Chapter 10

Question 1

Four types of credit market instruments

1. 2. A

4.​

Answer 1

Four types of credit market instruments

1. Simple loan: The lender provides the borrower with an amount of funds (principal) that must be repaid to the lender at the maturity date, along with an additional payment for the interest.
2. A fixed-payment loan (fully amortized loan): the lender provides the borrower with an amount of funds that the borrower must repay by making the same payment, consisting of part of the principal and interest, every period for a set number of years.
3. Coupon bond: pays the owner of the bond a fixed-interest payment every year until the maturity date, then the face value/par value is repaid.

• Face value
• Corporation or government agency that issues the bond;
• Maturity date of the bond;
• Bond’s coupon rate: the dollar amount of the yearly coupon payment expressed as a percentage of the face value of the bond

4.​Discount bond (zero-coupon bond): is bought at a price below its face value (at a discount), and the face value is repaid at the maturity date. Example: Canadian government treasury bills and long-term zero-coupon bonds.

Question 2

Yield to maturity to measure interest rates

• 1. Yield to maturity (internal rate of return):
• 2. For simple loans,
• 3.
• 4. Coupon bond:
• 5. Yield to maturity and bond price for a coupon bond:
• a. When the coupon bond is priced at its face value, the yield to maturity
• b. The price of a coupon bond and the yield to maturity are …; that is …
• c. The yield to maturity is greater than the coupon rate when …
• 6. Consol (perpetuity): …
• 7. Discount bond: ….

Answer 2

Yield to maturity to measure interest rates​

• 1. Yield to maturity (internal rate of return): the interest rate that equates the present value of cash flow payments received from a debt instrument with its value today.
• 2. For simple loans, the simple interest rate equals the yield to maturity.
• 3. Fixed-payment loan
• 4. Coupon bond: equate today’s value of the bond with its present value.
• 5. Yield to maturity and bond price for a coupon bond:
• a. When the coupon bond is priced at its face value, the yield to maturity equals the coupon rate;
• b. The price of a coupon bond and the yield to maturity are negatively related; that is the yield to maturity rises, the price of the bond falls. The yield to maturity falls, the price of the bond rises.
• c. The yield to maturity is greater than the coupon rate when the bond price is below its face value and is less than the coupon rate when the bond price is above its face value
• 6. Consol (perpetuity): a perpetual bond with no maturity date and no repayment of principal that makes fixed coupon payments of $C forever. P=C/i
• 7. Discount bond: for a discount bond, the yield to maturity is negatively related to the current bond price.

Question 3

Bond returns

Current bond prices and interest rates are …: When the interest rate …, the price of the …, and vice versa.

A rate of return (RoR) is …

Return on a bond will not …

• A. …
• B. A….
• C. T…
• D. ….
• E. ….

Answer 3

Bond returns

Current bond prices and interest rates are negatively related: When the interest rate rises, the price of the bond falls, and vice versa.

A rate of return (RoR) is the net gain or loss on an investment over a specified time period, expressed as a percentage of the investment’s initial cost.

Return on a bond will not necessarily equal the yield to maturity on that bond.

• A. The only bonds whose returns will equal their initial yields to maturity are those whose times to maturity are the same as their holding periods;
• B. A rise in interest rate is associated with a fall in bond prices, resulting in capital losses on bonds whose terms to maturity are longer than their holding periods.
• C. The more distant a bond’s maturity date, the greater the size of the percentage price change associated with an interest rate change;
• D. The more distant a bond’s maturity date, the lower the rate of return that occurs as a result of an increase in the interest rate;
• E. Even though a bond may have a substantial initial interest rate, its return can turn out to be negative if interest rate rise.

Question 4

Real and Nominal Interest Rates:

• Nominal interest rate:
• Real interest rate
  
  • *
• The real interest rate is a better
  
  • When the real interest rate is low,
• Fisher equation
  
• Indexed bonds

Answer 4

eal and Nominal Interest Rates:

• Nominal interest rate: makes no allowance for inflation
• Real interest rate is adjusted for changes in the price level (inflation) so that it
  more accurately reflects the cost of borrowing
  
  • Ex ante real interest rate is adjusted for expected changes in the price level
  • Ex post real interest rate is adjusted for actual changes in the price level
• The real interest rate is a better indicator of the incentives to borrow or lend
  
  • When the real interest rate is low, there are greater incentives to borrow
    and fewer incentives to lend
• Fisher equation
  
  • The nominal interest rate i equals the real interest rate Ir plus the expected
    rate of inflation π^e
  • I=Ir + π^e
• Indexed bonds
  
  • Bonds whose interest and principal payments are adjusted for changes in
    the price level (i.e., indexed to the Consumer Price Index)