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chapter 4 money and banking

Terms in this set (20)

cash flows
streams of cash payments
present value (present discounted value)
a dollar paid to you one year from now is less valuable than a dollar paid to you today
simple loan
lender provides borrower with an amount of funds (principal) that must be repaid to lender at the maturity date, along with an additional payment for the interest

100 x ( 1 + i ) ^ n
yield to maturity
interest rate that equates the present value of cash flow payments received from a debt instrument with its value today

*** for simple interest loans, the simple interest rate equals the yield to maturity
simple present value
PV = CF/(1+i)^n
Four types of credit market instruments
simple loan, fixed-payment loan, coupon bond, & discount bond
fixed-payment loan (fully amortized loan)
lender provides 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 (such as a month) for a set number of years

LV= loan value
i= annual interest rate
n= number of years

LV= FP/ (1+i) + FP/ (1+i)^2 +...+ FP/(1+i)^n
coupon bond
pays the owner of the bond a fixed interest payment (coupon payment) every year until the maturity date, when a specified final amount (face value or par value) is repaid
coupon rate
dollar amount of the yearly coupon payment expresses as a percentage of the face value of the bond

P= price of the coupon bond
C= yearly coupon payment
F= face value of the bond
n= years to maturity date

P= C/ (1+i) + C/ (1+i)^2 +...+ C/ (1+i)^n + F/ (1+i)^n
Coupon bond facts
1. coupon bond priced at face value, YTM equals the coupon rate

2. price of coupon bond and YTM are negatively related

3. YTM is greater than the coupon rate when bond price is below its face value and is less than the coupon rate when the bond price is above its face value

YTM =CR, PV =FV
YTM> CR, PV < FV
YTM< CR, PV> FV
Consol or Perpetuity
special case of coupon bond, perpetual bond with no maturity date and no repayment of principal that makes fixed coupon payments $C forever.

Pc = price of the perpetuity (consol)
C = yearly payment
ic = yield to maturity of perpetuity (consol)

Pc = C/ ic or ic = C/ Pc
current yield
the yearly coupon payment divided by the price of the security, frequently used as an approximation to describe interest rates on long-term bonds
discount bond (zero-coupon bond)
bought at a price below its face value at a discount, and the face value is repaid at the maturity date. Does NOT make any interest payments, it just pays off the face value.

PV = CF/ (1+i)^n

***1 year discount bond:

F= face value of the discount bond
P= current price of the discount bond

i= F-P/P

***current bond prices and interest rates are negatively related: when the interest rate rises, the price of the bond falls, and vice versa.
return or rate of return
the amount of each payment to the owner plus the change in the security's value, expressed as a fraction of its purchase price

***the return on a bond will not necessarily equal the yield to maturity on that bond

R= return form holding the bond from time t to time t+1
Pt= price of the bond at time t
Pt+1= price of the bond at time t+1
C= coupon payment

R= C + Pt+1 - Pt/ Pt

note: C/Pt = ic
rate of capital gain
change in the bond's price relative to initial purchase price (g)

note: Pt+1 -Pt/ Pt = g

Therefore: R= ic + g

*** prices and returns for long-term bonds are more volatile than those for shorter-term bonds
interest-rate risk
can be quantitatively measured using the concept of duration.
nominal interest rate
interest rate that makes no allowance for inflation
real interest rate
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.

-referred to as ex ante real interest rate because it is adjusted for expected changes in the price level
ex post real interest rate
interest rate that is adjusted for actual changes in the price level, describes how well a lender has done in real terms after the fact.

r= i - (pi symbol)^e --- Fisher Equation

i= nominal interest rate
(pi symbol)^e = expected interest rate
real terms
terms of real goods and services you can buy

*** when the real interest rate is low, there are greater incentives to borrow and fewer incentives to lend
THIS SET IS OFTEN IN FOLDERS WITH...