ECO 3223 EVANS FA 2014 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 identify and understand the concepts that might be used for the exam questions CHAPTER 4 UNDERSTANDING INTEREST RATES 1 Simple and compound interest single period and multiple periods For the exam you need to know how to calculate a Simple interest rate Interest Payment Amount of loan Ex you make Jane a 1 year loan for 100 and require her to repay loan in 1 yr with an additional 10 payment for interest 10 100 10 Compound interest rate 100 x 1 i n Simple future present value single period Future Present value multiple periods b Simple Present single period PV CF cash flow 1 i n Simple Future single period FV P principle 1 i n Simple PV mult periods P C 1 i n Discount Bond Yield to Maturity Ex on pg 76 Return Which portion of this formula gives us the capital gain c i F face value P current price of discount bond P d R c coupon payment Pt price of bond at time t Pt 1 Pt Pt Pt 1 Pt Pt g Gives us the capital gain and can be rewritten as R ic g which shows how the return on a bond is the current yield ic plus the rate of capital gain g Be able to explain why bond prices and interest rates are inversely related Bond prices and interest rates are inversely related due opportunity cost As market interest rates change a bond s coupon rate which remember is fixed becomes more or less attractive to investors who are therefore willing to pay more or less for the bond itself 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 To see what happens when interest rates rise on a previously issued bond Let s suppose that later that year interest rates in general go up If new bonds costing 1 000 are paying an 8 coupon 80 a year in interest buyers will be reluctant to pay you face value 1 000 for your 7 ABC bond In order to sell you d have to offer your bond at a lower price a discount that would enable it to generate approximately 8 to the new owner In this case that would mean a price of about 875 1 If the selling price of bond falls the true yield to maturity 2 3 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 The theory of asset demand Factors that will shift the demand curve for bonds 1 Wealth the total resources owned by the individual including all assets Increase in wealth raises the quantity demanded shifts the demand curve Q demanded right 2 Expected Interest rate Expected inflation higher expected interest rate lowers the quantity demanded shifts the curve to the left 3 Risk the degree of uncertainty associated with the return on one asset relative to alternative assets If an assets risk rises relative to that of alternative assets its quantity demanded will fall shifting the curve left 4 Liquidity the ease and speed with which an asset can be turned into cash relative to alternative assets The more liquid an asset is relative to the alternative assets the more desirable it is and raises the quantity demanded shifting curve right 3 factors that will shift the Supply Curve for bonds and in which direction with an increase decrease 1 Expected profitability of investment opportunities in an expansion the supply curve shifts to the right 2 Expected inflation an increase in expected inflation shifts the supply curve for bonds to the right 3 Government budget increased budget deficits shift the supply curve to the right 4 the impact upon bond prices and interest rates of any shift in Demand or Supply especially 2 a an increase in expected inflation interest rates rise bond prices fall a business cycle expansion interest rates tend to rise during expansion bond prices rise as demand rises a b a business cycle contraction opposite of expansionary 5 factors that determine and shift the supply and demand for money what is meant by stating that the interest rate is the opportunity cost of holding money Liquidity Preference Framework determines the equilibrium interest rate in terms of the supply of and demand of money Aside from this framework interest rates and inflation as well as prices affect the supply and demand of money The interest rate is the opportunity cost of holding money because depending upon the interest rate you will be sacrificing that rate expected return by not holding an alternative asset By holding your money your loosing out on the opportunity of benefiting from whatever the interest rate may be if its increasing This explains how the quantity of money demanded and the interest rate should be negatively related As interest rate on bonds opportunity cost of holding money quantity of money demanded declines CHAPTER 6 THE RISK AND TERM STRUCTURE OF INTEREST RATES 1 Be able to calculate tax equivalent yield on a municipal bond Tax Equivalent Yield TEY TEYM CM 1 t CM coupon rate on municipal bond t federal income tax rate 2 How do default risk liquidity and income tax considerations affect bond prices and interest rates on bonds As a bonds default risk increases the risk premium on that bond the spread between its interest rate and the interest rate on a default free Treasury Bond rises The greater liquidity of Treasury bonds also explains why there interest rates are lower than those on less liquid bonds If a bond has a favorable tax treatment as do municipal bonds whose interest payments