1、Banking and FinanceReview pt.2Return on a bond Total earnings from the bond For one year = coupon + capital gain or coupon capital loss Expressed as a percentage by dividing by initial price paid Example: A bond with a $1,000 face value and a coupon rate of 8%. If the end-of-year price is $1,271.81,

2、 then, the rate of return for the year is: If the end-of-year price is $812.61, then, the rate of return for the year is:Coupon + capital gain = 80 + 271.8 = 0.352 = 35.2% Purchase price 1,000 80- 187.30 = -0.107 = -10.7% 1000 What is the return on a 5 percent coupon bond that initially sells for $1

3、,000 and sells for $900 next year? a) 5 percent b) 10 percent c) -5 percent d) -10 percent e) None of the aboveCurrent YieldThe current yield is the annual return on the dollar amount paid for a bond The current yield is how much a debt instrument is making for an investor in interest. Annual intere

4、st (coupon) payment current priceWhen a bond sells at par, the current yield will equal the coupon rate of the bond. When the bond sells for: a premium the current yield will be lower than the coupon a discount the current yield will be higher than the coupon Current yield does not account for capit

5、al gains or losses on bonds bought at prices other than par value. It also does not account for reinvestment e on coupon payments. Whats the current yield on a $ 1000 face value bond with a 5% coupon selling for $960 5.21% Which of the following are true for the current yield? a) The current yield i

6、s defined as the yearly coupon payment divided by the price of the security. b) The formula for the current yield is identical to the formula describing the yield to maturity for a discount bond. c) The current yield is always a poor approximation for the yield to maturity. d) All of the above are t

7、rue. e) Only (a) and (b) of the above are true. For a bond selling for $4000, with a par value of $5000 and a coupon rate of 10 percent, the current yield is 5 percent. 10 percent. 12.5 percent. 20 percent. 25 percent.Yield to Maturity Tells you the total return you will receive if you hold a bond u

8、ntil maturity The yield to maturity equals the coupon rate ONLY when the bond price equals the face value of the bond. When the bond price is less than the face value (the bond sells at a discount), the yield to maturity is greater than the coupon rate. When the bond price is greater than the face v

9、alue (the bond sells at a premium), the yield to maturity is less than the coupon rate. The yield to maturity is inversely related to the bond price. Yield to maturity assumes the bond is held until maturity and that all coupon e can be reinvested at a rate equal to the yield to maturity.Discount Bo

10、nds What is the coupon rate for a discount bond? A one-year discount bond that sells for price P with face value FV. The yield to maturity is: i = FV-P P Consider a coupon bond with i = 6%, FV = $1,000, n = 5 years. The price of the bond (P) is the sum of the present values of 6 payments: For a bond

11、 that makes coupon payments (C) and matures in n years:Bond Prices and Yield to MaturityWhat is the Yield to Maturity for the following?A) A discount bond with a price of $9,000, which has a face value of $10,000 and matures in 1 year.B) A corporate bond with a face value of $1,000, a price of $975,

12、 a coupon rate of 10%, and a maturity of 5 years.Bond Rates and Yields Suppose a bond currently sells for $932.90. It pays an annual coupon of $70, and it matures in 9 years. It has a face value of $1000. What are its: coupon rate current yield yield to maturity (YTM)?1.The coupon rate (or just “cou

13、pon”) is the annual dollar coupon expressed as a percentage of the face value: Coupon rate = $70 /$1000_ = 7%2.The current yield is the annual coupon divided by the current market price of the bond: Current yield = $70 /932.90= 7.5%Under what conditions will the coupon rate and current yield be the

14、same? The Yield to maturity = 932.90 = 70 + 70 + 70 70 + 1000 (1+i) (1+i) (1+i) (1+i) (1+i) inflation Fisher Equation Nominal interest rate = real interest rate + inflation Real interest rate are interest rates that are adjusted for changes in purchasing power.Who benefits from inflation? Assume tha

15、t banks lend billions of dollars at a fixed nominal interest rate of 5%. If inflation were to unexpectedly increase from 2% to 4%, then borrowers real interest rate paid would be reduced from 3% to 1% If you expect the inflation rate to be 15 percent next year and a one-year bond has a yield to matu

16、rity of 7 percent, then the real interest rate on this bond is 7 percent. 22 percent. -15 percent. -8 percent. none of the above. If the nominal rate of interest is 2 percent, and prices are expected to fall (negative inflation) by 10 percent, the real rate of interest is 2 percent. 8 percent. 10 pe

17、rcent. 12 percent. -8 percent. In which of the following situations would you prefer to be the lender? The interest rate is 9 percent and the expected inflation rate is 7 percent. The interest rate is 4 percent and the expected inflation rate is 1 percent. The interest rate is 13 percent and the exp

18、ected inflation rate is 15 percent. The interest rate is 25 percent and the expected inflation rate is 50 percent. In which of the following situations would you prefer to be borrowing? The interest rate is 9 percent and the expected inflation rate is 7 percent. The interest rate is 4 percent and th

19、e expected inflation rate is 1 percent. The interest rate is 13 percent and the expected inflation rate is 15 percent. The interest rate is 25 percent and the expected inflation rate is 50 percent.What Do People Do With Their Savings in the US?The financial system matches savers and borrowers throug

20、h two channels: Banks and other financial intermediaries Financial marketsFinancial markets and financial intermediaries facilitate two types of flow of funds:Indirect Finance Funds flow from lenders to borrowers indirectly through financial intermediaries, such as banks.Direct Finance Funds flow di

21、rectly from savers to borrowers.Financial InstitutionsThe most important financial intermediaries are commercial banks.Commercial banks take in deposits and use them to make loans. Name some other financial intermediaries.A financial intermediary is a financial firm that borrows funds from savers an

22、d lends them to borrowers.Nonbank Financial Intermediaries Insurance companies Pension funds Investment Bankssavings banks, and credit unions are nonbank financial intermediaries that also take in deposits and make loans, but they are legally distinct from banks. Mutual fundsA mutual fund obtains mo

23、ney by selling shares to investors and invests the money in a portfolio of financial assets.BarterThere are four main sources of inefficiency in a barter economy:1. There must be a double coincidence of wants. The time and effort spent searching for trading partners in a barter economy increases the

24、 transactions costs.Each good has many prices.When there are N items: Number of prices = N(N 1)/2.3. There is a lack of standardization.4. It is difficult to accumulate wealth.Money What is commodity money? How does it differ from fiat money? What are the four main functions of money? Describe each

25、function.Money serves four key functions in the economy. What are they?Medium of exchange Something that is generally accepted as payment for goods and services; a function of money.Unit of account A way of measuring value in an economy in terms of money; a function of money.Store of value The accum

26、ulation of wealth by holding dollars or other assets that can be used to buy goods and services in the future; a function of money.Money can facilitate exchange not only at a point in time, but also over time, as a standard of deferred payment.What is Fiat Money? Why is it acceptable?Fiat money - Mo

27、ney, such as paper currency, that has no value apart from its use as money.The federal government has designated paper currency to be legal tender, which means the government accepts paper currency in payment of taxes and requires that individuals and firms accept it in payment of debts.Our societys

28、 willingness to use pieces of paper issued as money makes them an acceptable medium of exchange. When an economist states that barter is impossible, she doesnt really mean that barter is impossible. Her real meaning is that a) barter transactions are relatively costly. b) barter has no useful place

29、in todays world. c) it is impossible for barter transactions to leave parties to an exchange better off. d) barter is illegal. e) each of the above is true. The problem of the double coincidence of wants can be avoided if a) trade is organized in a central market. b) money is used to facilitate exch

30、anges. c) barter trades are encouraged. d) both (a) and (b) of the above. Most Financial Transactions Involve Payments in the FutureThe importance of the interest rate comes from the fact that most financial transactions involve payments in the future.The interest rate provides a link between the fi

31、nancial present and the financial future.Compounding and DiscountingFuture value is the value at some future time of an investment made today.Compounding is the process of earning interest on interest, as savings accumulate over time.The future value of an investment (principal) in one year (FV1) wi

32、th an interest rate i:If you invest the principal for n years, then you will have at the end of n years:Present value is the value today of funds that will be received in the future.Funds in the future are worth less than funds in the present, so they have to be reduced, or discounted, to find their

33、 present value.Discounting is the process of finding the present value of funds that will be received in the future (i.e., the opposite of compounding).Some Important Points about Discounting1. Present value is also known as “present discounted value.”2. The further in the future a payment is to be

34、received, the smaller its present value.3. The higher the interest rate used to discount future payments, the smaller the present value of the payments .4. The present value of a series of future payment is simply the sum of the discounted value of each individual payment. What is the present value

35、of $1,000 to be received it 4 years. Interest rate is 5% 1000 = $822.70 (1 + 0.05) If you invest $2,000 at 8% interest how much will you have in 4 years if interest is compounded annually? 2000 x (1+.08) $2,720.98The following data are the additional earningsof college graduates over high school gra

36、duates by age: Age 22: $7,200Age 23: $7,200Age 24: $7,300Age 25: $7,300 What is the present value of a college education from ages 22 to 25? Assume an interest rate of 5%.With an interest rate of 5 percent, the present value of $100 next year is approximatelya) $100.b) $105.c) $95.d) $90.A credit ma

37、rket instrument that pays the owner a fixed coupon payment every year until the maturity date and then repays the face value is called aa) simple loan.b) fixed-payment loan.c) coupon bond.d) discount bond.A bond that is bought at a price below its face value and the face value is repaid at a maturit

38、y date is called asimple loan.fixed-payment loan.coupon bond.discount bond.Which of the following are true for a coupon bond?When the coupon bond is priced at its face value, the yield to maturity equals the coupon rate.a) The price of a coupon bond and the yield to maturity are positively related.b

39、) The yield to maturity is greater than the coupon rate when the bond price is above the par value.c) All of the above are true.d) Only (a) and (b) of the above are true.Which of the following $1,000 face-value securities has the highest yield to maturity?a) A 5 percent coupon bond with a price of $

40、600b) A 5 percent coupon bond with a price of $800c) A 5 percent coupon bond with a price of $1,000d) A 5 percent coupon bond with a price of $1,200e) A 5 percent coupon bond with a price of $1,500Which of the following $1,000 face-value securities has the lowest yield to maturity?a) A 15 percent co

41、upon bond with a price of $600b) 15 percent coupon bond with a price of $800c) A 15 percent coupon bond with a price of $1,000d) 15 percent coupon bond with a price of $1,200e) 15 percent coupon bond with a price of $1,5001. Wealth2. Expected return on bonds3. Risk4. Liquidity5. Information costsWhat effect do the following have on the demand for bonds AND interest r