHAPTER 5 THE BEHAVIOR OF INTEREST RATES 1 According to the Theory of Asset Demand what factors will shift the Demand Curve for bonds 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 Pg 99 Table 2 1 Wealth in an expansion with growing wealth the demand curve for bonds shifts to the right 2 Expected Returns higher expected interest rates in the future lower the expected return for long term bonds shifting the demand curve to the left 3 Expected Inflation an increase in the expected rate of inflations lowers the expected return for bonds causing the demand curve to shift to the left 4 Risk an increase in the riskiness of bonds causes the demand curve to shift to the left 5 Liquidity increased liquidity of bonds results in the demand curve shifting right 2 What is the impact upon bond prices and interest rates of a an increase in expected inflation Supply curve shifts Demand curve shifts Bond price drops Interest rates increase b a business cycle expansion Bond price drops inters rates increase c a business cycle contraction Bond price increases interest decreases CHAPTER 6 THE RISK AND TERM STRUCTURE OF INTEREST RATES 1 Be able to calculate tax equivalent yield on a municipal bond 2 Tax equivalent yield Tax free yield 1 your federal tax bracket Suppose the yield on a taxable fund is 1 50 percent while the yield on a tax free fund is 1 percent Your federal tax bracket is 28 percent 1 0 30 0 70 1 0 70 1 43 Tax equivalent yield is 1 43 percent the taxable fund at 1 50 percent would be the better deal 2 How do default risk liquidity and income tax considerations affect bond prices and interest rates on bonds 1 The greater a bond s default risk the higher its interest rate relative to other bonds 2 The greater a bond s liquidity the lower its interest rate 3 Bonds with tax exempt status will have lower interest rates then they otherwise would 3 What theory best explains why yield curves are generally upward sloping Liquidity premium the theory that the interest rates on a long term bond will equal an average of the short term interest rates expected to occur over the life of the long term bond plus a positive term liquidity premium Be able to interpret the various yield curve shapes visually and discuss their macroeconomic implications CHAPTER 7 THE STOCK MARKET 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 The Gordon Growth Model page 150 is useful for finding the value of stock give a few assumptions 1 Dividends are assumed to continue growing at a constant rate forever 2 The growth rate is assumed to be less than the required return on equity D1 ke g The perceived risk of holding stock is negatively positively related to stock price Positively What is the effect of expansionary and contractionary monetary policy upon stock prices Expansionary increase stock price Contraction lower stock price CHAPTER 14 THE MONEY SUPPLY PROCESS 3 4 1 2 3 1 2 3 4 5 What is the monetary base What is the money supply The monetary base is the currency in circulation plus the total reserves in banking system Referred to as MB C R It is called high powered money because an increase in the monetary base can create a stronger increase in the money supply through the money multiplier What is the effect on the monetary base of an Open Market Purchase Open Market Sale Page 348 351 Open Market Purchase increases the monetary base The Fed uses cash to pay for bonds they buy and that money gets deposited by banks to the Fed as reserves thus increasing the monetary base An Open