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BA 3303- Exam 2 Latest Update
Interest rates - Answer -The cost of borrowing money stated as a percentage of the loan -A measure of what an investor can expect on a debt related investment. Basis point - Answer Common term for a unit of interest rates in finance 1 basis point = .01% 100 basis points = 1.00% Nominal interest rate - Answer Interest rate that is observed in the marketplace Risk free rate - Answer Interest rate on a debt instrument with no default, maturity, or liquidity risks (Treasury securities are the closest example). Basic equation of interest rates: rn = r r + i p + dfp - Answer r n : Nominal Rate of interest r r : Real Rate of interest. Interest rate on a risk-free debt instrument when no inflation is expected i p : Inflation Premium Average inflation rate expected over the life of the security d fp : Default Risk Premium Compensation for the possibility of the borrower's failure to pay interest and/or principal when due Default risk - Answer Risk that a borrower will not pay interest and/or repay the principal on a loan according to the agreed contractual terms nominal interest rate = 7% real rate = 2% inflation premium = 3% What is the default risk premium? - Answer dfp = r n - r r - i p dfp = 7% - 2% - 3% dfp = 2% Interest rate risk - Answer Definition: Possible price fluctuations in fixed-rate debt instruments associated with changes in market interest rates Reason: An inverse relationship exists between debt instrument values or prices and nominal interest rates in the marketplace
Current 5 year US Treasury rates is 4.5%. Annual inflation is 2.5%. Assuming that the default premium is 0, what is the nominal interest rate ( also called market rate)? - Answer 7.0% U.S. Treasury Debt Obligations: Treasury Bills - Answer Obligations that bear the shortest (up to one year) original maturities U.S. Treasury Debt Obligations: Treasury Notes - Answer Obligations issued with maturities of one to ten years U.S. Treasury Debt Obligations: Treasury Bonds - Answer Obligations issued with maturities usually over ten years and up to thirty years What is the "term structure of interest rates"?
What is a "yield curve"? - Answer Term structure: the relationship between interest rates (or yields) and maturities. A graph of the term structure is called the yield curve. Term structure - Answer Relationship between interest rates or yields and the time to maturity for debt instruments of comparable quality. Yield curve - Answer Graphic presentation of the term structure of interest rates at a given point in time. Term Structure Theories: Expectations Theory - Answer Shape of the yield curve indicates investor expectations about future inflation rates Term Structure Theories: Liquidity Preference Theory - Answer Investors are willing to accept lower interest rates on short-term debt securities which provide greater liquidity and less interest rate risk Term Structure Theories: Market Segmentation Theory - Answer Interest rates may differ because securities of different maturities are not perfect substitutes for each other Types of Inflation: Inflation - Answer Occurs when an increase in the price of goods or services is not offset by an increase in quality Types of Inflation: Cost-Push Inflation - Answer Occurs when prices are raised to cover rising production costs, such as wages Types of Inflation: Demand-Pull Inflation - Answer Occurs during economic expansions when demand for goods and services is greater than supply Types of Inflation: Speculative Inflation - Answer Caused by the expectation that prices will continue to rise, resulting in increased buying to avoid even higher future prices Inflation risk - Answer Risk that the rate of inflation will exceed the rate of return of an
Roughly how long will it take $10,000 to double at 8 % interest? time to double = 72/8 = 9 years Annuity due - Answer A series of EQUAL periodic payments that is made at the beginning of each period. Ordinary annuity - Answer Exists when the equal payments occur at the end of each time period (also referred to as a deferred annuity) Amortized Loan - Answer A loan repaid in equal payments over a specified time period Loan Amortization Schedule - Answer A schedule of the breakdown of each payment between interest and principal, as well as the remaining balance after each payment until the loan balance is 0.
When a company wants to raise capital, there are two ways that it can do it... - Answer Equity - Stocks Debt - Bonds
Who buys bonds? - Answer Pension funds Insurance Companies Trust Funds Endowment Funds Conservative Investors Retirees looking for income
Characteristics of a bond - Answer A Fixed Income asset
A "loan" contract between the issuer (borrower) and the investor (lender).
Issuer pays a fixed, periodic interest payment until maturity. Interest payment does not reduce principal.
Principal is paid to investor at maturity.
Maturities can range from 2 to 30 years, but some fixed income investments have maturities of 40 or 50 years others may not have a stated maturity date.
Bondholders can initiate bankruptcy/reorganization threat if contract is violated
Priority claim on assets, cash flow as creditors
Less return potential than equity
Little/no voice in management And... Has lots of cool gadgets!
Who issues bonds? - Answer US Government Treasuries Federal agencies. Example: Federal National Mortgage Association (Fannie Mae)
State and local governments Municipal Bonds for public projects
Corporations
Foreign and emerging market countries.
Maturity date - Answer Date on which the principal invested in bond becomes payable.
Types of Bonds: Junk Bonds - Answer Below investment grade -Industry calls them high yield bonds
Types of Bonds: Municipal Bonds - Answer interest is "tax-free" of Federal Income Taxes
Bond pricing - Answer Basic concept: Price of an asset = Present value of future expected cash flows Prices fall .... As market interest rate rises Interest rate fluctuations are primary source of bond market risk Bonds with longer maturities more sensitive to fluctuations in interest rate
interest rate risk - Answer the concern that interest rates will change, and therefore, a reduction in the value/price of a security.
You were looking a list of bonds available to purchase. If the coupon rate is 5% and the yield to maturity is 8%, the value of the bond should be - Answer Less than the par value of $1,
T/F? Bondholders have priority claims over equity holders to a firm's assets and cash flows. - Answer True
T/F? The claims of collateralized bondholders are junior to the claims of debenture holders. - Answer False
T/F? The higher the discount rate or yield to maturity, the lower the price of a bond. - Answer True
T/F? A bond with a coupon rate of 4% and a discount rate of 6% will pay $60 in interest each year. - Answer False
T/F? A bond will sell at a premium if its required return or discount rate is greater than its coupon rate. - Answer False
All other things being equal, a bond's value will be below its maturity value of $1,000 if it pays interest of $100 per year and investors require a rate of return that is... - Answer Higher than 10%
Most bonds pay coupon interest... - Answer Semi-annually
Which of the following constitute default on a bond? - Answer Nonpayment of par value Nonpayment of coupon Violation of the indenture
A speculative (junk) bond issue as rated under Standard & Poor's would be rated ______ or below: - Answer BB+
An example of asset securitization is - Answer A bond backed by credit card receivables
Which of the following bond types would describe unsecured obligations that depend on the general credit strength of the corporation? - Answer Debenture bonds
When the market interest rate is above the coupon rate for a particular quality of bond, the bond will be priced: - Answer Below its par value
What is the main advantage of owning bonds over stock in a firm? - Answer priority claim on the firm's cash flows and assets
You are considering investing in a bond. You are in the 33% tax bracket. There is a municipal bond paying 4.5% and a corporate bond paying 6.5%. Which of these two bonds would yield the best tax-equivalent yield? - Answer Municipal bond paying 4.5%
